Yield Curve

1. What it is?
The yield curve, also known as the "term structure of interest rates," is a graph that plots
the yields of similar credit-quality bonds against their maturities, ranging from shortest to
longest. (Note that the chart does not plot coupon rates against a range of maturities --
that's called a spot curve.)
2. Working and examples of Yield curves.
The yield curve shows the various yields that are currently being offered on bonds of
different maturities. It enables investors at a quick glance to compare the yields offered by
short-term, medium-term and long-term bonds.
The yield curve can take three primary shapes. If short-term yields are lower than long-
term yields (the line is sloping upwards), then the curve is referred to a positive (or
"normal") yield curve. Below you'll find an example of a normal yield curve:

If short-term yields are higher than long-term yields (the line is sloping downwards), then
the curve is referred to as an inverted (or "negative") yield curve. Below you'll find an
example of an inverted yield curve:


Finally, a flat yield curve exists when there is little or no difference between short- and
long-term yields. Below you'll find an example of a flat yield curve:


It is important that only bonds of similar risk are plotted on the same yield curve. The
most common type of yield curve plots Treasury securities because they are considered
risk-free and are thus a benchmark for determining the yield on other types of debt.
The shape of the yield curve changes over time. Investors who are able to predict how the
yield curve will change can invest accordingly and take advantage of the corresponding
change in bond prices.
You may like to play with the dynamic yield curve of S&P 500 over past several years at:
http://stockcharts.com/freecharts/yieldcurve.php to understand it better.
3. Importance
In general, when the yield curve is positive, this indicates that investors require a higher
rate of return for taking the added risk of lending money for a longer period of time.
Many economists also believe that a steep positive curve indicates that investors expect
strong future economic growth and higher future inflation (and thus higher interest rates),
and that a sharply inverted yield curve means investors expect sluggish economic growth
and lower inflation (and thus lower interest rates). A flat curve generally indicates that
investors are unsure about future economic growth and inflation. Because the yield curve
is generally indicative of future interest rates, which are indicative of an economy's
expansion or contraction, yield curves and changes in yield curves can convey a great deal
of information.
4. Points to ponder
Historically, an inverted yield curve has been viewed as an indicator of a pending
economic recession. Can you think why would this be the case?
The Yield curves for USD and GBP are given below (as on Feb 2005). What are the
implications of the differences?