The yield curve is a simple comparison of short term, mid term and long term bond yields. In other words, the yield curve is a reflection of the collective wisdom of investors on the likely direction of the economy. A bond’s yield is how much it will return to you on an annualized basis from the time you purchase it until it matures. The yield curve will change over time and these changes can be very important indications for what investors think about the market today and what they expect in the future.
A normal yield curve slopes gently upward, reflecting a gradual increase in interest rates as maturities lengthen out. A normal yield curve indicates lower short term yields and a mild increase between mid-term and long-term debt. For example, if 85% of the yield on a 30-year bond is available on a 10-year bond, you will probably be best served by buying the 10-year bond. The yield curve tells you that you will not be adequately compensated for the additional risk inherent in the long-term bond. This is a very common scenario and indicates a normal level of confidence about the future.
An inverted yield curve exists when short term rates are significantly higher than long term rates. That is extremely bearish because it means that investors are expecting yields to drop significantly in the long term and that short term risk is high as well. An inverted yield curve has a striking correlation to bear equity markets.
A flat yield curve indicates also a lack of investor confidence in the future. A flat yield curve exists when the yields on short and long term securities are nearly identical. It is often an early warning sign that the economy is moving into recession. With their inflation fears quelled by the threat of recession, investors will often buy long term bonds to capture higher yields. This causes prices of these bonds to appreciate and their yields to move down closer to short term rates, resulting in a flattened yield curve.
In a steep yield curve environment, yields climb much more rapidly than normal. This type of curve is correlated with rallies in the stock market. This can occur when the economy is starting to pick up speed and investors’ inflation concerns cause them to sell longer term bond, depressing the prices of those bonds and driving their yields higher. As a means of protecting against inflation, investors might consider altering their fixed income portfolio allocations and shifting some of their holdings into securities that are immune to inflation, such as inflation linked bonds that pay a principal at maturity that is adjusted for inflation and they also pay coupons as a percentage of the adjusted principal.
From a portfolio strategy standpoint, investors can look at the yield curve for clues to what direction the market thinks interest rates are headed and determine the best segment of the curve to hold.
In summary, a yield curve shows you how a bond’s yield is related to its maturity. A careful look at the yield curve can help you determine if you are being adequately compensated for the risk you are assuming with your bond portfolio, and thereby increase the return of your entire portfolio.