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Monday, November 14, 2011

How to interpret bond yield curves

Yield curves are the percent return on investment offered by financial instruments such as bonds. Bond yield curves are important indicators of economic activity, risk, monetary policy and market conditions. Consequently, bond yield curves are useful in financial analysis. For example,  bond rating and yield indicate the quality of the bonds, and the angle at which the yield curve slopes indicates how risky longer-term bond issues are perceived to be. 

Understanding what bond yield curves mean can help investors with assessing risk and in arriving at investment decisions such as which bonds, if any to invest in. Before delving into some of the particulars of yield curves, watching the video below allows for acclimation with the financial concept:

 

Duration


The length of time until a bond's face amount becomes due to the buyer is called the duration. Generally, with longer durations, the yield of a bond goes up because the opportunity cost and investment risk rises with time. It is for this reason that yield curves tend to curve upward, however the slope of these curves can either be low or high depending on the issuer's credit rating. For example, the U.S Treasury Bond yield curves below are from the Federal Deposit Insurance Corporation (FDIC) and show a higher yield for 30 year bonds than they do for 6 month bonds.  More up to date bond yield curves can be viewed at the U.S. Department of the Treasury.

U.S. Treasury Security Yield Curves
 Source: FDIC US-PD

Classification


The kind of bond also affects the bond yield curve. As evident in the above bond yield curve graphs, conventional bond yield curves are placed higher than the Treasury Inflation Protected Securities or TIPS. This is because investors are willing to pay in the form of lower yield for the inflation protection of security that is not offered by conventional bonds according to the Wall Street Journal. Moreover,  when the demand for TIPS is higher, then the yield will be lower. The reason the yield isn't higher regardless of demand is because the inflation protection is not incorporated into the yield, but rather the principal balance according to Treasury Direct.

Issuer


Bond yield curves also differ by bond issuer. For example, a country with a high credit rating is more likely to have lower bond yields, and a flatter bond yield curve due to the low-risk associated with those bonds. However, if an economy is performing badly, the affect on bond yields tends to be toward higher yields and more vertical curvature. This is evident in recent rises to Italian and Spanish bond yields after being downgraded by Standard and Poor's per Reuters. In other words, with lower-risk bond issues, price rises with demand, but the yield curve then moves down. 

Risk


Market risk also affects bond yields. To illustrate, consider an especially highly rated bond; these are thought to be a financial safe haven or low-risk investments for large institutional investors, sovereign wealth funds and individual investors seeking to lower investment risk via diversification into bonds. If other investments seem too volatile for investors, they may invest a larger amount into bonds because of their safety. The affect of this increased investing on the bond yield curve will be  a downward movement of the whole curve where the longer-term issues still curve up, but at lower yields due to increased demand.

Policy


Bond yield curves can also reflect monetary policy. A good example of this is the Federal Reserve Bank's bond buying programs. Quantitative easing as it is also known adds money to the financial system because the central bank purchases more bonds. This causes the Federal Reserve's assets to increase, and also puts downward pressure on the bond yield curve. Another example of this is the Federal Reserve Banks' 'Maturing Extension Program and Reinvestment Policy' or selling of short-term Treasury Securities and buying of long-term ones. This causes the yield curve to flatten at the back end and become more horizontal which subsequently demonstrates the influence of monetary policy on the bond yield curve.