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Simply Put: Yield Curve

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Two young professionals meet up for coffee and end up discussing financial terms after watching some news on the TV screen at the cafe.

Kuldeep: I think I will have a cappuccino. Espresso for you?

Navya: I am a little distracted. I am trying to understand what they are saying on TV about interest rates.

Kuldeep: I never knew you were interested in all this financial mumbo-jumbo. This ‘mocha’ me very happy!

Navya: Nice pun. Wait, they are saying post the RBI policy, the overall yield curve hardened while the shorter end of the yield curve hardened by a greater extent. What is this curve business?

Kuldeep: That’s not a hard question, ha-ha. A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates.  Short end of the yield curve refers to yields that are generally less than one year. On the other hand, long end of the yield curve refers to yields that are 10 years or greater.

Navya: That’s a brewtiful explanation.

Kuldeep: Thanks, you are good with puns too. Think of the yield curve as a graphical illustration of the relationship between interest rates and bond yields of various maturities. The graph is plotted with the y-axis depicting interest rates, and the x-axis showing the increasing time durations.

Navya: But sir, what is the use of this yield curve?

Kuldeep: Basically, the slope of the yield curve gives an idea of future interest rate changes and economic activity. Shifts in the shape and slope of the yield curve are thought to be related to investor expectations for the economy and interest rates.

Navya: I just googled yield curve images and it shows this.

Kuldeep: That’s a normal yield curve.

Navya: What’s normal about this?

Kuldeep: Here, I thought we’d be spending some quality time. Instead, we are discussing yields and curves! Short-term bonds typically have lower yields than longer-term bonds. So, the curve slopes upwards from the bottom left to the right. That is a normal yield curve.

Navya: Okay. So, why does the curve change then?

Kuldeep: You got to understand that interest rates and bond prices have an inverse relationship. So, prices fall when interest rates rise, and vice versa. So, when interest rates change, the yield curve will shift, representing a risk. This is called yield curve risk. Bond investors are worried about it.

Navya: But why are they worried? Wouldn’t the curve change all the time due to market activity?

Kuldeep: ​Flattening or steepening of the yield curve is a result of changing yields among comparable bonds with different maturities. When the yield curve shifts, the price of the bond will change. If prices fall, you will face a loss. 

 Navya: And when does the curve flatten? 

 Kuldeep: Usually when long- and short-term interest rates converge, the yield curve flattens. This happens due to narrowing of the yield spread. The yield spread refers to the difference in the yield on two different bonds or two classes of bonds. When this happens, the price of the bond will change accordingly. A flattening yield curve usually indicates economic weakness.

Navya: Oh! So, in case of steepening yield curve, the spread widens?

Kuldeep: Exactly. If the yield curve steepens, this means that the spread between long- and short-term interest rates has widened. So, the yields on long-term bonds are rising faster than yields on short-term bonds, or short-term bond yields are falling as long-term bond yields are rising. A steepening curve typically indicates stronger economic activity and rising inflation expectations and, by extension, higher interest rates.

Navya: This was all so informative. You explained it with so much patience.

Kuldeep: Hope you will be buying me a strong cup of coffee and we can continue our chat.

Published on May 13, 2022

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