The yield curve is a graphical representation of the Yield to Maturity (YTM) of bonds with varying maturities. It provides information on the internal rate of returns the market expects for investing over different horizons.

The graph vertical axis denotes the bond YTM and the horizontal axis denotes the time left for maturity.

Many fixed-income analysts consider the yield curve as an indicator of the market outlook towards the issuer. An upward sloping curve implies higher interest rates in the future as compared to the present and a downward sloping curve implies lower interest rates in the future.

The key Yield curves are:

Normal Yield curve - The normal curve implies that investors expect a higher yield for investing their capital for a longer duration. That means short-term debt will attract lower yield and long-term debt will attract higher yield. This is called a normal curve because usually, investors expect higher compensation for taking on greater risk. Under the normal yield curve, the market expects more compensation for holding their bonds for a longer duration which is exposed to the market ups and downs. This means bonds are exposed to the market risks such as fluctuations in the interest rates and exposure to potential defaults. The normal yield curve moves upward to represent higher yields as mentioned in the below graphical representation associated with the longer-duration investments. However, after touching at a certain peak the market sentiments assume that the bond will generate a lower interest rate in the future, and this shifts the momentum of the curve sloping downwards after its peak. Generally, the sloping curve refers to the falling of long-term interest rates below the short-term interest rates. Thus at certain points in the economic cycle, the curve slope downwards and in fact turns flat thereby stating indications of the market that the interest rates will be lower in the future than they currently are.

Inverted yield curve - Inverted curves are downward sloping curves. Under this scenario, investors expect higher yields for short-term debt and lesser yield for longer-term debt. An inverted yield curve scenario is a rare one and is usually considered as a sign of an impending recession. Historically, inverted yield curves have been followed by recessions in some parts of the world and hence an occurrence of an inverted yield curve attracts a lot of attention.

Humped yield curve - Under the humped yield curve the YTM on the medium-term bonds are more than both the short-term and long-term bonds. This implies that investors expect some period of uncertainty in the economy.

The yield curve is considered important by investors across the world since it conveys the market outlook for the future.

Consult your Bondskart consultant today to understand more about the yield curve.