knowing your bonds by reading the yield curve

Yield curves depict how a bond’s yield is related to its maturity. Yield curves based on the US Treasury are published daily in major financial newspapers. Yields on shorter-term bonds, such as 1-month, 3-month, and 6-month Treasuries, are depicted on the left side of the curve. Yields for longer-term bonds, up to the 30-year bellwether Treasury, are on the right side of the curve.

Typically, higher yields are available on longer maturities. This is because investors expect to be compensated for giving up their capital for longer periods of time. On a yield curve, this translates into an upward-sloping line. A “flat” yield curve has only a small spread between the yields available on the shortest and longest securities. As a practical example of a flat yield curve, if the 1-month Treasury yielded 5.00% when the 30-year Treasury was yielding 5.80%, the spread would be just 0.80%, or 80 basis points. Conversely, if the 30-year Treasury was yielding 6.50%, the spread would be 1.50% and the yield curve would be considered “steep”. During times of steep yield curves, investors demand a significantly higher yield on their long-term securities.

Sometimes, however, higher yields are actually available on shorter maturities. This results in a downward-sloping or “inverted” yield curve. Usually inverted yield curves happen when investors believe that interest rates are about to decline. And since interest rates usually decline during recessions, an inverted yield curve can sometimes predict tough economic times ahead. However, the inverted yield curve tends to be somewhat pessimistic: it has predicted nine out of five recessions.

Historically the yield curve has moved all over the place. There have been periods of long bonds yielding much more than short bonds (steep yield curves), to long bonds yielding just a little more than short bonds (flat yield curves), to long bonds actually yielding less than short bonds (inverted yield curves.)

Say you’ve looked at the yield curve and determined that it is upward-sloping; that is, longer-term bonds are yielding more than short-term bonds. Why would you ever buy a lower-yielding short or intermediate-term security under these conditions? The answer is that long-term securities present both greater risks and greater rewards. The primary risk for long-term bond investors is interest rate risk. If interest rates increase, the price of long-term bonds will decline more than the price of short-term bonds will decline. If you need to reclaim your capital before the bond matures, you will need to sell it into the market at a loss. This is a large and misunderstood risk for bond investors, and it is one that the yield curve can help you mitigate.

Shorter-term securities are less susceptible to interest rate risk, but they offer a lower yield. There is no perfect solution; only a tradeoff between security and maximum potential return. The yield curve captures this trade-off clearly, on a daily basis. For example, if 90% 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.

On the other hand, what if you are looking at an inverted yield curve? Why would you buy a longer-term, lower-yielding security rather than a less risky, higher-yielding security? The answer is simple: you will lock in returns for longer. During the 1980’s, interest rates rose to unprecedented highs. Investors who locked in the high yields for long periods of time made a lot more money than those who were forced to reinvest their money at lower interest rates just a year or two later.

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 security and return of your entire portfolio.