How to Understand a Bond Yield Curve

The yield curve refers to a graph displaying the yield (effectively the interest rate) of bonds issued by one issuer against the time to maturity. The yield is plotted on the y-axis, with zero at the bottom increasing upwards, and maturity period on the x-axis, with 0 on the left increasing to the right.

One method by which a large entity – normally a government, municipality, parastatal organisation, or even large corporation – raises money is by issuing bonds. These generally have a coupon price (nominal interest rate) and a maturity date.  Investors then buy these bonds – effectively lending money to the issuer – and receive the interest as specified in the coupon.

Bonds can then be traded on secondary markets such as the NYSE. The price at which these bonds are traded  depends on the perceived risk of the issuing organization:– will it be able to pay the interest due?  If the issuer is seen to be risky, the price of the bond falls, thereby effectively pushing up the interest rate. As an example, if a USD100 bond with coupon of 3% is traded for USD90, the effective interest rate will be 3.3% (3/90 as a percentage). If however it is traded for USD 110, the effective interest rate will be 2.72% (3/110 as a percentage). We see this effect markedly in the Eurozone at the beginning of 2012:- some Italian debt was ‘sold’ at effective yields of above 7% during the height of the crisis, while bonds issued after the Eurozone rescue plan traded at a yield just above 6%.

To develop the yield curve we graph all of the bonds issued by a particular issuer, and graph them against the maturity date. A review of on 16th January showed bonds issued by the US government with a maturity period of  3, 6 and 12 months, as well as 2, 3, 5, 7, 10 and 30 years. The coupon rate varied from 0% (3, 6 and 12 month) to 3.125% (30 year) while the effective yields based on market trades ranged from 0.03% to 2.92% . What is noticeable is that as the period increased, the yield increased. This differs slightly from bonds issued by the German government (also as shown by Bloomberg on 16th January) where again there were bonds with maturity periods of 3, 6 and 12 months, as well as 2, 3, 4, 5, 6, 7, 8, 9, 10, 15, 20 and 30 year. In this case the effective yield did not show a steady increase with time. For bonds maturing in 6 months to 2 years the effective yield is less than bonds maturing in 3 months.

A yield curve which shows a steady increase over time is considered a ‘normal’ curve. In a stable environment an investor feels confident about the near future, but less confident the further into the future you go. An increased yield is required to compensate for this risk. However when the risk curve is flat or inverted (the yield is lower for long term bonds than for short term bonds) there is a large perceived risk in the near future. This could be a fear of recession or other financial turmoil. The yield curve for the German bond could be showing some of this fear – it could however also be a result of market turmoil in an unstable environment.

The yield curve is therefore seen as a leading indicator for the economy. Leading indicators indicate what the market expects to occur. A normal yield curve indicates normal stability; an inverted curve shows expected instability, even recession.

For the record, the yields as presented by Bloomberg at the end of 16th January 2012 are shown in the graph above.