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1. Learning Outcomes
After studying this module, you shall be able to

 Know how bond prices and bond yields are determined.

 Learn how current and expected future short-term interest rates influence bond prices and
yields.
 Understand the concept of the yield curve and the term structure of interest rates.
 Analyzeand interpret the slope of the yield curve.

2. Introduction

Definition of Bond

Bond is a debt instrument issued by the issuer (government or company) to raise funds
and provide regular interest payments in addition to paying their face value (F.V., amount that
will be paid when the bond matures) at maturity to bond holders. Different bonds may bear
different default risk depending on the risk that the issuer of the bond will not pay back the full
amount promised by the bond. Here, we focus on bonds issued by identical borrowers; the only
differences are differences in the times at which the bonds mature. Before introducing the concept
of the term structure of interest rates, let us briefly look at the concept of yield to maturity.

3. Yield to Maturity
Yield to maturity is the interest rate at which the price paid for the bond would have to be
invested to return the stream of payments generated by the bond.Alternately, it is the interest rate
that makes the bond price equal to the present value of future returns on the bond. For example,
having paid 1000 rupees for the bond, in the following year you will receive annual payment of
100 rupees and 1100 rupees face value. Then, the yield to maturity on this bond is the interest rate
i, which satisfies the followingcondition:-

+
=
+�

→ +� = = .

Hence, yield to maturity for this bond is 20%. In general, yield to maturity for a
bondmaturing in n periods satisfies the following condition:-

� � � + . �.
��� ��� = + −−−−−−
+� +� +� �

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ECONOMICS MODULE NO. 13: YIELD CURVE
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Wherex is the annual payment to the bond holder. Thus, Bond Price and Yield are inversely
related.

4. Term Structure of Interest Rates and theYield Curve

Term structure of interest rates refers to the relation that holds at a particular point of time
between maturities of a bond and its yield. The graphical depiction of the term structure of
interest rates is known as the yield curve. It summarizes the yields of otherwise identical bonds of
varying maturities at a particular point of time. (Figure 1).

Yield (%)

8%

6%

1 year 5 year Term to Maturity

Figure 1: Yield Curve on a Particular Date

Yield curves can also be drawn for other debt instruments such as treasury bills. Yield
curves can be upward sloping, downward sloping or flat. We now explain a theory to explain the
slope of the yield curve.

4.1 Expectation Hypothesis

According to this hypothesis, longer term yields are an average of the shorter term yields
expected to prevail during the life of a longer-term bond. This hypothesis is based on the
assumption that investors are concerned only about expected return from asset. If investors have
option to choose between a one year bond and a two year bond, the decision would be based on
the expected return from each type of asset after a year. For example, suppose that an investor
has 1000 rupees to invest for two years. Current yield on one year bond is 5% and next year one
year bond will pay interest of i1%. Thus, if the investor purchases a one year bond today and
purchases another one year bond after it matures, in two years he will have

�� = +. +�

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ECONOMICS MODULE NO. 13: YIELD CURVE
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Unfortunately, the investor does not know the yield on one year bond after ayear; he relies on his
expectation about future interest rate to estimate the expected return of buying a series of one year
bonds in two years, i.e.

�� = +. + �

Instead, if the investor invests in the two-year year bond, the return after two years would
be:-

�� = +�

Since, the investor is only concerned about expected return and hence is risk neutral, he
will not purchase the long term(twoyear) bond if VL<VS. In contrast, if VL>VS, the investor will
not purchase the short term bond. In fact, under the expectations hypothesis, the only condition
in which both one year bond and two year bondsare sold in the market is that where investors are
indifferent between purchasing either of the two : VL = VS.

Suppose, investors expect that after one year the one year bond yield would rise to 7%
i.e. E1i = .07. In this case, the yield on a two-year bond that equates the expected return of holding
a two year bond with that of a series of one-year bonds, gives us the condition:-

+� = +. +.

+� = .

Hence, the yield on long term bond (here, two-year bond) is 6%. At this rate, investors
earn exactly the same return from both investments: VS = VL = 1123.5.

This analysis reveals that according to the expectation hypothesis, long term yield is
determined by expectations about successive shortterm yields. The current yield on long term
bond will change, if expectations about future short term yields change. For instance, if the
current yield on one year bond is 5% and investors expect the yield rate to remain at 5% next
year, the yield rate on a two-year bond will satisfy the condition:-

+� = +. +.

→ � =.

Thus, if investors expect that the yield on short term bonds will remain unchanged then
the rate on one year bond will equal that on two year bond.Similarly, if investors expect the yield
on short term bond to fall to 3 percent next year, the yield rate on long term bond is given by the
condition:-

+� = +. +.

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ECONOMICS MODULE NO. 13: YIELD CURVE
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→ � =.

Figure 2 illustrates the yield curves for the three cases we just discussed.

