Investors expect to receive some income or return as compensation for lending funds to a borrower. The return on debt investments, when annualised in percentage terms is referred to as yield. The concept of 'yield' in debt securities plays a crucial role in determining the investment and trading decisions of a bondholder. Depending on the nature of the investment, bond yields have different yield options, i.e., Nominal Yield, Current Yield, and Yield to Maturity.

Nominal yield is the bond issuer's coupon rate, while current yield is its interest rate as a percentage of its market price. Yield to Maturity estimates an investor's income if they hold the bond till maturity.

What is a Yield Curve?

The yield curve is a graphical representation of the yields on a series of fixed-income securities with different maturity dates and similar credit ratings. The curve plots the yield of these securities on the y-axis and their respective maturities on the x-axis.

The above chart indicates that for tenure between 1 to 5 years, Indian government securities' yield to maturity offers 7.00-7.10% returns, and the longer tenure bonds with maturity between 35 to 40 years offer 7.48-7.51%.

A graph can be plotted for corporate bond securities with different maturity dates and similar credit ratings to derive the corporate bond yield curve as well.

The yield curve is generally upward-sloping, stating that longer-tenure bonds tend to offer higher yields than shorter-tenure debt securities. The slope of the curve gives the relative risk premia for the additional time that investors' money is being lent.

The yield curve, which plots the yield level of a grouping of bonds for government securities helps in assessing the future state of the economy, i.e., if the economy is going to grow fast or may slip into a recession.

The shape of the yield curve is used to indicate the state of the economy. There are generally four types of yield curves.

Yield Curve Shapes

The yield curves typically take four shapes:

• Normal
• Inverted
• Flat
• Humped

Normal Yield Curve:

This upward-sloping yield curve shows that yield increases with increasing maturity. Given that risk premia are higher for longer maturities, long-term yields are higher than short-term.

The upward slope of the yield curve in this instance implies investors' views that the economy would expand in the future and, more crucially, that this expansion will probably be accompanied by a higher risk of inflation.

Inverted Yield Curve:

The short-term yields are higher than the long-term yields in this type of curve. Periodically, policy rates are raised to curb excessive demand and burst financial bubbles.

Strong asset-liability mismatches may cause an inverted yield curve. Inverted yield curves can foretell recessions and economic downturns. Technical causes like a flight to quality, or global economy or currency crisis could enhance demand for bonds at the long end of the yield curve, lowering rates.

Flat Yield Curve:

Here, yields are constant regardless of maturity period. There is no distinction between short-term and long-term yields, indicating that greater maturities do not carry a premium.

Later in the economic cycle, when interest rates rise as a result of rising inflation expectations and tighter monetary policy, there is little to no difference between short- and long-term interest rates.

Humped Yield Curve:

When yield curves are humped, the medium-term yield is higher than the short- and long-term yields. It may occur when the market expects interest rates to rise in the future but then fall back again in the long term.

A humped yield curve can also signify market anxiety, where investors are unsure on interest movements.

Economists closely monitor the yield curve because it can reveal important information about the status of the economy and financial markets. An economy may be improving if the yield curve is steepening, while an economy may be slowing down or entering a recession if the yield curve is flattening or inverted.

Sources: Clearing Corporation of India Ltd, Financial Benchmarks India (Private) Ltd