Question: I often hear references to the yield curve in discussions about bond funds. Can you explain what it is?
Answer: The yield curve represents the different levels of bond yields as one moves from shorter- to longer-term maturities.
Or, to put it another way, it describes the amount of yield that investors demand for bonds of various required holding periods.
Before we investigate further, let's look at a visual example of what the yield curve is.
Below is a recent chart of the yield curve for U.S. Treasury bonds, with the current yield curve in blue and the yield curve from a year earlier in green.
At the far left are yields for the shortest-term Treasuries (starting with the 3-month T-bill) and at the far right are the yields for the longest-term Treasuries (ending with the 30-year bond).
Yield and maturity: a special relationship
To better understand why yields typically rise as one moves into longer maturities, keep in mind the relationship between the length of time that borrowed money is held and the amount of interest paid on that borrowed money. As a general rule of thumb, the longer money is borrowed, the more that is required to entice a lender--in this case, the person buying a bond--to make the loan. After all, who wants to lock up their money for a long period of time, at a fixed rate of interest, without being adequately compensated for doing so?
You may have first-hand experience with this concept if you've ever bought a home and weighed the pros and cons of taking out a five-year fixed mortgage versus a shorter-term one. The rate on the shorter mortgage is usually lower, in part because the lender--the bank--expects the money to be repaid more quickly than it would if you chose to repay during a five-year time frame. If you want to take longer to repay the loan, you'll normally have to pay a higher rate to make it worth the lender's while. The same principle applies in reverse if you go to buy a guaranteed investment certificate, in which case you act as the lender and the bank acts as the borrower. The longer you agree to tie up your money in the GIC, the higher the interest rate the bank normally has to pay you if it wants your money.
The yield curve and interest-rate risk
If you look again at our chart above, you'll see that the yield curve has steepened since last year, and that yields are higher for maturities of two years and longer. This usually happens when demand for longer-term government bonds decreases, meaning they must offer higher interest rates to attract buyers. The steeper the yield curve the greater the added reward for investors willing to hold longer-dated bonds.
Of course, this reward does not come without risk--in this case, the risk that interest rates in general will rise, thus making bonds worth less, especially longer-dated issues. To illustrate, let's say a five-year bond pays 1% in interest while a 30-year bond pays 3%. Buying the 30-year bond may be more enticing if you're looking for a higher yield. But if interest rates rise across the board, the 30-year bond is likely to lose more of its value than the five-year bond. Why? Remember that when interest rates rise the prices of older bonds, whose rates are now lower than an investor can get with new bonds, drop to compensate for this difference. And because the 30-year bond is set to pay its yield for a much longer period than the five-year bond, its value is more affected by a rate increase than the short-term bond's value is. This is why bonds with longer durations--a measure of interest-rate sensitivity based in part on the bond's length of maturity--are considered more vulnerable when rates rise than bonds with short durations.
Also note that the yield curve isn't necessarily smooth. There may be certain points along the curve that are steeper or flatter than others, and during inflection points in the economy the curve can even be inverted for a while. Bond-fund managers with the ability to invest up and down the maturity spectrum watch these patterns for opportunities. For example, if a small increase in maturity results in a significant increase in yield, a fund manager might feel it's worth taking on the added interest-rate risk by buying the longer-dated bond. On the other hand, if the yield curve is relatively flat and the bond manager is concerned about interest-rate risk, he might move to shorter-maturity bonds under the assumption that the reduced rate risk of the shorter-maturity bond more than makes up for its lower yield.
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