Synopsis
Yield curves are usually of three types—normal, flat and inverted— depending on the varying slopes of the curves. A yield curve can be used as a predictor for future interest rate movements of debt instruments, and can subsequently help in taking investing decisions based on their existing investments.
Getty ImagesYield curve
It’s a graphical representation of the yield (interest rate) changes in debt instruments of the same credit quality but varying maturities. In India, it’s mainly used to map out a bond’s yield for varying maturities. In the graph, the Y axis represents the bond’s yield and the X axis shows the time to maturity.
Types of yield curves
Yield curves are usually of three types—normal, flat and inverted— depending on the varying slopes of the curves.
Normal: It’s referred to as normal curve because it’s the most common curve shape. Usually, short term bonds have lower yields and bonds with longer maturity periods offer higher yields because higher risk over an extended period is rewarded with a higher interest rate. Hence, it’s an upward curving graph from left to right, which indicates that investors expect a positive market outlook, with the economy growing at a regular pace.
Flat: As the name suggests, this yield curve is flat which means that there is little difference in the interest rates or yields of short-term and long-term bonds. This may indicate a flat or stable market, where investors don’t expect too many changes in the economic and market outlook.
Inverted: An inverted curve shows the reverse yield behaviour, where the short-term bonds offer higher yields and long-term bonds provide lower yields as opposed to the normal curve. The downward graph points at a poor market outlook, with indications of a rise in inflation and a fall in economic growth. This yield curve could also signal an approaching recession.
Uses for investors
Investment decisions: A yield curve can be used as a predictor for future interest rate movements of debt instruments, and can subsequently help in taking investing decisions based on their existing investments.
Portfolio diversification: Since long-term bonds generally offer higher yields at a greater risk, and short-term bonds offer lower yields at a lower risk, investors can balance risk and reward by picking a mix of short- and long-term instruments. This can help in the diversifcation of their investment portfolios.
Economic outlook: Since the interest rate movements can indicate market and economic outlook, yield curves can be used as predictors for rise or fall in inflation and the future economic growth or downturn.