Fixed income exposure has been a staple for many investors, as historically these products have offered steady sources of current income as well as relatively low levels of risk. Often referred to as the “safe haven” asset class, bonds have typically been the go-to investment for those nearing retirement and those wanting to park their assets in something safer during volatile environments [see also Want A Simple, 3-ETF Portfolio? Here are 25 of Them].
Since the unprecedented rounds of quantitative easing by the Federal Reserve, however, bonds have not exactly followed their fundamentals. With the central bank keeping interest rates artificially low, yields on Treasury and investment-grade bonds have subsequently fallen, forcing investors to look towards other asset classes on the hunt for yield.
Now that the Fed is scaling back its massive bond buying program and has announced its intentions to raise interest rates sometime in the next year or two, investors will need to get back to basics when it comes to fixed income investing. And for bond investors, there is one concept that is absolutely essential to grasp: yield curves.
What Is a Yield Curve?
While there are a number of metrics and terms that bond investors should be familiar with, such as the difference between current yield and yield to maturity (read more about yields here), the yield curve is one of the most closely scrutinized models in the finance world. Simply put, the yield curve is a line graph that depicts the relationship between yields to maturity and time to maturity for bonds of the same asset class and credit quality. Below is a picture of a normal yield curve (we’ll learn more about curve types below):
In a yield curve graph, the x-axis measures maturity and the y-axis measures yield. The starting point of the curve is called the spot interest rate, which is the rate for the shortest maturity. In this example, bonds with longer maturities have higher yields relative to shorter-dated bonds.
The Most Important Yield Curve: U.S. Treasuries
Though a yield curve can be drawn for essentially any type of fixed income security, investors are most concerned with the U.S. Treasury yield curve. Because U.S. Treasury bonds theoretically have no credit risk (i.e. the U.S. will not default), investors can use the Treasury yield curve to price other fixed income securities (which do have credit risk).
For example, a corporate bond of investment grade quality may be priced to yield 60 basis points higher than the yield of a Treasury bond with the same maturity. Conversely, a junk bond with the same maturity could be priced 400 basis points higher than the Treasury bond yield (or “over the curve”) [See 101 ETF Lessons Every Financial Advisor Should Learn].
Besides pricing other bonds relative to Treasuries, the yield curve is also analyzed for economic purposes. The shape (more importantly the slope) of the Treasury yield curve can tell us about investors’ expectations for future interest rates, as well as the risk premiums that investors require to hold longer-dated securities. The Treasury yield curve has also had a history of being a leading indicator of economic conditions, allowing investors to see a glimpse of where the economy may be headed next.
Analyzing Yield Curves
As mentioned, the shape and slope of a Treasury yield curve can give investors insight into future expectations for interest rates, as well as some economic insight. Below, we take a look at the key shapes investors should be looking for.
Normal Yield Curve
A normal yield curve is characterized as having an upward slope, as depicted to the right. Notice, however, that the slope of the curve is not steep, and that towards the longer maturities, the curve “flattens” out.
Interest Rate Implication: Interest rates for longer-dated bonds will be higher than shorter maturities. This is considered normal since individuals and institutions prefer to lend money for shorter periods of time, instead of longer periods.
Economic Implication: As the name of the shape suggests, a yield curve that is normal implies that economic conditions are stable. The Treasury yield curve has spent the majority of its time in the shape of a normal curve.
Steep Yield Curve
A steep yield curve is also characterized as having a sharp upward slope, as depicted to the right. Unlike the normal curve, the steep yield curve does not “flatten” out.
Interest Rate Implication: In this situation, investors expect interest rates to rise significantly in the future. As such, investors will demand a higher yield for bonds with longer maturities.
Economic Implication: When the yield curve steepens, this is often a sign that the economy is likely headed toward an upturn. As noted, investors will demand higher yields since alongside rapid economic growth often comes higher inflation and higher interest rates, which can both hurt bottom line returns. Note that when inflation is rising, the Fed will typically raise interest rates.
