You are on page 1of 4

PRUDENTIAL INVESTMENTS MUTUAL FUNDS

FIXED INCOME PRIMER An educational series for trustees, board members and other fiduciaries.
UNDERSTANDING YIELD CURVES
A yield curve is a line graph that illustrates the relationship between the yields
and maturities of fixed income securities.
Yield curve graphs provide a quick way to review and compare the yields that
different types of fixed income securities offer, and to determine investor
expectations for market conditions in the future. They are created by plotting the
yields of different maturities for the same type of bond. The spreads between
the yields of different maturities are what create the slope, or shape, of the yield
curve for a given type of security.

Yield to Maturity %

The chart below shows a normal yield curve. As you can see, it is upward sloping.
The longest-maturity securities offer the highest returns while the shortest maturities
offer the lowest returns. This scenario is considered normal because longer-term
securities generally bear the greatest investment risks and, as a result, should offer
higher interest rates. Of course this is not always the case. In addition to a normal,
upward sloping curve, a yield curve may also be inverted, or downward sloping, or it
may be humped, as we will discuss later in this paper.

8
7
6
5
4
3
2
1
0

Normal Yield Curve

10

30

Term to Maturity: Years


For illustrative purposes only.

TYPES OF YIELD CURVES

WANT TO KNOW MORE ABOUT


FIXED INCOME INVESTING?
Ask your financial professional.
prudentialfunds.com

Yield curves may be created for any type of fixed income security, including
US Treasury securities, investment grade and high yield corporate securities,
global bonds, and municipal bonds. The yield curve for US Treasury securities is
considered a market benchmark, as it is often used as a basic reference point by
fixed income investors to evaluate market conditions. It is also used as a benchmark
to evaluate the relative attractiveness of investing in non-US Treasury securities. This
is because US Treasuries, in theory, have no credit risk, so the extra yield offered by
a similar maturity, non-US Treasury security should offer adequate compensation for
any additional risks incurred by the investor.

FIXED INCOME PRIMER

The yield curves for corporate securities are more typically


known as credit curves because, unlike yield curves that
plot the yield and maturity of a specific security, credit curves
plot the yields available on a universe of corporate bonds
of a specific credit quality, such as AAA-rated (the highest
investment-grade credit quality) through BBB-rated (the lowest
investment-grade credit quality), as well as for lower quality,
high yield bonds.

Investors can also evaluate spreads from a current vs.


historical standpoint. In other words, lets say the spread
today between a 10-year US Treasury bond vs. a 10-year
AAA-rated corporate bond is +50 basis points. Is that typical?
Perhaps not. Perhaps the spread was only +35 basis points a
year ago. If thats the case, the AAA-rated corporate bond, with
the +50 basis points yield advantage today, looks particularly
attractive.

COMPARING YIELD CURVES

Finally, investors also use yield curves to compare the


relationship between maturities within the same type of
security, such as between two-year and 10-year US Treasury
securities (often called 2s/10s for short). In the above
example, that spread is +175 basis points. (4.25% vs. 6.00%)
Another maturity relationship that is frequently evaluated is
the spread between the ultra-short 3-month US Treasury bill
versus the ultra-long 30-year US Treasury bond. This spread
tells investors whether they are being paid enough in extra
yield to compensate them for the additional interest rate
risks associated with extending maturities within the same
type of security.

Comparing the yield curves of different types of securities can


help investors determine the relative value of a bond and
can also help to create strategies to increase a portfolios total
return. Investors may wish to compare the US Treasury yield
curve against AAA-rated and AA-rated corporate bonds, for
example, to see how much additional yield they could capture
by assuming some credit risk. (See charts below.)
One way to do this is to review the spread, or the difference
in yields between different types of securities. The spread
columns in the chart below show the difference between the
yields on the benchmark US Treasury yield curve and the
AAA- and AA-rated corporate bond curves, respectively.
Investors can use this data to determine if the amount of
spread available today on a AAA- or AA-rated bond offers
enough additional yield over US Treasuries to make the
security an attractive investment.

SPREADS
Govt

AAA

1 Year

4.00%

4.15%

4.45%

0.15%

0.45%

2 Year

4.25

4.45

4.90

0.20

0.65

3 Year

4.50

4.75

5.20

0.25

0.70

5 Year

5.00

5.30

5.90

0.30

0.90

10 Year

6.00

6.50

7.25

0.50

1.25

30 Year

7.00

7.70

8.50

0.70

1.50

For illustrative purposes only.

