• The yield curve is a graph that depicts the relationship between bond yields and maturities.
  
  
• Investors use the yield curve for forecasting interest rates, pricing bonds and creating strategies for boosting total returns.
  
  
• The yield curve has also become a reliable leading indicator of economic activity.

What is Yield?

Yield refers to the annual return on an investment. The yield on a bond is based on the purchase price of the bond and the interest, or coupon, payments received. A bond’s coupon interest rate is usually fixed, but the price of the bond fluctuates with changes in interest rates, supply and demand, time to maturity and the credit quality of that particular bond.

After bonds are issued, they generally trade at premiums or discounts to their face value until they mature and return to full face value. Because yield is a function of price, changes in price cause bond yields to move in the opposite direction.

Calculating bond yields

There are two ways of looking at bond yields:

• Current yield is the annual return earned on the price paid for a bond. It is calculated by dividing the bond’s annual coupon interest payments by its purchase price. For example, if an investor bought a bond with a coupon rate of 6 per cent, and full face value of $1,000, the interest payment over a year would be $60. That would produce a current yield of 6 per cent ($60/$1,000). When a bond is purchased at full face value, the current yield is the same as the coupon rate. However, if the same bond were purchased at less than face value, or at a discount price, of $900, the current yield would be higher at 6.6 per cent ($60/ $900).
  
  
• Yield to maturity reflects the total return an investor receives by holding the bond until it matures. A bond’s yield to maturity reflects all of the interest payments from the time of purchase until maturity, including interest on interest. It also includes any appreciation or depreciation in the price of the bond. Yield to call is calculated the same way as yield to maturity, but assumes that a bond will be called, or repurchased by the issuer before its maturity date, and that the investor will be paid face value on the call date.

Because yield to maturity (or yield to call) reflects the total return on a bond from purchase to maturity (or the call date), it is generally more meaningful for investors than current yield. By examining yields to maturity, investors can compare bonds with varying characteristics, such as different maturities, coupon rates or credit quality.

What is the yield curve?

The yield curve is a line graph that plots the relationship between yields to maturity and time to maturity for bonds of the same asset class and credit quality. The plotted line begins with the spot interest rate, which is the rate for the shortest maturity, and extends out in time, typically to 30 years.

Figure 1 is the yield curve for Australian government bonds on 30 September 2016. It shows that the yield at that time for the two-year Australian government bond was 1.55 per cent while the yield on the 10-year Australian government bond was 1.91 per cent.

A yield curve can be created for any specific bond, from triple-A rated mortgage-backed securities to single-B rated corporate bonds. The US Government (or Treasury) bond yield curve is the most widely used as US Treasury bonds have no perceived credit risk and the Treasury bond market includes securities of virtually every maturity, from three months to 30 years.

A yield curve depicts yield differences, or yield spreads, that are due solely to differences in maturity. It shows the overall relationship at a given time in the market between bond interest rates and maturities. This relationship between yields and maturities is known as the term structure of interest rates.

As illustrated in the above graph, the normal shape, or slope, of the yield curve is upward (from left to right), which means that bond yields usually rise with maturity. Occasionally, the yield curve slopes downward, or inverts.

The slope of the yield curve

Historically, the slope of the yield curve has been a good leading indicator of economic activity. Because the curve can indicate where investors think interest rates are headed, it can indicate economic expectations. A sharply upward sloping, or steep yield curve, has often preceded an economic upturn. The assumption behind a steep yield curve is interest rates will rise significantly in the future. Investors demand more yield as maturity extends if they expect rapid economic growth because of the associated risks of higher inflation and higher interest rates, which can both hurt bond returns. When inflation is rising, central banks will often raise interest rates to fight inflation.

Steep

The graph below shows the steep Australian Government Bond yield curve as the Australian economy began to recover from the global financial crisis of 2007-2009.

Flat

A flat yield curve frequently signals an economic slowdown. The curve typically flattens when the central bank raises interest rates to restrain a rapidly growing economy. Short- term yields rise to reflect the rate hikes, while long-term rates fall as expectations of inflation moderate. A flat yield curve is unusual and typically indicates a transition to an upward or downward sloping curve.

The flat Australian Government Bond yield curve below signalled an economic slowdown in the midst of the global financial crisis.

Inverted

An inverted yield curve can be a leading indicator of recession. When yields on short-term bonds are higher than those on long-term bonds, it suggests that investors expect interest rates to fall, usually in conjunction with a slowing economy and lower inflation.

Historically, the yield curve has become inverted 12 to 18 months before a recession. The graph below depicts an inverted yield curve around a year and a half before the global financial crisis.

Different uses of the yield curve

The yield curve provides a reference tool for comparing bond yields and maturities which can be used for several purposes:

• The yield curve has an impressive record as a leading indicator of economic conditions, alerting investors to an imminent recession or signalling an economic upturn.
  
  
• The yield curve can be used as a benchmark for pricing other fixed-interest securities. Because US Treasury bonds have no perceived credit risk, most fixed-interest securities, which entail credit risk, are priced to yield more than Treasury bonds. For example, a three-year, high-quality corporate bond could be priced to yield 0.50 per cent, or 50 basis points, more than the three-year Treasury bond.

By anticipating movements in the yield curve, fixed-interest managers can attempt to earn above-average returns on their bond portfolios. Several yield curve strategies have been developed in an attempt to boost returns in different interest-rate environments. One such strategy is known as ‘Riding the yield curve’ as a bond approaches maturity on an upward-sloping yield curve (also called ‘rolling down the yield curve’), it is valued at successively lower yields and higher prices. Using this strategy, a bond is held for a period of time as it appreciates in price and is sold before maturity to realise the gain. As long as the yield curve remains normal, or in an upward slope, this strategy can continuously add to total return on a bond portfolio.