What is a yield curve? (Definition and how it works)

By Indeed Editorial Team

Published 11 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

A bond is one type of investment in which an investor purchases the debt of an entity, such as a government or corporation and expects to earn interest on the transaction. A yield curve is a method investors use to predict how much profit their investments are to yield. Understanding this method and how it works can help you better understand investment risks and opportunities. In this article, we define what the yield curve is, the types and the unique factors to consider when making use of one.

What is the yield curve?

The yield curve is a depiction of the future yields that an investor may make from debts in the form of a graph. The graph shows the bond's yield on the vertical axis and how long it takes to mature across the horizontal axis. If investors lend money for a specific amount of time, this graph can help predict the expected return. At varying points in the economic cycle, the yield curve may take several shapes but it mostly slopes upwards.

Related: How to become an economist: a step-by-step guide (with tips)

How do these curves work?

The yield curve helps bond investors measure the risks related to particular investments. It can work as an economic indicator. If it takes an inverted shape, it indicates that there is an economic downturn. Considering that rates often behave in unique ways when compared to one another, they can suggest the returns investors expect to receive. If you're an investor, consider using this method to make predictions about your investments and the economy.

Yield curve types

The four types of this curve are:

The normal curve

This is the most common type in analysis and economics. The normal curve reflects a higher return for the long term when compared to the short term. The curve has a positive slope because the longer money stays invested, the higher the risk and the higher the compensation.

This implies that if you invest funds for a longer period of time, they may be more likely to earn a favourable return because there is a higher chance of negative impacts, such as default or other unforeseen circumstances. The normal curve occurs when bond investors anticipate normal growth in the economy without major obstacles or inflation.

Related: What is yield? Definition, how to calculate it and examples

The inverted curve

When short-term returns outweigh long-term returns, this is an inverted curve. This occurs when an investor predicts a rate cut and it means that the economy soon enters an off-season. Long-term investors may settle for fewer rewards when compared to investors in the short term if they believe that they have gotten their last opportunity to seal the present rates. An inverted curve often indicates that the economy is soon coming to a standstill.

Related: What is risk aversion? (with definition and examples)

The steep curve

Generally, there is a steep curve in the early stages of economic growth. This often happens after a period of recession, which begins with an increase in capital demand. The steep curve shows that long-term returns are growing at a faster rate than short-term returns. A steep curve usually indicates that the economy is entering a period of growth. Similar market conditions affect both normal and steep curves, but steep curves show large differences between short-term and long-term yield expectations.

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The flat or humped curve

A flat or humped curve happens when a curve goes through a season where short-term rates increase so much that they are close to long-term rates. This leads to the curve's shape being flat or humped, elevated slightly in the middle. Humped curves are rare and they often serve as indicators of slow economic growth.

Factors that influence these curves

  • Inflation: Considering that central banks are usually more likely to respond to an increase in anticipated inflation with a corresponding increase in the interest rate. This increase in inflation often causes a decrease in purchasing power and investors to anticipate a boost in the interest rate for the short-term period.

  • Interest rates: If central banks increase the interest rate on treasuries, this leads to a higher demand for treasuries, thus leading to the interest rates witnessing a decrease. This factor influences curves greatly.

  • Growth in the economy: Economic growth can also lead to an increase in inflation which happens as a result of aggregate demand. With stable economic growth, there is more competition for capital and the economic growth can lead to a yield increase and steep curves.

Related: Aggregate demand: definition and how to calculate it

Why is this curve important?

The curve is of major importance to investors and economists. It enables them to gain a clearer understanding of the present economy and allows them to predict how the economy may transform in the next few years or months. Here are some of the major benefits of knowing how they work:

  • The curve helps predict future interest rates: By studying the shape of the curve, investors can easily predict future interest rates. For instance, if they observe a normal curve sloping upward, they can forecast that long-term securities can get to have a higher yield.

  • It helps to understand financial intermediaries: Financial establishments inclusive of banks and different firms lend most of their funds by means of utilising long-time period loans and borrowing by means of promoting short-time period deposits. The better the upward-sloping curve, the greater the distinction between their lending and borrowing rates which additionally implies a better income and a downward-sloping curve means there are lower profits.

  • It indicates the tradeoff between maturity and yield: They help to show the traditional trade-offs between maturity and yield. As the curve rises, investors realise that they're to invest in long-term securities to get better returns.

  • It indicates overpriced and under-priced securities: The curve can also show investors which security is presently under-priced or overpriced, to know if a certain security's price is below what it is worth and to see if the security's return rate is above the curve. If it is above, then it is priced below its worth, if it lies below, then it is priced above its worth.

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What are the yield curve theories?

Consider these theories:

  • The pure expectation theory: This theory suggests that you can substitute the different maturities for one another and the market's expected future interest rates can predict the shape of the yield curve. Investors using this theory may know the long-term interest rate and apply the same rate to short-term investments to make a prediction.

  • The liquidity preference theory: The liquidity preference theory takes the pure expectation theory to a deeper level. It considers the risks associated with holding long-term debt in the short term and suggests that long-term investments are to earn a more favourable rate because of those inherent risks.

  • The segmented market theory: This theory suggests that the unique demand and supply relationships that exist between long-term and short-term securities mean that you are to treat each product as unique. Knowledge about one maturity does not apply to other maturities.

  • The preference habitat theory: This theory assumes the segmented market theory to be true, it assumes that most investors have a preferred investment maturity and require some form of premium for them to invest outside of that. The theory also suggests that most investors prefer short-term yields if no premium exists.

Related: Understanding the cost of debt (tips on how to calculate it)

Can you use this curve?

You can make use of the treasury curve shape to assess how the economy's state and predict its state in the future. You can also refer to the treasury curve as the benchmark curve because the treasury bond yields are usually the lowest yields because the government supports them. This enables investors to easily analyse the treasury curve and compare it with the curve for other assets with more risks. By analysing these yield curves, you're able to understand the present economy better and make accurate economic predictions.

Related: A guide to prediction interval vs confidence interval

How to use this curve

The following show various ways by which the yield curve can assist to maximise profit. These include:

  • It predicts when you're to make a purchase: Assessing the graphs helps you to predict the perfect time to make a bond or loan purchase. With this, you can target when to buy loans at a relatively low price in which its value will likely increase with time with an increased interest rate.

  • It also predicts when you're to sell: It helps you to figure out the best time to sell your bonds. You can easily know when a recession will occur and quickly sell your bonds.

  • It predicts when you're to make reasonable risks: If there's a positive increase in a curve for a reasonable period of time, you can make a purchase. This sometimes predicts the direction of the economy although, you are to keep a close watch on the curve.

  • It relates the interest rate to the available credit: The yield curve determines the relationship between interest rate and available credit. It helps you to determine how the value of a particular interest rate will influence the available credit over time and this could either be a positive or negative influence.

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