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 curveYield CurveA yield curve is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis). The slope of the yield curve provides an estimate of expected interest rate fluctuations in the future and the level of economic activity. 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].
#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 a large pension fundLarge Pension FundA pension fund refers to any plan or scheme set up by an employer which generates regular income for employees after their retirement. This pooled contribution from the pension plan is invested conservatively in government securities, blue-chip stocks, and investment-grade bonds to ensure that it generates sufficient returns. 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 liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. 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.
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 an inverted curve means short-term securities have a higher yield.
- Banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. 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.
- 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 the 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 demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices. 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 in 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, the 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 “durationDurationDuration is a risk measure used by market participants to measure the interest rate sensitivity of a debt instrument, e.g. a Bond. It tells how sensitive is a bond with respect to the change in interest rates. This measure can be used for comparing the sensitivities of bonds with different maturities. There are three different ways to arrive duration measures, viz. Macaulay Duration, Modified Duration, and Effective Duration..”
- Duration measures the linear relationship between yield and bond price and is a simple measure for small changes in yield, whereas convexityConvexityConvexity of a bond is a measure that shows the relationship between bond price and yield, and it helps risk management tools to measure and manage a portfolio's exposure to interest rate risk and loss of expectation. measures the non-linear relationship and is more accurate for large changes in yields.
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 detailed explanation. You can learn more about fixed income from the following articles –