Yield Curve
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Yield curves depict the level of interest paid by different bonds with the same level of risk but different maturities. In other words, quality of these bonds is the same but they are yet offered at different rates which differ as per their maturity.
The maturity period could range from 3 months to 30 years. Yield curve is a line formed by plotting the rate of interest for different bonds. The line or the curve could be upward sloping, downward sloping or flat.
Different types of yield curves can be assessed to get an idea of the macro-economic situation and future interest rates that depend on these situations. Yield curve is a prediction of changes in interest rates that may or may not occur, steeper curves depict big changes while flat curves depict no change at all.
Types of Yield Curves:
Normal Yield Curve –
It is an upward sloping yield curve which depicts that the short-term interest rates are lower than long-term interest rates. Here investors project that the short-term interest rates may rise in the future.
Inverted Yield Curve –
it is a downward sloping yield curve which depicts that interest rate for bonds with longer maturity is lower than that of short-term in which case, investors project that short-term interest rates may fall in the future.
Flat Yield Curve –
flat curves depict no change in interest rates.
Why is it important?
Assessing yield curves can help you forecast the future course of interest rates. For instance, a downward slope suggests that interest rates may fall in future which means the prices of these bonds are set to rise which will open more opportunities to enter the market.
The slope is important for financial intermediaries to ascertain the spread between borrowing and lending rates. If the curve is upward sloping, banks sell their short-term deposits and borrow funds to lend them for a longer term. Wider the gap between borrowing and lending rates, greater the profit for these financial institutions. For borrowers, if the slope is downward, they may refrain from taking long term loans with fixed interest rates and wait until the rates fall.
The yield curve helps investors determine whether a particular security is under- valued or over-valued. If the yield of a particular security is above the yield curve, then that means that this security is temporarily undervalued (since securities with higher yields have a lower price). This deviation could take place due to a number of reasons, spotting it at the right time can help investors seize rare opportunities.
The curve also helps investors arrive at investing decisions in terms with maturity. For instance, if the curve is upward sloping, the investor can increase their average return by investing in securities with longer maturity provided the returns are a reasonable trade off for the risk that comes with long maturities.