Yield Curve: What It Is and How to Use It

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What Is a Yield Curve?

A yield curve is a line that plots the yields or interest rates of bonds that have equal credit quality but different maturity dates. The slope of the yield curve predicts the direction of interest rates and the economic expansion or contraction that could result.

Yield curves have three main shapes: normal upward-sloping, inverted downward-sloping, and flat. Yield curve rates are published on the U.S. Department of the Treasury’s website each trading day.

Key Takeaways

• Yield curves plot the interest rates of bonds of equal credit and different maturities.
• Normal curves point to economic expansion.
• Downward-sloping curves point to economic recession.
• Yield curve rates are published on the U.S. Department of the Treasury’s website each trading day.

Using a Yield Curve

A yield curve is a benchmark for other debts in the market such as mortgage rates and bank lending rates. The yield curve can predict changes in economic output and growth over time.

The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year, and 30-year U.S. Treasury debt. Yield curve rates are available on the Treasury's interest rate websites by 6:00 p.m. ET each trading day.

Some investors use the yield curve to make investment decisions based on the likely direction of bond rates. A visual representation of the curve is easy to build using an Excel spreadsheet.

Types of Yield Curves

The three types of yield curves include normal, inverted, and flat.

Normal Yield Curve

A normal yield curve shows low yields for shorter-maturity bonds increasing for bonds with a longer maturity. The curve slopes upward. This indicates that yields on longer-term bonds continue to rise, responding to periods of economic expansion.

A normal yield curve implies stable economic conditions and a normal economic cycle. A steep yield curve implies strong economic growth with conditions often accompanied by higher inflation and higher interest rates.

Sample yields on the curve can include a two-year bond that offers a yield of 1%, a five-year bond that offers a yield of 1.8%, a 10-year bond that offers a yield of 2.5%, a 15-year bond offers a yield of 3.0%, and a 20-year bond that offers a yield of 3.5%.

Some bond investors will use a roll-down return strategy and sell a bond as it moves toward its maturity date. This strategy is also known as riding the curve. It works in a stable rate environment as the bond's yield falls and the price rises. Investors hope to capture profit from the rise in bond prices.

Inverted Yield Curve

An inverted yield curve slopes downward with short-term interest rates exceeding long-term rates. This type of curve corresponds to a period of economic recession when investors expect yields on longer-maturity bonds to trend lower in the future.

Investors seeking safe investments in an economic downturn tend to choose longer-dated bonds over short-dated bonds, bidding up the price of longer bonds and driving down their yield.

An inverted yield curve is rare. It's historically been a warning of recession.

Flat Yield Curve

A flat yield curve shows similar yields across all maturities, implying an uncertain economic situation. A few intermediate maturities may have slightly higher yields that cause a slight hump to appear along the flat curve. These humps are usually for mid-term maturities of six months to two years.

The curve shows little difference in yield to maturity among shorter and longer-term bonds. A two-year bond may offer a yield of 6%, a five-year bond of 6.1%, a 10-year bond of 6%, and a 20-year bond of 6.05%.

In times of high uncertainty, investors demand similar yields across all maturities.

What Is a U.S. Treasury Yield Curve?

The U.S. Treasury yield curve is a line chart that allows for the comparison of the yields of short-term Treasury bills and the yields of long-term Treasury notes and bonds. The chart shows the relationship between the interest rates and the maturities of U.S. Treasury fixed-income securities.

The Treasury yield curve is also referred to as the term structure of interest rates.

What Is Yield Curve Risk?

Yield curve risk refers to the adverse effect of a shift in interest rates on the returns from fixed-income instruments such as bonds. It stems from the fact that bond prices and interest rates have an inverse relationship to each other. The prices of bonds in the secondary market decrease when market interest rates increase and vice versa.

How Can Investors Use the Yield Curve?

Investors can use the yield curve to make predictions about the economy that will affect their investment decisions.

An investor might move their money into defensive assets that traditionally do well during a recession if the bond yield curve indicates an economic slowdown. They might avoid long-term bonds with a yield that will erode against increased prices if the yield curve becomes steep, suggesting future inflation.

The Bottom Line

Yield curves come in three main shapes: a normal upward-sloping curve, an inverted downward-sloping curve, and a flat curve. The slope of the yield curve predicts interest rate changes and economic activity. Investors can use the yield curve to make investment decisions that factor in the likely direction of the economy in the near future.

1. U.S. Department of the Treasury. "Treasury Yield Curve Methodology."
2. U.S. Department of the Treasury. "Daily Treasury Par Yield Curve Rates."
3. Federal Reserve Bank of Chicago. "Chicago Fed Letter, No. 404, 2018: Why Does the Yield-Curve Slope Predict Recessions?"

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A Treasury Bill, or T-bill, is a short-term debt obligation issued by the U.S. Treasury and backed by the U.S. government with a maturity of one year or less

Price value of a basis point (PVBP) is a measure used to describe how a basis point change in yield affects the price of a bond.

Ba2/BB are ratings by Moody's Investor Service and S&P Global Ratings, respectively, for a credit issue or an issuer of credit below investment grade.

A war bond is is a form of government debt that seeks to raise capital from the public to fund war efforts.

A payment-in-kind bond is a type of bond that pays interest in additional bonds rather than in cash. PIK bonds are typically issued by companies facing financial distress.

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