Yield Curve

Financial Dictionary -> Investing -> Yield Curve

The yield curve is a line, which shows the ratio between the interest rate of a given debt instrument and its maturity period. There are three main types of yield curves, each reflecting particular trends on the stock market, which the prospective investors must be aware of, before committing their money to the debt instrument of their choice. This article will deal with each curve type separately, making short comments on what they signify for the near future development of the stock market.

The first and, by far, the most common type of yield curves is the normal or positive yield curve. Its line on the yield - maturity graph is an upward slope, which shows that, all other things being equal, bonds with longer maturities have bigger interest rates. That a bond, held for a longer period of time, should pay off more, is all too natural, since longer periods of time typically involve greater risks and deserve a greater payout. The normal yield curve is a sign for a relatively stable stock market.

The second major type of yield curve is the flat yield curve. This instrument signifies a narrow difference in interest rates between short-term and long-term bonds and marks a transitional period on the stock market: from normal yield curves to the third type of yield curves, the inverted ones.

The inverted yield curve of a debt instrument, a downward slope on the yield - maturity graph, reflects the fact that investments in this instrument (for shorter periods) are more profitable, that is, they pay bigger interest rates than longer-period investments. In the past, such situations have often presaged economic recessions yet, nowadays, many financial experts claim that they may simply reflect the supply-and-demand picture: if longer-term bonds are in high demand, they will - quite naturally - pay smaller interest rates than shorter-term bonds. Be it one way or the other, inverted yield curves have a direct influence on consumers. Thus, for example, if a consumer has bought property with an adjustable-rate mortgage, they may find themselves paying ever bigger sums, as mortgages are based on short-term interest rates. In the case of inverted yield curves, they tend to grow bigger with time.

In conclusion, we would like to advise that, before investing in a particular debt instrument, one should become well-acquainted with what the yield curve signifies, since it is an excellent indicator for both, the present and future development of the instrument. In general, investment experts point out that longer-term investments should be preferred over shorter-term ones, as they tend to be safer and the profit they generate - more predictable and stable.