Demystifying the Yield Curve

Many investors approach fixed income markets with a sense of trepidation as the concepts underlying them appear somewhat arcane. Partly this is due to the nature of fixed income investments and the more formalised dynamics and relationships which drive their returns. To demystify the fixed income markets what follows is a series of primers outlining the key concepts behind fixed income dynamics and portfolio management. The second installment of this series shall take a closer look at the concept of the yield curve.

Defining the Yield Curve

A yield curve is a line that plots the yields of a series of bonds having equal credit quality but differing terms to maturity. As the term to maturity lengthens the yield curve effective sets out the yield earned by an investor committing to longer investment horizons. An important nuance for investors to appreciate is that the yield to maturity of a bond is only earned when held to maturity. Accordingly, the difference in yield between say, a 5 year bond and a 10 year bond, is the yield differential earned from extending the investment horizon from 5 years to 10 years. The difference in yield earned by investing in longer terms to maturities is referred to as the term premium. Investors should also note that there is technically no such thing as ‘the’ yield curve or term premium. Since a yield curve assumes equal credit quality there will be many yield curves based on different levels of credit quality. In practice when referring to the yield curve the reference is most often to that derived from ‘risk free’ bonds which usually comprise the highest quality government bonds; i.e. bonds without a credit spread premium.

Interpreting the Yield Curve

There are several ways of interpreting the yield curve though the most common is as an indicator of the economic cycle and the outlook for interest rates. To see why start by considering that the most common type of yield curve is one where yields are rising as the term to maturity lengthens; i.e. term premium is positive. This may be referred to as a ‘normal’ yield curve. The term ‘normal’ in this context references the natural tendency that an investor will require a higher yield, or a term premium, to be induced to commit to a longer investment horizon.

The linkage to the economic cycle occurs as the required term premium is not a constant and may be impacted by a range of factors. One of the most important of these factors is the market’s expectation regarding the future path of interest rates. To see why consider that logically it follows the higher an investor expects future interest rates to be the higher the term premium required to induce then to commit to longer maturity bonds. Higher expectations regarding future interest rates therefore result in a steeper yield curve as the term premium required to induce investors to hold longer term bonds increases. Due to this dynamic a ‘normal’ yield curve is usually associated with the expansion phase of the economic cycle; i.e. reflects the natural bias for economies to grow over time.

Under this interpretation of the yield curve it follows that the opposite holds as an economy goes into the contraction phase of the cycle. As the market expects that interest rates will be lower going forward this will push down the term premium required to induce investors to hold longer maturity bonds. This can occur until the point is reached that investors actually require a lower yield to hold a longer dated bond compared to a shorter dated bond; i.e. the term premium becomes negative. Where the market’s expectations create a negative term premium the result is what is referred to as an ‘inverted’ yield curve.

Inverted yield curves are accordingly a signal that the market expects that economic conditions will deteriorate sufficiently that interest rates will be materially lower going forward. It is via this connection of the term premium with expected future bond yields that the yield curve becomes an important indicator of the market’s assessment of the state of the economy and its positioning within the growth/monetary policy cycle. Importantly, under the pure expectations theory the shape of the yield curve not only indicates the directional bias of expected interest rates but also the absolute level of expected future interest rates.

Factors Impacting on Expectations Theory

Complicating the interpretation of the yield curve are other factors which may act to drive a wedge between the actual yield curve and the pure expectations model. The reason for this is that the expectations theory implicitly assumes that all bonds, irrespective of the term to maturity, are considered by investors as being perfect substitutes. Under such an assumption the differences in yields for different maturities will simply reflect differences in expected future interest rates. In practice this may not necessarily be the case with there being several factors which may result in bonds of different maturities not being viewed as substitutes.

IIliquidity Premium : Illiquidity premium refers to the additional return investors require as compensation for securities not being readily tradeable. The logic follows that the longer the term to maturity of a bond the less liquid the bond will be and the higher the illiquidity premium required by investors; i.e. the term to maturity of a bond and its level of illiquidity are positively related. Hence a longer term bond will have a higher yield partly because it is less liquid. The result is that the actual yield curve will have a bias to lie above the expected future interest with this difference increasing as the term to maturity of a bond increases. An example of the impact of the potential existence of a liquidity premium is that a modestly upward sloping yield curve may simply reflect such a premium rather than signalling that interest rates are expected to rise.

Preferred Habitat : Proposes that different bond investors have a preference for a particular maturity length over another; i.e. have a preferred habitat. For such investors any move outside of their preferred maturity band is viewed as risky. Accordingly, for investors to be willing to buy bonds outside of their preferred habitat they require a higher yield as compensation. The result of the existence of preferred habitats is that changes in the supply and demand for bonds at different parts of the yield curve can have a more material impact on yields.

Segmented Market : A stronger variant of the preferred habitat is the segmented market. In a segmented market the difference in investors preferences is so strong that short term and long term interest rates are no longer related to each other. Effectively short, intermediate and long term bond rates should now be viewed as different markets for debt securities where yields are determined solely by the supply and demand dynamic within each segment. The existence of such a strong version of investor preferences is likely to be associated with specific regulatory requirements being applied to financial markets or institutions.

The yield curve is one of the cornerstone dynamics indicating the market’s expectations regarding both interest rates and the economic cycle. Understanding the yield curve and its interpretation is accordingly one of the key aspects to appreciating the different dimensions associated with managing the risk within a fixed income portfolio. For this reason, though the yield curve may be useful in signalling the market’s expectation regarding the directional bias of interest rates, using it to forecast the actual expected future level of interest rates beyond a couple of years can prove much more problematic.