Yield curve

Key Takeaways

Yield curve is a graph charting the yield offered by bonds with the same credit rating, but with different maturity periods

Yield Curve may be divided into three types based on its shape: Normal Yield curve, Flat Yield curve and Inverted Yield Curve

What is a Yield Curve?

Yield curve is a graph charting the yield offered by bonds with the same credit rating, but with different maturity periods. The slope of the yield curve hints at changes in the interest rate and economic activity in the future. On the basis of its shape, the yield curve can be of three types: normal yield curve (upward sloping), the inverted yield curve (downward sloping) and flat yield curve.

Example

The most commonly used yield curve is the Government of India-issued bond yield curve. The maturity of these bonds can range from 91 days to 10 years.

Types of Yield Curve

Normal Yield Curve:

Since bonds with shorter maturity are comparatively less susceptible to market fluctuations, the bond holder carries lesser risk and in turn lower yield. This is represented in the yield curve as well. Moving from left to right, the normal yield curve is upward sloping which suggests that the longer you commit to a bond, the higher yield you avail in the times of economic expansion.

Inverted Yield Curve:

An inverted yield curve may be an early sign of a recession, as it could indicate investors moving their money from short-term bonds to long-term bonds, leading to a rise in demand for long-term bonds and a decrease in their yield. An inverted yield curve signals that yields on bonds with longer maturity may keep on falling. When investors see that yield might continue to fall, they purchase long-term bonds to freeze the yield.

Flat Yield Curve:

A flat yield curve reflects uncertainty in the economy. It may come up from a normal or inverted yield curve during the times of economic changes.

When the economy is slowing down or moving towards recession, yields on longer-term bonds decrease and that on shorter-term bonds increase, changing the shape of the yield curve from upward sloping to flat.

Similarly, when the economy is recovering from a recession, yields on longer-term bonds tend to increase and that on shorter-term bonds tend to decrease again causing a change in the inverted yield curve to transition into flat yield curve.