Yield Curve: Types & Explanation

Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll explain three types of yield curves: upward, downward and flat. You'll learn about how bond maturities and interests form the basis for each curve and its meaning.

What Are Yield Curves?

Bailey's a junior attending the University of LBY majoring in finance. She's having a difficult time understanding yield curves and finds a tutor to help. The tutor, James, starts by explaining the first step in understanding yield curves is having a solid foundation in bonds.

Bonds are securities sold by corporations and the government when they want to expand and grow. In return, the investor expects periodic interest payments and repayment of the bond at maturity. The bond is similar to a loan: the investor loans money to an entity and the entity pays interest until the bond is repaid.

In the larger scheme of things, bankers, economist, investors, market analysts and others are interested in determining how bond interest rates will change based on differing maturities and, therefore, use yield curves to help with the analysis. Although no one can predict the future, yields curves help us understand the patterns.

For the rest of this lesson, we'll review bond maturities and interest and their impact on three types of yield curves: upward sloping, downward sloping and flat.

Short, Intermediate & Long-Term Bonds

James asks Bailey to identify the maturities for short, intermediate and long-term bonds. Bailey explains that short-term bonds mature in about one to three years, intermediate bonds are repaid in about three to ten years and long-term bonds mature in ten to 30 years.

Investors purchase short-term bonds if they're interested in using their money sometime in the near future. For example, if you won the lottery and planned to purchase a house once you graduated from college in a few years, a short-term bond would pay more interest than depositing the money in a savings account.

Bailey then asks why an investor would purchase an intermediate or long-term bond. James gives an example of a parent saving for their child's college fund, while a long-term bondholder may be interested in saving for retirement or estate planning. Now let's take a look at the correlation between interest rates, maturities and the economy.

Upward Sloping Yield Curve

James asks Bailey to remember a simple correlation between risk and interest rate returns. Typically, short-term bonds pay a lower interest rate return than long-term bonds, hence they have an upward sloping yield curve. Bailey looks puzzled and asks why. James explains that in a recession, short-term interest rates will be lower.

Corporate and government entities aren't interested in paying the bondholder back anytime soon and, therefore, pay a lower interest rate return on short-term bonds. Additionally, short-term bonds simply have less risk than long-term bonds. Investors face risk in any investment, and while stocks are more risky than bonds, bonds still have some risk, even short-term bonds.

The Riskiness of Bonds

When we think about government bonds (treasury bonds), we know they're backed by the full faith and credit of the United States and, therefore, have minimal risk. In sum, treasury bonds have little risk of default. However, corporate bonds carry default risk. It's possible that a corporation may lose its strong financial position and not be able to pay the bondholders back.

Liquidity risk also exists if the bondholder decides to sell the bond before maturity, meaning he or she may not be able to sell due to minimal demand. Therefore, their option for liquidating the bond or turning it into cash becomes drastically diminished.

Another type of risk concerned with corporate and government bondholders is inflation risk. Inflation risk occurs when prices rise substantially and the bondholder loses money from his or her locked in interest rate return. For example, let's say a bondholder has a 3% interest rate return, but inflation increases interest rates to 7%, which makes the bondholder's purchasing power diminish.

James sighs and says that he explained the whole risk/return thing to say that bondholders who carry bonds a longer time are rewarded with higher interest rate returns because of the risks involved. As a result, upward sloping yield curves are historically frequent, though the opposite can occur.

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