What is Normal Yield Curve?
Normal Yield Curve or Positive Yield Curve arise when longer maturity debt instruments offer higher yield as compared to shorter maturity debt instrument carrying similar credit risks and credit quality. The yield curve is positive (upward sloping) because investor demands more money for locking up their money for a higher period.
Graphical Presentation of Normal Yield Curve
The yield curve is created below on a graph by plotting yield on the vertical axis and time to maturity on the horizontal axis. When the curve is normal the highest point is on the right.
Different Theories of Interest Rates
#1 – Expectation Theory
Expectation theory which says that long term interest rates should reflect expected future short-term rates. It argues that forward interest rates corresponding to certain future periods must be equal to future zero interest rates of that period.
If the 1-year rate today is at 1%, and the 2-year rate is 2% then the one-year rate after one year (1yr forward rate) is around 3% [1.02^2/1.01^1].
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#2 – Market Segmentation Theory
There is no relationship between short term, medium-term and long-term interest rates. The interest rate at a particular segment is determined by demand and supply in the bond market of that segment. Under the theory, a major investment such as large pension fund invests in a bond of a certain maturity and does not readily switch from one maturity to another.
#3 – Liquidity Preference Theory
Investor prefers to preserve liquidity and invests funds for a short period of time. On the other hand, Borrowers prefer to borrow at fixed rates for long periods f time. This leads to a situation where the forward rate is greater than the expected future zero rates. This theory is consistent with the empirical result that yield curve tends to be often upward sloping than they are downward sloping.
Changes or Shifts in Normal Yield Curve
- Parallel Shifts – Parallel shift in yield curve occurs if the yields across all the maturity horizon change (increase or decrease) by the same magnitude and similar direction. It represents when a general level of interest rate changes in an economy.
- Non Parallel Shifts – When the yield across different maturity horizon changes at a different level in both magnitude and direction.
Importance
It forecast the future direction of the interest rates:
- The shape of the yield curve gives an indication of the future direction of the interest rate. A normal curve means longer-term securities have a higher yield and inverted curve means short term securities have a higher yield.
- Banks and financial institutions accept deposits from customers and provide loans to corporate or retail clients in exchange for a return. The wider the difference between lending and borrowing rate the greater will be spread. The steeper upward sloping curve will provide higher profits whereas the downward sloping curve will lead to lower profits if the major portion of bank assets are in the form of long-term loans after taking into account short term customer deposits.
- A trade-off between maturity and yield- long term bonds tend to be more volatile than short term bonds and hence offer a greater premium to an investor in the form of higher yield to encourage them to lend.
- It provides an indication to investors whether the security is overpriced or under-priced based on its theoretical value. If the return is above the yield curve security is said to be under-priced and if the return is below the yield curve security is overpriced.
Influence
- Central bank’s target economic growth and inflation rate through changing interest rate level. In order to respond to a rise in inflation central banks increase interest rate levels wherein borrowing becomes expensive and erosion of purchasing power of consumers which further leads to an inverted yield curve.
- Economic growth: strong economic growth provides the varying opportunity for investment and expansion in business which leads to an increase in aggregate demand for capital given limited supply of capital yield curve increases which results in steeping of the yield curve.
Key Points to Remember
- It is an upward sloping normal curve from left to right indicates that yield increases with maturity. It is often observed when the economy is growing at a normal pace without any major interruptions of available credit for e.g. 30-year bonds offer higher interest rates as compared to 10-year bonds.
- An investor investing on longer maturity bonds require higher compensation for taking additional risks as there is a greater probability of occurrence of unexpected negative events in the long term. In other words, longer the maturity, the longer time it will take to get back the principal amount the greater the risks involved higher would be the expected yield which will lead to the upward sloping yield curve.
- The shape of the yield curve determines the current and future strength of the economy. It provides early warning signals on the future direction of the economy. It always changes based on shifts in the general market conditions.
- Every bond portfolio has different exposures to how the yield curve shifts — i.e. yield curve risk. The predicted percentage change in the price of a bond that occurs when yields changes by 1 basis point is captured by an advanced concept called “duration.”
- Duration measures the linear relationship between yield and bond price and is a simple measure for small changes in yield whereas convexity measures the non-linear relationship and is more accurate for large changes in yields.
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This has been a guide to what is a normal yield curve. Here we discuss different theories of interest rate, changes or shift in the normal yield curve, its influence, and importance with a detail explanation. You can learn more about fixed income from the following articles –
