What is a Yield Curve and why does it matter?

Those who follow financial news will have likely heard of the yield curve, but for some investors the term can seem bewildering. So, what is a yield curve and why do economists follow it so closely?

Yield and bonds

A good place to start when trying to wrap your head around the concept of a yield curve, is with some basic knowledge of yield and bonds.

In investments, yield refers to how much an investor is being paid from their investments as a percentage of the asset’s current value. While stocks have the dividend yield, the yield curve actually refers to bond yield.

So, what is a bond? A bond is a debt instrument whereby investors can loan money to corporations and governments for the benefit of collecting interest. Think of it as an interest-only loan. When the bond is first issued its price is known as the face value. The annual interest rate paid to investors is fixed and is a percentage of the face value. During the lifetime of a bond, (ie. before its maturity date) bond holders can sell their bond and, depending on demand, the bond’s value can fluctuate. This can impact the yield of a bond. Here’s an example:

Let’s say, Sally has purchased a bond with a face value of $500, an interest rate of 5% and maturity date of 10 years. Therefore, the bond pays Sally $25 each year for the next 10 years. However, two years in, Sally is now looking to sell her bond. If demand for bonds is low, the price of her bond will fall, let’s say it drops to $450. Because the coupon payment (ie. the $25 payment) is fixed the new bond holder would receive a more attractive yield at 5.5%.  The opposite is also true. If demand for bonds is up, then the price of Sally’s bond will increase. If it was sold for $550, the yield would then fall to 4.5%.

To learn more about bonds, check out this helpful article.

What is the yield curve and why does it matter?  

The yield curve is a graphical representation of the yield of bonds from the same issuer or with same level of risk, but over various maturity dates. Any series of bonds can create a yield curve, although the one reported and referred to in local news is based on Australian Government bonds. The yield curve is used by some in the finance industry for its predictive quality; it has historically reflected the market’s sense of the economy. Depending on the shape and severity of the curve, it has been known to predict when the economic outlook is positive and when it’s less so.  

There are three different types of yield curves: normal, flat or inverted.

Normal yield curve

When the yield curve is sloping upwards it is considered normal. A normal yield curve occurs when the yield for short-term bonds is lower than that of longer-term bonds. This is typically the case, as the longer you hold your bond the riskier it can be. Therefore, to compensate, bonds with a longer maturity date generally offer a higher yield. Here’s an example:

Normal

Normal yield curve
Prepared by Canstar. For illustrative purposes only. 

For some investors, a normal yield curve indicates that the economy is generally going well and the future outlook is positive.

Flat yield curve

When the yield curve is flat, the yield for short-term and long-term bonds is roughly the same. This generally occurs when demand for bonds with a longer maturity date is high, pushing the price up. When the price is up, the yield goes down. Here’s an example:

Flat

Prepared by Canstar. For illustrative purposes only. 

This can be a warning sign of economic troubles ahead. A flat yield curve can suggest investors feel there are greater risks elsewhere on the market that outweigh the risks of a long-term bond.

Inverted yield curve

An inverted yield curve occurs when the demand for long-term bonds has increased the price to the point that the yield of short-term bonds is now higher than long-term bonds. For some investors, this is where the alarm bells really start to ring. If investors are rushing into long-term government bonds, it can indicate that concern for the economy is high. Therefore, investors are willing to accept lower returns on long-term bonds to ensure they have a source of interest in the future. Here’s an example:

Inverted

Inverted yield curve
Prepared by Canstar. For illustrative purposes only. 

What does the yield curve mean for investors?

Like the oil light in your car, the yield curve is a good indicator of the market’s view of the near and long term future of the economy. It’s worth keeping an eye on, but doesn’t necessarily lead to specific actions for investors. Instead, what you can do is ensure your investment portfolio is well diversified. This could mean that your investments are spread across different countries, assets and industries. Also worth doing, is to have back-up fund in case the economy does take a downhill slide. Finally, investing should be enjoyable and rewarding, if you’re not finding this to be the case, ensure that your investments match your risk tolerance.

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