A yield curve is a line that is drawn upon by plotting the yield or the interest rate at a given point of time, for the bonds having equal credit rating but different terms of maturity. The typical maturities which are considered for this are 3-month, 2-years, 5-years, and 10-years and 30-years US Treasury. This yield curve which is formed taking into the consideration the interest rates is considered as the benchmark, and hence the other bonds are valued considering this yield curve.
So, through the normal yield curve, it can be very well interpreted that the longer maturity fixed income securities depict higher yield compared to shorter term instruments.
In contrast with this phenomenon, an inverted yield curve is a curve which depicts a totally inverse scenario and describes an interest rate environment where the short-term yields are higher than the long-term yields. For e.g., a short term, i.e., 5 year or 10-year treasury yield is higher than the long term, i.e., 10-year treasury yield. This is usually the scenario when market is expecting economy to be at the tip of recession. The fall in the economic activity & a phenomenon of recession is depicted from such an inverted yield curve.
In such a scenario, investors anticipate interest on the long-term bonds to be lower in the future as compared to the current scenario. This expectation of lower interest rates going forward pushes up the prices of the long-term bonds as the demand for the long-term bond rises in the market in the anticipation of locking in higher yields, which ultimately leads to the falling bond yields.
The flat yield curve explains the transition between normal and inverted yield curve, suggesting bonds with different maturities reflects same yield to market participants.
The humped yield curve depicts higher yield with medium-term bonds as compared to short-term and long-term instruments.
From this, there emerges a strategy which is called as riding the yield curve; this involves buying a bond with a maturity which is longer than the investor’s holding period, with an objective to produce enhanced returns as compared to an investor who buys a bond with a term which equates his investment horizon. Hence this is an active strategy. Thus, in an environment where the bond investors are insensitive to the risk prevailing in the market, the return derived by an investor while buying a bond which has a term to maturity of 3 month shall equate with the return that is derived by an investor who invests in a bond which has a term of 6 months but held for three months and then sold the same at the end of horizon period.
The bond prices are typically very sensitive to the yield that is prevailing in the market. As the market yield falls, the bond prices rise at an increasing rate. However, when the market yield rises, the bond prices fall, but it falls at a much slower rate. This phenomenon is also known as bond convexity. This volatility is on account of the risk which is associated with the time, also known as the maturity risk.
Understanding the concept of yield curve becomes all the more important with inverted yield curve noted in US, anticipating recession for the super powerful economy.
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