

BONDS

 FIXED INCOME

Yield Curve: What It Is and How to Use It

By
ADAM HAYES

Updated September 27, 2023

Reviewed by
GORDON SCOTT
Fact checked by
SUZANNE KVILHAUG
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What Is a Yield Curve?

A yield curve is a line that plots yields, or interest rates, of bonds that have
equal credit quality but differing maturity dates. The slope of the yield curve
can predict future interest rate changes and economic activity.

There are three main yield curve shapes: normal upward-sloping curve,
inverted downward-sloping curve, and flat.

KEY TAKEAWAYS

 Yield curves plot interest rates of bonds of equal credit and different
maturities.
 Three types of yield curves include normal, inverted, and flat.
 Normal curves point to economic expansion, and downward-sloping
curves point to economic recession.1
  Yield curve rates are published on the U.S. Department of the
Treasury’s website each trading day.2

Types of Yield Curves

Normal Yield Curve
A normal yield curve shows low yields for shorter-maturity bonds and
then increases for bonds with a longer maturity, sloping upwards. This curve
indicates yields on longer-term bonds continue to rise, responding to periods
of economic expansion.

As yields increase over time, the points on the curve exhibit the shape of an
upward-sloping curve. Sample yields on the curve may include a two-year
bond that offers a yield of 1%, a five-year bond that offers a yield of 1.8%, a
10-year bond that offers a yield of 2.5%, a 15-year bond offers a yield of 3.0%
and a 20-year bond that offers a yield of 3.5%.

Important; A normal yield curve implies stable economic conditions and a

normal economic cycle. A steep yield curve implies strong economic growth,
with conditions often accompanied by higher inflation and higher interest
rates.
Inverted Yield Curve
An inverted yield curve slopes downward, with short-term interest rates
exceeding long-term rates. Such a yield curve corresponds to periods of
economic recession, where investors expect yields on longer-maturity bonds
to trend lower in the future.1 In an economic downturn, investors seeking
safe investments tend to purchase longer-dated bonds over short-dated
bonds, bidding up the price of longer bonds and driving down their yield.
Important; An inverted yield curve is rare but suggests a severe economic
slowdown. Historically, the impact of an inverted yield curve has been a
warning of recession.1

Flat Yield Curve

A flat yield curve reflects similar yields across all maturities, implying an
uncertain economic situation. A few intermediate maturities may have slightly
higher yields, which causes a slight hump to appear along the flat curve.
These humps are usually for mid-term maturities, six months to two years.

The curve shows little difference in yield to maturity among shorter and
longer-term bonds. A two-year bond may offer a yield of 6%, a five-year bond
of 6.1%, a 10-year bond of 6%, and a 20-year bond of 6.05%. In times of high
uncertainty, investors demand similar yields across all maturities.

What Is Yield Curve Risk?

Yield curve risk refers to the risk investors of fixed-income instruments, such
as bonds, experience from an adverse shift in interest rates. Yield curve risk
stems from the fact that bond prices and interest rates have an inverse
relationship to one another, as the price of bonds decreases when market
interest rates increase and vice versa.

How Can Investors Use the Yield Curve?

Investors can use the yield curve to make predictions about the economy to
make investment decisions. If the bond yield curve indicates an economic
slowdown, investors might move their money into defensive assets that
traditionally do well during a recession. If the yield curve becomes steep, this
might signal future inflation. In this scenario, investors might avoid long-term
bonds with a yield that will erode against increased prices.