What is a yield curve?
A yield curve
is a chart showing the interest rates offered on the bonds of a borrower against its maturity dates.
When you buy bonds, you lend money to the issuer of the bond. In return for this, the issuer pays out fixed interest rate payments twice a year until the bond matures.
The interest rate plotted on the chart is the redemption yield of the bond. In other words, it takes into account the timing of future interest rate payments, plus the return of the amount the issuer borrowed when it issued the bond.
The yield curves of government bonds are the most important. This is because banks use these yield curves to set the interest rates they charge on different types of debt, such as loans and bonds (home loans).
How a yield curve looks
Have a look at the chart showing a yield curve below (source: Sharenet
Yield curves usually slope upwards from left to right. This is because bonds that have longer maturities have higher interest rates.
The higher interest rates offered on longer-term bonds is to compensate investors for the risk of interest rates changing, the effects of inflation and the risk of default.
Professional investors spend a lot of time studying yield curves as they can try to profit from changes in them or at least avoid losing money.
If you see a yield curve that slopes downwards, this can indicate a looming recession. This is because it suggests the market expects the government to cut interest rates to boost the economy.
But it isn’t always the case. It can be down to the behaviour of institutional investors, such as pension fund managers, who opt for long maturity assets as they match up to their long-term liabilities.
So there you have it. The ins and outs of a yield curve explained.
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