Fixed-income. A topic not widely covered in the blogosphere, but very important to understand.
Defined:
The Yield curve is a line that plots the interest rates, at specific time points, of bonds that have different maturity dates. The two metrics being calculated are: (i) the interest rate, and (ii) time. You may have seen this graph before and not even known it. It’s a graph that shows the 3-month, 2-year, 5-year and 30-year interest rates for the U.S. Treasury debt. This curve is frequently used as the benchmark for many other debt-contingent markets like the mortgage industry and banking industry. It also is used as the “risk-free rate” when you’re using the CAPM model whether in valuation or in some other fashion. It’s also a good indicator for change in the economic, sociocultural and growth climate.
Video Overview:
Types of Treasury Debt:
- Treasury Bills: Short-term (1 month to a 11 months) loan/IOU
- Treasury Notes: 1 year to 10 year loan/IOU
- Treasury Bonds: 10 year loan/IOU
Why It’s Important:
The reason why the yield curve is brought up frequently revolves around the future speculation that can be reasonably drawn. What do I mean? The future interest rate, economic activity and needs of the government can be deciphered through rate changes.
Types of Yield Curves:
There are three main types of yield curve shapes:
Normal (above): A normal yield curve (pictured here) is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time.
Inverted (above): An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession
Flat (above): (or humped) yield curve is one in which the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition
The slope
The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.
Why It’s Misunderstood:
When you think of yield, you think of how much it will return, which is used interchangeably in society. This is true; however, don’t forget that the yield is stretched over the x-axis: time. That’s why there’s a curve. Very simple. A synonym for yield curve could be: the interest rate (return) stretched over time. That’s it. Simple.
Analysis:
So how can you draw critical analysis from the yield curve?
First, here’s a worthwhile read on drawing analysis from the yield curve: pdf download
Second, it’s worth reading PIMCO’s reports, here, where they discuss issues relating the fixed-income markets. It definitely gives one a 1,000 foot view perspective on launching a venture. Bill Gross’ recent Investment Outlook is particularly insightful, as well as entertaining: here
Last, here’s a video that’s insightful to grasp a bigger understanding:
Sources: Investopedia