Yield Yield Yield

6%

5% ` 5% 5%

4%

1 2 Years Term to maturity (Years) 1 2 Years

Short term rate Short term rate Short term rate
expected to rise expected to remain expected to fall
same

Figure 2: Yield Curves for different expectations for short term rates

In general, the yield (or yield to maturity) on n- year bond (in) is given by the condition:-

�
+ �� = +� + � + � ……… + �− �

Solving for in:

�
�� = √ +� + � + � ….. + �− � (1)

Notice that the solution we get from the above condition is very close to the simple
average of the current and expected one year yields. In particular, if we take logarithm of
equation (1), we get:-

� �� + �� = �� + � + �� + � + �� + � … … … �� + �− �

Since the logarithm of (1+x) approximately equals x when x is small, we can write:-

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ECONOMICS MODULE NO. 13: YIELD CURVE
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�+ �+ � + ⋯……. �− �
�� ≈
�

4.1.1Forcasting future yield rates

The Expectation hypothesis can be used to obtain market forecast of future yield to
maturities. Suppose you do not know whether short term yield rate will rise or fall. All you
know is that the current yield on a one year bond is. i=6% and the yield on a two year bond isi2 =
8%. The hypothesis can be used to infer what the market believes the future one year yield rate
will be, even if investors do not directly report their estimate.

�+ �
Since, � = :-

�= . � −. =.

Thus, based on information currently available to you about yields on short term and long
term bonds, you get to know that the market thinks that one-year bond yields will rise to 10%
next year. Hence, varying shapes of yield curves are due to different expectations of future short
term yield rates.

5. Interpreting the Yield Curve

The yield curve is a potential source of information about future economic conditions.
Another term often used by economists relating to the yield curve is‘yield spread’. Larger the
spread, the steeper is the slope of the yield curve. Following are certain hypotheses regarding the
information content of the yield curve.

 The yield spread contains information on future yield rate movements. An upward
sloping curve reflects an indication of rising short-term yield rates. Thus, a significant
positive correlation has been observed between yield spread and future short-term yield
rate changes.
 The yield spread reflects the direction of future inflation changes and credibility of
monetary policy: When long term expectations of inflation rise, investors demand higher
long-term yield rates resulting in steepening of the yield curve. Hence, yield spread also
indicates credibility of monetary policy in containing inflation. Improved credibility
results in lower inflation risk premium resulting a flatter yield curve. An inverted yield
curve (Negatively sloped) signals deflation, reflecting impending recession and lack of
effective demand.
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 The yield spread contains information on economic growth. During recession, investors
turn risk averse and demand less of longer maturity bonds due to higher interest rate risk
leading to decline in price of long-term bonds and consequent increase in their yields.
Also, due to accommodative monetary policy short term yields remain low, resulting in
an upward sloping yield curve. Thus during recession, the steeper the yield curve,
stronger is the economic recovery expected.
 The yield spread contains information on credit market conditions: Increase in
investments leads to an increase in the supply of long-term bonds by
corporate/government as a result of which price of long term bond falls and long term
yields rise. Hence, steeper yield curve is an advance sign of higher real economic
activity. Conversely, a negatively sloped yield curve is an advance sign of a recession,
since it implies lesser supply for bonds, indicating absence of investment opportunities
resulting in higher price and lower longer term yield rates. A flat yield curve is an
indicator of weakening economy.
 The yield spread reflects the stance of monetary policy: A flat yield curve (a low yield
spread) reflects relatively tight monetary policy and a steep yield curve (a high yield
spread) reflects a relatively loose monetary policy. The impact of monetary policy is felt
the most at the short term of the maturity spectrum which then gradually gets transmitted
to the longer end. When monetary policy is tightened, short-term rates rise more than the
long term rates resulting in flatter yield curve (Figure 3). This may even give rise to a
negatively sloped yield curve. Similarly, when monetary policy is accommodative, short
term rates fall more than long term rates, resulting in a steeper yield curve.

Yield (%)

Flatter yield curve after tight monetary policy

Original yield curve

1 year 5 year Term to Maturity

Figure 1: Tight monetary policy

5.1 The Yield curve in Emerging Market Economies

The yield curve tends to be flatter in emerging market economies (EMEs). Following are some
reasons put forward as explanation.
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 Countries with large scale foreign exchange inflows, tend to have flat yield curves. Large
inflows result in surplus liquidity conditions and flattens the yield curve flattens by
lowering long-term yields.
 There is dominance of hold-to-maturity investors (like insurance companies and pension
funds) and statutory requirements in developing economies. Investors in developed
countries have to constantly churn their portfolios to minimize the market risk. On the
other hand, investors in developing economies prefer the longer maturity segment, as
there is less of market risk in EMEs.
 Increased credibility of monetary policy in the past in many EMEs has led to lower
inflation expectations, causing the yield curve to be flat.
 Higher saving rates in Asian EMEs in comparison to many advanced economies can also
be a reason for a flatter yield curve in such economies

Summary
 Bond is a debt instrument issued by the issuer (government or company) to raise funds
and provide regular interest payments in addition to paying their face value at maturity to
bond holders.
 Yield to maturity is the interest rate at which the price paid for the bond would have to be
invested to return the stream of payments generated by the bond. It is the interest rate that
makes the current bond price equal to the present value of the future returns on the bond.
It varies inversely with the bond price.
 Term structure of interest rates refers to the relation between maturities of bond with its
yield.
 According to the Expectation Hypothesis, longer term yields are an average of the shorter
term yields expected to prevail during the life of a longer-term bond. This hypothesis is
based on the assumption that investors are risk neutral and care only about the expected
return from assets.
 The yield curve is a potential source of information about future economic
conditions.The slope (or the yield spread) contains informationabout future yield rate
movements, the direction of future inflation changes and credibility of monetary policy
etc.
 The yield curve tends to be flatter in emerging marketing economies.

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ECONOMICS MODULE NO. 13: YIELD CURVE