Flat Yield Curve
As the name suggests, a flat yield curve is characterized as having no slope.
Interest Rate Implication: When the yield curve is flat, investors’ inflation expectations have decreased to the point where there is no longer demand for premium for holding longer dated bonds.
Economic Implication: The curve typically flattens after the Federal reserve raises interest in response to high inflation, which is associated with a rapidly growing economy. A flat curve also indicates that the economy may be headed for an economic slowdown [see also 3 Market Valuation Indicators ETF Investors Must Know].
Inverted Yield Curve
An inverted yield curve is characterized by a downward slope.
Interest Rate Implication: In this instance, shorter dated bonds have higher yields than longer dated securities. Investors expect interest rates to decline in the future.
Economic Implication: While an inverted yield curve is rarely seen, it does have significant economic implications. This shape is one of the surest signs of an oncoming economic slowdown (or recession). An inverted yield curve also is a signal for lower inflation.
Humped Yield Curve
A humped yield curve is characterized by having an upward slope for the shorter maturities and a downward slope for the longer maturities.
Interest Rate Implication: Humped yield curves are very rare, but when they happen it means investors expect interest rates on medium-term fixed income securities to be higher than short- and long-term securities.
Economic Implication: Not to be confused with an inverted yield curve, the humped yield curve can also be an indicator of a slowing economy. And like the flat curve, this shape also indicates that the Fed may be cutting interest rates soon.
Play the Curve with ETFs
Essentially, there are three main plays investors can make based on their expectations of where the yield curve is headed next. The curve can either steepen or flatten; investors will need to use a long/short strategy to gain from the changes in the spreads between long- and short-term securities. Furthermore, investors can also make a play on the curve from an inflation perspective [see ETF Technical Trading FAQ].
If you think the curve will steepen …
When a yield curve steepens, the yield differentials between the short end versus the long end of the curve will increase. Therefore, if you believe the yield curve will steepen, you would want to be long short-term Treasuries and short long-term Treasuries:
Long Position: Barclays 1-3 Year Treasury Bond Fund (SHY, A)
Short Position: Barclays 10-20 Year Treasury Bond Fund (TLH, B-)
All-in-one Option: US Treasury Steepener ETN (STPP, C+)
- STPP’s underlying index tracks the returns of a notional investment in a weighted long position in relation to 2-year Treasury futures and a weighted short position in relation to 10-year Treasury futures. Essentially, if you believe the yield curve will steepen, this fund allows you to be “long” short-term Treasuries and “short” longer-dates Treasuries.
If you think the curve will flatten …
When a yield curve flattens, yield differentials between the short end versus the long end will contract (or narrow). Therefore, if you believe the yield curve will flatten, you would want to be long long-term Treasuries and short short-term Treasuries:
Long Position: Barclays 10-20 Year Treasury Bond Fund (TLH, B-)
Short Position: Barclays 1-3 Year Treasury Bond Fund (SHY, A)
All-in-one Option: US Treasury Flattener ETN (FLAT, C)
- Like STPP, FLAT also obtains its objective through notional investments in long/short positions in relation to Treasuries. Offering inverse exposure to the same underlying index, FLAT is designed to increase in value when the gap between 2-Year and 10-Year Treasury yields narrows.
If you want to make an inflation play …
When inflation is expected to rise, the yield curve is likely to steepen. Investors can make a similar play outlined above, but can take into account inflation by using TIPS [see 5 Most Important Chart Patterns For ETF Traders].
Long Position: Short-Term Inflation-Protected Securities Index (VTIP, A-)
Short Position: 15+ Year U.S. TIPS Index Fund (LTPZ, C)
The Bottom Line
Just as we check major indexes–like the S&P 500–to see how the markets are doing, investors should also pay close attention to yield curves. The Treasury yield curve can tell us a lot about the health of the economy and how to position our portfolios.
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Disclosure: No positions at time of writing.