What Is a Bond Yield Curve?

The yield curve is a representative graph of the rates of the same bond at a point of time. The yield curve normally runs from 1 to 30 years, though that may vary depending on the outstanding bonds in the secondary market. The most well known yield curve is that of United States Government Treasury Bonds. Yield curves are used to predict the economic future and to price other, lesser quality bonds.

Creating a Yield Curve

To properly create a yield curve, you must get closing price data for every maturity year of the bond. Do not use yields that are priced to call or have sinking funds or other extraordinary items. Ideally, you would construct a yield curve with series of non-callable bonds. Yield curves can be created for any credit quality or maturity structure. When bonds cannot be identified for any maturity, the yield curve is completed by interpolating the results between years. Another method is to mark the known bond year yields and get the rates of change from year to year from other yields and then interpolate. This will help keep the yields as a curve rather than a straight line between two known points.

Predicting the Economic Future with a Yield Curve

When the economy is beginning to come out of a recession inflation is low, there is little economic activity so the absolute level of rates are low and the yield curve has a gradual steepening to reward investors for the risk of investing in longer maturities. As the economy improves short rates increase faster than long rates and all rates move up somewhat. This flattening of the yield curve is a sign that economic activity will become more concerned about inflation and the Federal Reserve Bank will act to raise short term rates and slow the economy. When short rates rise above long-term averages, the economy has peaked.

Federal Reserve Banks Fight Inflation as the Economy Slows

Tightening by the Federal Reserve Bank with raise rates further and commercial borrowings will peak. The yield curve will then turn negative signaling that the economic expansion is over. As tighter rates and credit rationing begin to stifle short-term demands, businesses will redeem short-term notes with the proceeds with long-term bond sales. Thus rates begin to fall, and the yield curve is ready for another expansion.

Bond Trading and Pricing New Issue Bonds

Traders use the bond curve to determine the relative value of differently rated bonds to each other. Traders will look at the shape of the yield curve, for example, for AAA-rated bonds and AA-rated bonds. Traders will look for yield curve discrepancies caused by supply coming into a market or a shortage of bonds in specific maturities.

Yield Curves are Used For Advising Banking Clients

Yield curves are used by investment bankers when advising issuers where the most cost effective maturity exists for issuing bonds. Rather than a specific yield traders refer to bonds trading '20 off' or '125 off' a benchmark yield curve. Rather than a yield quote, the security would trade at 20 or 125 basis points (a basis point is one-hundredth of a percent) cheaper than the equivalent United States Treasury bond for the same maturity. Traders regularly trade two corporate or municipal bonds not in terms of yield but in terms of yield curve spreads.

References

• Composite Bond Yield Curve
• Inverted Yield Curve

Resources

• Definition of Yield Curve