The Yield Curve
The three types of bonds most commonly issued are government, municipal, and corporate bonds. They are typically issued with a face value, which is paid in full upon maturity, and interest payments, also known as coupons, which are paid periodically to the bondholder until maturity. The cash flow that an investor receives from bonds is fixed, which is why bonds are the prototypical example of a ‘fixed income’ instrument.
A bond’s yield is its effective rate of return, and is inversely proportional to its price: when the price of a bond rises, investors are paying more for the same series of cash flows, lowering its effective rate of return.
Fig. 1 Example of ordinary upward-sloping yield curve
The Yield Curve
A yield curve plots the yield of a given type of bond (y-axis) at various maturities (x-axis). The most notable yield curve is the U.S. Treasury yield curve, which portrays yields on U.S. Treasury debt of various maturities (1 month to 30 years). Typically, it slopes upwards - that is, bonds with longer maturities have higher yields. That higher yield (rate of return) compensates investors for risks they take on when investing in longer-maturity bond:
Interest rate risk: in a growing economy, investors expect interest rates to rise over time, which would lower the price of existing bonds as they become less attractive compared to new bonds issued at higher interest rates. Hence, they demand a higher yield for a bond they will have to hold for a long time, to offset the risk of that bond substantially falling in value over time.
Default risk: ordinarily, near-term default risk is lower than long-term default risk. There is much more uncertainty about a government or company’s ability to repay a bond in 10 years’ time compared to in 2 years’ time; hence, holders of longer maturity bonds face a higher default risk.
When the yield curve inverts, short-term yields become higher than long-term yields. It is widely considered to be a predictor of economic recessions, and has been extremely accurate in predicting past recessions. In fact, every recession in the U.S. since WW2 has been preceded by a yield curve inversion, with the recession typically taking place between 12 and 18 months after the inversion.
Relationship between the Yield Curve and Recessions
Recall that an upwards-sloping yield curve indicates that investors expect interest rates to rise and view near-term default risk as relatively low. Conversely, an inverted yield curve signals that investors expect interest rates to fall and for near-term default rates to be exceptionally high. Both events are correlated with recession – in a recession, central banks lower interest rates to stimulate the economy, while companies and governments hit by a sluggish economy are much more likely to default on their debt. That is why an inverted yield curve is regarded as an indicator of recessionary expectations.
Fig. 2 Chart depicting difference in yield between 10-year and 3-month U.S. treasuries, which is positive under ordinary circumstances. A negative value represents an inversion of the yield curve. The shaded region represents the recession sparked by the 2008-09 Global Financial Crisis, which followed the last yield curve inversion prior to 2019.
Relevance of the Yield Curve Today
The yield curve has inverted several times since the start of 2019, with the Yield Curve first inverting in March 2019 and most recently in February-March 2020. The most recent inversion could be attributed to fears of a slowdown in global growth due to the Covid-19 pandemic, while the March 2019 inversion was mostly attributable to the U.S.-China trade war, for which tensions was then at its peak.
With the swift escalation of the Covid-19 crisis over the past month, a recession is indeed almost certainly on the cards in 2020. As policymakers employ sweeping policy intervention to limit the damage to the broader economy, we are facing a historically-low interest rate environment, with the U.S. Federal Reserve cutting interest rates to near zero through a series of rate revisions. The yield curve reflects this state: at present, yields are depressed across the board, with the 10-Year treasury yield standing at under 1% and shorter-term treasury bills offering a yield even closer to 0.
Fig. 3 U.S. Treasury yield curve in April 2020
The yield curve, while straightforward in its derivation, reveals tremendous insight into the aggregate sentiment of investors and the prevailing state of the economic and financial markets. With the present moment presenting an unprecedented time for the markets, it is interesting to note how evolving developments in the present macroenvironment shape the markets in the months ahead, and how all of that plays out in the yield curve.