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Understanding the basics of yield curves

Jun 14, 2011

Very often you may come across the term 'yield curve' and wonder what it implicates for a common investor. In this article we will try and understand the basics of bond yield curves. Let's start off with a simple example. Say your office colleague, wants to urgently borrow Rs 5,000 from you. He promises to repay you the very next day. If you have the money with you, you would give it to him without even thinking twice.

Now let's say he wanted to borrow Rs 5,000, but he tells you that he will pay you back after 5 years. This time you may not be as confident that you will get your money back safely. You worry that he may forget to pay you back, move jobs, or even move out of the city. You may ask for some sort of additional compensation from him as a security.

We will now see how this simple logic works in the government bond market as well. Governments raise money by issuing bonds to the public. This money is then used to fund infrastructure and other initiatives. As these bonds pay a fixed rate of interest (or coupon), they are also called 'fixed income securities.'

The yield of a debt instrument like a bond is the overall rate of return available on the investment. For example, your savings bank account that pays you an annual interest of 4% every year has a yield of 4% per annum. Yield on a bond depends on the purchase price as well as the coupon (interest) payments that a bond makes over its lifetime.

Treasury yield curves

The term yield curve according to Wikipedia - "...The yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency."

The two major variables are: time to maturity measured in years and the interest rate (yield to maturity).

Source: Yahoo Finance

Based on the current data on US Treasuries (government bonds), one can see that the relation between the yield and the time to maturity is positive. US treasuries are currently exhibiting a 'normal yield curve'. In this scenario, long term yields are greater than short term yields. This is a typical case, where the yields rise as the maturity lengthens.

Going back to our example, while you were willing to lend Rs 5,000 to your colleague for a day without any concern, you would be a lot more cautions if you had to lend him the same money for 5 years. In the same way an investor in government bonds needs additional compensation for the risk in keeping his funds parked for a longer period.

Over the long term many variables may change including the interest rate cycle, macro-economic environment, and even leadership at the top level. Decision makers like Presidents and Central Bank Governors are only elected for 4 year terms, and not for 10-15 years. Plus, if you keep your money in one place for a long time, it limits your ability to use money in other ways. Thus one needs compensation for the time value of money. In this case, additional compensation is in the form of higher yields.

Conclusion

What works in developed economies like the United States may not always hold true for emerging economies. India's central bank, the RBI has been on the offence, raising interest rates 9 times since March 2010. With inflation still being uncomfortably high in India, the central bank may continue on its path of monetary tightening.

This has lead to a situation where short term interest rates are even higher than long term interest rates. This is called as an inverted yield curve. In our following article we will try and understand the impact of yield curves on investment and the current situation in emerging markets like India. We will also discuss what this indicator is signaling for the long term prospects of the economy.


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5 Responses to "Understanding the basics of yield curves"

ANUSHREE GADRE

Aug 21, 2011

brilliantly written......... helpful for the students to understand such basics

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A.K.Atray

Jun 25, 2011

Excellent,very well written and explained.Looking forward for second part of the article.

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jayakumar thachoth

Jun 17, 2011

Normally an average reader is allergic to the words like 'yield curves',etc.But you have presnted it in a simple and digestible manner that even a layman can understand without effort.Please continue this revolutionary endeavour.

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shekhar

Jun 17, 2011

brilliant. Very informative in a simple narrative.Looking forward to the follow up article ''imapct of yield curves on investments''

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Abhishek

Jun 16, 2011

This is it!!....very informative!!....well I am also a subscriber to Personal FNresearch 'Debt Select' and requested them to send me some basic write-up on yields,interest rates effects on debt investments etc but they were unable to answer well..! Indeed this is well written

Request you to kindly send me the follow on article as soon as possible.

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Equitymaster requests your view! Post a comment on "Understanding the basics of yield curves". Click here!

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