What is Yield Curve on Bonds?
A 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.
Yield Curve Explanation
In general, when you hear market ‘experts’ talk about the yield curve, reference is made to the government bond’s yield curve. Taking about corporate bond yield curves are mentioned specifically. The government issues bonds majorly to finance their budget deficitBudget DeficitBudget Deficit is the shortage of revenue against the expenses. The budgetary deficit could be the sum of deficit from revenue and capital account. . Below is a plot of the Italian and Spanish government bonds’ yield curve, aka sovereign yield curve on the mentioned date. Searching yield curves on the internet isn’t that difficult either.
The government issues bonds of various tenors. Some may be really short term, and some may be really long term. The shortest tenor bonds are generally called T-Bills (where ‘T’ stands for Treasury), which have a maturity lesser than a year. T-Notes are generally those with maturities from 1 year to 10 years (2 years, 5 years, 10 years are some common T-Note issuances). T-Bonds are generally those with the longest maturity but depend on how it is generally classified in a nation. Generally, bonds with maturities greater than 10 years are considered T-Bonds (15 years, 20 years, 30 years, 50 years are some common T-Bond issuances). Sometimes the 10-year bond is also considered to be a T-Bond.
So what is the conclusion? These terms are used quite loosely in the market, and not much importance is given to how we refer to them. It is subjective and doesn’t really matter much unless we totally screw it up – you can’t call a T-Bill is a T-Bond even by mistake. That would be a disaster of sorts! But people can say that the 5 years or whichever year’s bond is yielding x%.
To get the specifics right, one generally says that, “the 10-year USTs (US Treasury)/ the 10-year benchmarks are yielding 1.50%, or the 10-year BTPs (Italian bonds) are yielding 1.14%, or the 5 years UK Gilts are at 0.20%” for example.
Given this basic understanding of what a yield curve is, we can also term the yield curve differently – the difference in yields between the highest tenor bond and the lowest tenor bond. Right? Here is the subjective part of it – the highest tenor bond depends on the liquidity, commonality among market participants, a respectable tenor, and other factors.
For example, earlier, one would term the US yield curve as the difference between the 30 year and 2-year yields. Now one terms it as the difference between the 10 year and the 2-year yields. That’s how it has evolved. Obviously, in this case, the graph would look different since it is a spread between, say, the 2 year and the 10-year yields.
Types of Yield Curve Slope
The graph earlier and almost any other yield curve’s graph you see would look ‘upward sloping.’
Upward Slope Yield Curve
The reason is simple – longer the tenor, the riskier it is. If you take a 2-year bank loan, you would have to pay a lower rate of interest than a 5-year loan, which would be lesser than that of a 10-year loan. The same is applicable to bonds since they are essentially loans – term premium. This is also an indicator of the soundness of an economy. An upward slope yield curve indicates that the economy may normally be functioning. The steeper the curve is, the impression is that the economy is normal and not in a recession like a scenario anytime soon. Why does the curve indicate the position of the economy? The government runs the country and the economy along with the respective Central Bank, which is also part of the government.
The rates at which they borrow are generally riskless, and interest rates charged to other participants in the economy like institutions and individuals, are determined over and above these rates due to the borrower’s inherent riskInherent RiskInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization. of not paying back, etc. i.e., a spread over the government’s borrowing rates is added.
Flat / Inverted / Downward Yield Curve
If the yield curve is flat or inverted/downward, it could indicate that the economy may be closed or is in a recession to one. Imagine if the long rates and short rates are almost the same or that the long rates are lower than the short rates. One would obviously prefer borrowing long term as they lock in a lower rate for longer, indicates that the general equation of risk between long and short rates is topsy-turvy. The longer investors are willing to borrow long term, the lower the chances of having those rates go up and lower the demand for borrowing at a higher rate in the short term. Lower the rates for long, chances are that the economy is going to move slowly for long and might slip into a recession if necessary action is not taken. The depths of these are covered in the theory of the term structureTerm StructureThe term structure is the graphical representation that depicts the relationship between interest rates and various maturities. The graph itself is called a “yield curve.” The term structure of interest rates plays an essential part in any economy by predicting the future trajectory of rates. of interest rates.
Shifts & Twists
This is just a brief introduction to yield curve moves and shapes. You already know the shapes – upward sloping (steep), downward sloping (inverted), and flat. These are part of the yield curve moves. So let us look at the moves:
- If all the tenors’ yields move by the same amount, then the shift in the curve is called a ‘parallel shift.’ Eg. The 1y, 2y, 5y, 10y, 15y, 20y, and 30y yields all move ± 0.5%.
- If all the tenors’ yields do not move by the same amount, then the shift in the curve is called a ‘non-parallel shift.’
A steep curve (widespread between long rates and short rates) or a flat curve (thin spread between long rates and short rates).
While twists and parallel shifts generally talk about straight moves, a butterfly is about the curvature. A butterfly is a humped shape curve. Short and long rates are lower than the middle rates.
- Positive Butterfly: When the butterfly lessens its curvature and becomes flatter. The hump becomes less humped. The short, middle, and long rates are tending towards the same rate where the short and long rates rise more or fall less and/or the middle rate falls more or rises less, causing a positive butterfly.
- Negative Butterfly: When the butterfly increases its curvature and becomes even more humped. The short and long rates fall more or rise less and/or the middle rate rises more or falls less, causing a negative butterfly.