Understanding Yield Curve
Have you ever heard the term “yield curve”? If you haven’t, you’re not alone. But you might be interested to know that the yield curve is an important tool for investors.
Why the Treasury Market
Although a yield curve can be determined for the spreads between maturities of bonds for any sector, the term “yield curve” is most often used to refer to the curve determined by the U.S. Treasury Bill market. Risk-free discount rates can be derived from Treasuries to match most maturities. This information can be used as a benchmark to determine the value of other investments, and whether or not their returns are worth their risks.
Treasury securities are debt instruments that have a face value, market price and maturity date. Upon maturity, the bond pays the holder the face value. Longer-term bonds also have a coupon value and pay interest over the life of the bond. To put it simply, the sum of the interest payments and the final face value payment, divided by the price, make up an investor’s return or yield.
Although Treasury securities have fixed face values, maturities and coupon rates, their prices may vary because they are actively traded. Price changes may occur for a number of reasons. As the price changes, so does the yield.
The Yield Curve
The U.S. Treasury offers bonds with many maturities, varying from one year (a T-Bill) to 30 years. The yield curve plots the maturities and yields for all of these securities. Generally, the longer the time until maturity, the more risk a security holder bears, and therefore, the higher a return they expect. However, as market forces adjust the price for various securities, this may not be the case.
What the Shapes Mean
The yield curve’s slope or “shape” always fits one of three descriptions:
As you plan your portfolio, remember to keep an eye on the yield curve and the spread between short- and long-term Treasury securities. If the spread has been flattening for months, it might be a good idea to shift your allocation to steadier investments. If it’s growing, that’s generally a sign that you can feel good about equity investments. Just remember, all indicators should be taken with a grain of salt!
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