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Introduction to Yield Curves

A Yield curve is a graph that plots the relationship between the yield-to-maturity and length-to-maturity of a sample population of bonds that are comparable in structure and quality. The relationship between the yield-to-maturity and length-to-maturity of a sample population is known as the sample’s term structure of interest rates. Investors use yield curves to plot the term structure of interest rates of various groups of bonds including treasuries, comparable municipal bonds, and corporate bonds of the same industry (or the same credit rating).

Yield curves plot yield-to-maturity on the y-axis (vertical axis) and length to maturity on the x-axis (horizontal axis). Notice that the yield curve, below, has an upward slope. This is considered the normal shape of term structure according to the Liquidity Preference Theory which suggests that bonds with longer lengths-to-maturity must offer greater yields than shorter-term bonds because investors require additional compensation for exposing themselves to risk over time (Reference the following tutorial: Theories of Term Structure).

Although an upward sloping yield curve is considered normal, term structures continually change in response to supply and demand forces. Yield curves may become inverted, flat, or humped. For example, suppose a significant economic event transpires that results in a dramatic increase in short-term interest rates. If short-term yields exceed intermediate and long-term yields, the yield curve will develop an inverted slope, shown below.

A short-term increase in the supply of an intermediate-term note could significantly increase the note’s yield, creating a humped yield curve, shown below. Alternatively, if market interest rates are high, and investors expect them to decrease, the yield curve may temporarily assume a humped shape as yields adjust to supply and demand equilibrium.

On certain occasions the yield curve may also assume a relatively flat shape.

Questions:

1. What is a yield curve?

2. Explain the theory behind an upward sloping yield curve? Why is this a normal condition of term structure?

Answers:

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