Yield Curve Basics

Yield refers to the annual return on an investment. The yield on a bond is based on the purchase price of the bond and the interest, or coupon, payments received. A bond's coupon interest rate is usually fixed, but the price of the bond fluctuates with changes in interest rates, supply and demand, time to maturity and the credit quality of that particular bond.

After bonds are issued, they generally trade at premiums or discounts to their face value until they mature and return to full face value. Because yield is a function of price, changes in price cause bond yields to move in the opposite direction.

Calculating bond yields

There are two ways of looking at bond yields:

• Current yield is the annual return earned on the price paid for a bond. It is calculated by dividing the bond's annual coupon interest payments by its purchase price. For example, if an investor bought a bond with a coupon rate of 6 per cent, and full face value of $1,000, the interest payment over a year would be $60. That would produce a current yield of 6 per cent ($60/$1,000). When a bond is purchased at full face value, the current yield is the same as the coupon rate. However, if the same bond were purchased at less than face value, or at a discount price, of $900, the current yield would be higher at 6.6 per cent ($60/ $900).

• Yield to maturity reflects the total return an investor receives by holding the bond until it matures. A bond's yield to maturity reflects all of the interest payments from the time of purchase until maturity, including interest on interest. It also includes any appreciation or depreciation in the price of the bond. Yield to call is calculated the same way as yield to maturity, but assumes that a bond will be called, or repurchased by the issuer before its maturity date, and that the investor will be paid face value on the call date.
  
  Because yield to maturity (or yield to call) reflects the total return on a bond from purchase to maturity (or the call date), it is generally more meaningful for investors than current yield. By examining yields to maturity, investors can compare bonds with varying characteristics, such as different maturities, coupon rates or credit quality.

What is the Yield Curve?

The yield curve is a line graph that plots the relationship between yields to maturity and time to maturity for bonds of the same asset class and credit quality. The plotted line begins with the spot interest rate, which is the rate for the shortest maturity, and extends out in time, typically to 30 years.

The graph below is the yield curve for US Treasuries on 31 December 2002. It shows that the yield at that time for the two-year US Treasury bond was about 1.6 per cent while the yield on the 10-year US Treasury was about 3.8 per cent.

The yield curve in action: US Treasuries, 31 December 2002

Source: Salomon Yieldbook
This graph doesn’t represent the past or future performance of any PIMCO product

A yield curve can be created for any specific bond, from triple-A rated mortgage-backed securities to single-B rated corporate bonds. The US Treasury bond yield curve is the most widely used as US Treasury bonds have no perceived credit risk and the Treasury bond market includes securities of virtually every maturity, from three months to 30 years.

A yield curve depicts yield differences, or yield spreads, that are due solely to differences in maturity. It shows the overall relationship at a given time in the market between bond interest rates and maturities. This relationship between yields and maturities is known as the term structure of interest rates.

As illustrated in the above graph, the normal shape, or slope, of the yield curve is upward (from left to right), which means that bond yields usually rise with maturity. Occasionally, the yield curve slopes downward, or inverts.

The Shape of the Yield Curve

Most economists agree two major factors affect the slope of the yield curve: investors' expectations for future interest rates and ‘risk premiums’ that investors require to hold long-term bonds. Three theories have evolved that attempt to explain these factors in detail:

• The Pure Expectations Theory holds that the slope of the yield curve reflects only investors' expectations for future short-term interest rates. Much of the time, investors expect interest rates to rise in the future, which accounts for the usual upward slope of the yield curve.
  
• The Liquidity Preference Theory, an offshoot of the Pure Expectations Theory, asserts that long-term interest rates not only reflect investors' assumptions about future interest rates but also include a premium for holding long-term bonds, called the term premium or the liquidity premium. This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty. Because of the term premium, long-term bond yields tend to be higher than short-term yields, and the yield curve slopes upward.
  
• The Preferred Habitat Theory, another variation on the Pure Expectations Theory, states that in addition to interest rate expectations, investors have distinct investment horizons and require a meaningful premium to buy bonds with maturities outside their ‘preferred’ maturity. Proponents of this theory believe that short-term investors are more prevalent in the fixed-interest market and therefore, longer-term rates tend to be higher than short-term rates.
  

