The Yield Curve is a graphical representation of debt interest rates for various maturities. It depicts the expected return on an investor’s money if he lends his money for a set amount of time. The yield of a bond is shown on the vertical axis, while the time to maturity is shown on the horizontal axis. At different times in the economic cycle, the curve may take on different shapes, although it is usually upward sloping.
Because long-term returns are lower than short-term returns, a fixed income analyst may utilise the yield curve as a leading economic indicator, especially when it moves to an inverted shape, which forecasts an economic downturn.
Importance of Yield Curve
- The curve’s shape aids investors in determining the expected future direction of interest rates. Long-term assets have a higher yield on a normal upward sloping curve, but short-term securities have a higher yield on an inverted curve.
- Banks and other financial intermediaries get the majority of their money by selling short-term deposits and lending it out with long-term loans. The larger the difference between lending and borrowing rates, and the bigger their profit, the steeper the upward sloping curve is. A flat or downward sloping curve, on the other hand, usually indicates a drop in financial intermediary profits.
- The yield curve aids in determining the maturity-yield trade-off. If the yield curve is upward sloping, the investor must invest in longer-term securities to boost his yield, which means taking on greater risk.
- The curve can show investors if a security is overpriced or under-priced at the moment. If a security’s rate of return is higher than the yield curve, it is under-priced; if it is lower, it is overpriced.