AA

AAA

AA

Yield to Maturity %

US Governments vs. AAA/AA-Rated Credit Curves


9
8
7
6
5
4
3

Government
AAA
AA

3
5
10
Term to Maturity: Years

30

FIXED INCOME PRIMER

EVERY YIELD CURVE TELLS A STORY

Each yield curve shape tells a different story. A normal,


upward-sloping yield curve implies that investors expect the
economy to grow in the future, and for this stronger growth to
lead to higher inflation and higher interest rates. They will not
commit to purchasing longer-term securities without getting
a higher interest rate than those offered by shorter-term
securities. A normal yield curve typically occurs when central
banks (such as the Federal Reserve in the United States) are
easing monetary policy, increasing the supply of money and
the availability of credit in the economy.

Yield to Maturity %

A normal yield curve signals that investors expect the economy


to expand. An illustration of this is shown below.

8
7
6
5
4
3
2
1
0

Normal Yield Curve

10

30

An inverted yield curve, on the other hand, occurs when longterm yields fall below short-term yields. An inverted yield curve
indicates that investors expect the economy to slow or decline
in the future, and this slower growth may lead to lower inflation
and lower interest rates for all maturities. An inverted yield
curve typically indicates that central banks are tightening
monetary policy, limiting the money supply and making credit
less available. An inverted yield curve has often historically been
a harbinger of an economic recession. Investors are willing to
accept a lower interest rate now in return for being locked in for
years to come. An illustration of this is shown below.

Yield to Maturity %

Inverted Yield Curve


7
6
5
4
3
2
1
0
2

4
5
6
7
8
Term to Maturity: Years

Humped Yield Curve


6
5
4
3
2
1
0
1

4
5
6
7
8
Term to Maturity: Years

10

30

CONCLUSION

Term to Maturity: Years

Finally, a humped yield curve indicates an expectation of


higher rates in the middle of the maturity periods covered,
perhaps reflecting investor uncertainty about specific
economic policies or conditions, or it may reflect a transition
of the yield curve from a normal to inverted, or vice versa.

Yield to Maturity %

The shape of a yield curve provides valuable information to


investors as to what other investors believe will take place in
the fixed income market in the future.

10

30

Yield curves are created by illustrating the yields for a


particular type of security at different maturities. The US
Treasury yield curve is used as a benchmark to which yield
curves for other types of bonds can be compared. The shape
of the yield curve for a fixed income security reflects market
factors including the direction of interest rates, risk, and
investor demand. Yield curves are widely used by investors
and portfolio managers as a snapshot of market conditions
and to compare different investment options.

FIXED INCOME PRIMER

ABOUT PRUDENTIAL INVESTMENTS


Prudential Investments offers the expertise of Prudential Financials affiliated institutional managers to individuals and retirement
plans in a wide range of mutual funds and separate accounts. With access to Prudentials asset managers, investors in our
funds benefit from the same processes, research, risk management, and performance demanded by many of todays most
sophisticated investors. Our success is rooted in a disciplined investment process that has proven itself over decades. It reflects
a unique combination of experienced investment talent, intensive in-house research, and sophisticated risk managementall
dedicated to delivering superior, long-term performance.
FOR MORE INFORMATION, call the Prudential Investments Sales Desk at (800) 257-3893 or visit prudentialfunds.com.

Mutual fund investing involves risk. Some mutual funds have more risk than others. The investment return and principal value will fluctuate and shares
when sold may be worth more or less than the original cost and it is possible to lose money. There is no guarantee a Funds objectives will be achieved.

Fixed income investments are subject to interest rate risk, where their value will decline as interest rates rise.
Consider a funds investment objectives, risks, charges, and expenses carefully before investing. The prospectus and summary prospectus
contain this and other information about the fund. Contact your financial professional for a prospectus and summary prospectus. Read
them carefully before investing.
The comments, opinions and estimates contained herein are based on and/or derived from publicly available information. This outlook, which is for informational
purposes only, sets forth our views as of this date. The underlying assumptions and our views are subject to change. Past performance is not a guarantee of
future results.
Mutual funds are distributed by Prudential Investment Management Services LLC, a Prudential Financial company and member SIPC. Prudential Fixed Income is a unit of Prudential Investment
Management, Inc., a registered investment advisor and Prudential Financial company. 2013 Prudential Financial, Inc., and its related entities. Prudential Investments, Prudential, the
Prudential logo, Bring Your Challenges, and the Rock symbol are service marks of Prudential Financial, Inc., and its related entities, registered in many jurisdictions worldwide. .
MUTUAL FUNDS:

Are not insured by the FDIC or any federal government agency

0218561-00002-00 PI2129 Ed. 10/01/2013

May lose value

Are not a deposit of or guaranteed by any bank or any bank affiliate