Understanding the Treasury Yield Curve

Rates
Yield to maturity

The total return anticipated on a bond if the bond is held until

the end of its lifetime. Yield to maturity is considered a long-
term bond yield, but is expressed as an annual rate. In other
words, it is the internal rate of return of an investment in a
bond if the investor holds the bond until maturity and if all
payments are made as scheduled.

The Treasury Yield Curve plots the yields of bonds, of similar

quality against their maturities. It´s the primary benchmark
used in pricing fixed-income securities. It´s also known
as the term structure of interest rates, draws out a line chart
to demonstrate a relationship between yields and maturities
of on-the-run treasury fixed income securities. It illustrates
the yields of Treasury securities at fixed maturities, 1, 3 and
6 months and 1, 2, 3, 5, 7, 10, 20 and 30 years. Therefore,
they are commonly referred to as “Constant Maturity
Treasury” Rates or CMTs.

Market participants pay very close attention to the yield

curves, as they are used in deriving the interest rates which
are in turn used as discount rates for each payment to value
treasury securities. In addition to this, market participants
are also interested in identifying the spread between short
term rates and long term rates to determine the slope of the
yield curve, which is a predictor of economic situation of the
country.

Yields on Treasury securities are in theory free of credit risk

and are often used as a benchmark to evaluate the relative
worth of US Non-Treasury securities (as a mortgage rates,
banks’ lending rates). Below is the treasury yield curve chart
as on October 3rd 2014.

Source:  www.treasury.gov

The above chart shows a "Normal" Yield Curve” (positive

yield curve): , exhibiting an upward slope. This means that
30-year Treasury securities are offering the highest returns,
while the 1-month maturity Treasury Securities are offering
lowest returns. The scenario is considered normal because
the investors are compensated for holding the longer term
securities, which possess greater investment risks. The
spread between 2-year US Treasury securities and 30-year US
Treasury securities defines the slope of the yield curve,
which in this case is 259 basis points. (Note: There is no
industry-wide accepted definition of the maturity used for
long-end and the maturity used for the short-end of the yield
curve). The normal yield curve implies that both fiscal and
monetary policies are currently expansionary and the
economy is likely to expand in the future. The higher yields
on longer term maturity securities also means that the short
term rates are likely to increase in the future as the growth in
the economy would lead to higher inflation rates.

Other Shapes of the Yield Curve

1. Inverted Yield Curve (negative yield curve): This occurs

when short term rates are greater than the long term
rates. It would generally imply that both monetary and
fiscal policies are currently restrictive in nature and the
probability of the economy contracting in the future is
high. According to empirical evidence, the Inverted Yield
curve has been the best predictor of recessions in the
economy.

An inverted yield curve also has an impact on consumers. For

example, homebuyers financing their properties with
adjustable-rates mortgages have interest-rate schedules that
are periodically updated based on short-term interest rates.
When short-term rates are higher than long-term rates,
payments tend to rise. When this occurs, fiexed.rate loans
may be more attractive than adjustable-rate loans. Lines of
credit are affected, this reduces expendable income and has
a negative effect on the economy as a whole.

2. Humped Yield Curve (flat): This occurs when yields on

medium term US Treasury Securities are higher than the
yields on long term and the short term US Treasury
 Securities. This reflects that the current economic
condition is unclear and the investors are uncertain
about the economic scenario in the near future. It could
also reflect that monetary policy is expansionary and
fiscal policy is restrictive or vice-versa.

When short- and long-term bonds are offering equivalent

yields, there is usually little benefit in holding the longer-
term instruments - that is, the investor does not gain any
excess compensation for the risks associated with
holding longer-term securities
. For example, a flat yield curve on U.S. Treasury would
be one in which the yield on a two-year bond is 5% and
the yield on a 30-year bond is 5.1%.

http://www.investopedia.com/terms/y/yieldcurve.asp