Markets & Economy
The yield curve: What it is and what it means
July 22, 2013
This is how a yield curve is built. Along the bottom it shows bond maturities. On the vertical axis you see interest rates, or yields. Now, let's say that a two-year bond is offering a yield of 2.5%, and a five-year bond is offering 2.7%, and a ten-year bond offers 3.3%, and so on. When you connect all these dots, what you get is the yield curve. This is a typical yield curve. What makes it typical isn't the yield figures. Instead, it's the shape of the curve. A typical yield curve can start anywhere, but it will generally have a shape something like this, with a gradual rise from left to right. That's because people who invest at shorter maturities aren't taking on as much risk as others. So, they normally don't get paid as much. And that's true along the line.
This is a flat yield curve. Of course, the term "flat curve" doesn't seem to make much sense, but that's the way economists talk about it. When the yield curve looks like this, with short-term rates about the same as long-term rates, it's generally a signal that there's a lot of uncertainty about the outlook for the economy, interest rates, and inflation. In fact, this is the yield curve on July 1, 2007, just a couple of months before the financial crisis began.
This is an inverted yield curve with short-term interest rates higher than long-term rates. An inverted curve shows that the bond market is under stress because it essentially means that investors are being paid more for taking less risk. Inverted curves are not usually very dramatic looking, but they can be. For example, here is the yield curve from September 14, 1981.
What does this mean to you?
The short answer is not much in terms of your own investing. It can help provide context for interest rates, and it's a useful tool for economists and portfolio managers. But the yield curve, no matter what shape it is, is not a critical consideration for long-term investment planning. If you hold a broadly diversified bond portfolio, you'll probably have exposure to all parts of the yield curve.
How to make sense of the yield curve
The yield curve is one way to look at interest rates. It shows the rates—or yields—offered by bonds of different maturities. It is usually based on U.S. Treasury bonds.
The yield curve is always changing, depending on the direction of interest rates in the marketplace. The shape of the curve is one indicator that economists look at when they try to forecast what's ahead for the U.S. economy and the markets. Managers of actively managed funds look at it, too, when deciding which securities to hold.
This video explains the yield curve's basic shapes.
- The hypothetical illustrations do not represent the return on any particular investment.
- All investing is subject to risk, including the possible loss of principal.
- Investments in bonds and bond funds are subject to interest rate, credit, and inflation risk.
- Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
- While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates.
- Past performance is not a guarantee of future results.