The Slope of the Yield Curve

Historically, the slope of the yield curve has been a good leading indicator of economic activity. Because the curve can indicate where investors think interest rates are headed, it can indicate economic expectations. A sharply upward sloping, or steep yield curve, has often preceded an economic upturn. The assumption behind a steep yield curve is interest rates will rise significantly in the future. Investors demand more yield as maturity extends if they expect rapid economic growth because of the associated risks of higher inflation and higher interest rates, which can both hurt bond returns. When inflation is rising, central banks will often raise interest rates to fight inflation.

Steep

The graph below shows the steep US Treasury yield curve in early 1992 as the US economy began to recover from the recession of 1990-91.

Steep yield curve: US Treasuries, 30 April 1992

Source: Salomon Yieldbook
The graph above does not represent the past or future performance of any PIMCO product

Flat

A flat yield curve frequently signals an economic slowdown. The curve typically flattens when the central bank raises interest rates to restrain a rapidly growing economy. Short-term yields rise to reflect the rate hikes, while long-term rates fall as expectations of inflation moderate. A flat yield curve is unusual and typically indicates a transition to an upward or downward sloping curve.

The flat US Treasury yield curve below signalled an economic slowdown prior to the recession of 1990-91.

Flat yield curve: US Treasuries, 31 December 1989

Source: Salomon Yieldbook
The graph above does not represent the past or future performance of any PIMCO product

Inverted

An inverted yield curve can be a leading indicator of recession. When yields on short-term bonds are higher than those on long-term bonds, it suggests that investors expect interest rates to fall, usually in conjunction with a slowing economy and lower inflation.

Historically, the yield curve has become inverted 12 to 18 months before a recession. The graph below depicts an inverted yield curve in early 2000, almost a year before the economy fell into recession in 2001.

Source: Salomon Yieldbook
The graph above does not represent the past or future performance of any PIMCO product

Different Uses of the Yield Curve

The yield curve provides a reference tool for comparing bond yields and maturities which can be used for several purposes:

• The yield curve has an impressive record as a leading indicator of economic conditions, alerting investors to an imminent recession or signalling an economic upturn.
• The yield curve can be used as a benchmark for pricing other fixed-interest securities. Because US Treasury bonds have no perceived credit risk, most fixed-interest securities, which entail credit risk, are priced to yield more than Treasury bonds.  For example, a three-year, high-quality corporate bond could be priced to yield 0.50 per cent, or 50 basis points, more than the three-year Treasury bond.

By anticipating movements in the yield curve, fixed-interest managers can attempt to earn above-average returns on their bond portfolios. Several yield curve strategies have been developed in an attempt to boost returns in different interest-rate environments. Three yield curve strategies focus on spacing the maturity of bonds in a portfolio:

1. A bullet strategy: a portfolio is structured so that the maturities of the securities are highly concentrated at one point on the yield curve. For example, most of the bonds in a portfolio may mature in 10 years.

2. A barbell strategy: the maturities of the securities in a portfolio are concentrated at two extremes, such as five years and 20 years. In a ladder strategy, the portfolio has equal amounts of securities maturing periodically, usually every year.

   In general, a bullet strategy outperforms when the yield curve steepens, while a barbell outperforms when the curve flattens. Investors typically use the laddered approach to match a steady liability stream and to reduce the risk of having to reinvest a significant portion of their money in a low interest-rate environment.

   Using the yield curve, investors may also attempt to identify bonds that appear cheap or expensive at any given time. The price of a bond is based on the present value of its expected cash flows, or the value of its future interest and principal payments discounted to the present at a specified interest rate or rates. If investors apply different interest-rate forecasts, they will arrive at different values for a given bond. In this way, investors judge whether particular bonds appear ‘cheap’ or ‘expensive’ in the marketplace and attempt to buy and sell those bonds to earn extra profits.

3. Riding the yield curve: as a bond approaches maturity on an upward-sloping yield curve (also called ‘rolling down the yield curve’), it is valued at successively lower yields and higher prices. Using this strategy, a bond is held for a period of time as it appreciates in price and is sold before maturity to realise the gain. As long as the yield curve remains normal, or in an upward slope, this strategy can continuously add to total return on a bond portfolio.