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Understanding – and Using - the Yield Curve

Fixed income investors pay significant attention to what is known as the yield curve. This curve is a linear depiction of interest rates, or the yield over varying maturities of specific types of bonds. Maturities are represented on the horizontal axis of the graph and the interest rate for each maturity is plotted on the vertical axis – so connecting the dots creates a line showing market rates.

The chart above – which depicts US Treasury bonds – shows the shape of the yield ascending as the maturities lengthen. This is referred to as a positive, or normal, yield curve. Why normal? This is because long maturities are subject to a greater risk, hence the market demands higher returns.
The yield curve chart also shows us that rates are very low – near zero for very short maturities and only slightly above 4% on the 30 year bond. Low inflation, a slow domestic economy and European economic concerns have conspired to keep demand for US Treasuries high and yields low.
Changes in the Yield Curve
Yield curves are dynamic. So if you plot a yield curve using different dates, the shape of the curves may differ and the magnitude of the interest rates would differ.
For example, the chart below illustrates the yield curve today versus that of ten years ago. Both the magnitude and shape have changed. Yields are significantly lower today, around 4% versus 6%, on long maturities. The yield curve of June 9, 2000 was not only higher but it was a flat curve; rates were virtually the same irrespective of maturities. Such a shape is not “normal.”

Changes in Shape
The slope of the yield curve has been a reasonably accurate leading indicator of economic activity base4d on expectations of the market participants (traders, investors).
A sharply positive yield curve has often preceded a more robust economy. As the economy swells, investors expect that higher inflation and higher interest rates may occur. Such a result would be negative for long-term bond holders, so they demand higher rates on long maturities.
A flat yield curve is a predictor of economic slowdown. Flat yield curves in the early 1990s signaled the recession of 1990-91. The flat curve noted in 2000 preceded the “dot-com” meltdown and lower economic activity shortly thereafter. The Federal Reserve often raises short-term rates in very robust economies to stem rising inflation. This action helps create a flat curve by pushing up short rates toward those of long rates.
An inverted yield curve is definitely not normal. In this case, short-term rates are higher than long-term rates. This is a leading indicator of a coming recession. In the early 1980s, yields were very high, reflective of exceptionally high inflation.

Short-term rates were about 2 points higher than long-term rates. The economy faltered mightily. Eventually inflation was moderated significantly as a result of the recession and other forces. Short-term rates declined and the yield curve turned positive, which was predictive of coming economic expansion.
Comparing Various Types of Bonds
Sometimes it’s important to compare yield curves between two types of bonds – for example, US Treasury vs. corporate bonds. This comparison helps identify risk premiums and relative value and can act as a predictor of future activity.
The third chart, below, shows a comparison of Treasuries to A-rated industrial bonds. In this June 10 example, corporate bonds yielded over 1% more (another 25% higher) than Treasuries on the long end. At 10 years, the spread was particularly attractive.

Changes in the “quality spread” are particularly important. In improving or strong economic times, the quality spread narrows dramatically. A robust economy makes it easier for companies to be profitable. That means credit concerns diminish. Conversely, a slowing economy causes credit concerns to increase. Bond investors sell corporate bonds and seek the safety of Treasury issues. This is referred to as a “flight to quality”. Spreads widen as yields rise on corporate and decline on Treasuries.
Counter-intuitively, one may choose to be the most conservative when spreads become very narrow, i.e., you are not being rewarded for taking more risk. Aggressive investors may find the best rewards occur when all appears darkest, when the economy is lackluster and spreads are widest.
As an identifier of investment opportunities and a predictor of economic trends, these curves are great analytic tools.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.