There are often references in financial reports that refer to the ‘yield curve’. You may be aware that they have something to do with bonds, but perhaps you are unclear on what the yield curve actually is. The yield curve is one part of the financial puzzle that investors look at when understanding the financial landscape. This article is an introduction to the bond yield curve.
Firstly, what are bonds?
Bonds are loans.
The ‘maturity’ of a bond refers to the length of the loan. This means that a bond with a one year maturity, is really a loan for one year. The purchaser of a bond also buys an interest repayment option as part of that loan. A bond will have a ‘yield’ which is the interest repayment on that loan.
Bonds themselves are issued by Governments and companies. They also come with different maturities (different lengths). They can be one year, two years, three years etc. The general rule to go by is that the longer the bond this usually equates for a greater risk. This is intuitive since it is more risky to lend money for a longer period than a shorter period of time. There are far more uncertainties involved in lending money over a long period of time.
Secondly, what is the yield curve?
Investors often plot the different maturity lengths of bonds as well as the varying yields offered onto a graph (see the example chart below). The horizontal axis (left to right) in the charts below shows the length of the time of the bond’s maturity. The chart goes from the shortest bond maturity at the left to the longest on the right. The vertical axis (up and down) in the charts represent the yield offered. The chart goes from the lowest yield offered at the bottom to the highest yield at the top.
A normal yield curve
The longer dated bonds will incentivise investors with a higher yield than the shorter dated bonds. The shape of the curve above is as you would expect in a normal situation. For continued reading on some of he shapes of different yield curves see a one page description by JP Morgan here. For more explanations of using the bond yield curve and bond yield spreads between different countries you can search the topic here.