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You may have heard this term in the news, yet it may still be one that's unfamiliar. While a yield curve describes bond interest rates, it doesn't mean it's a topic that only bond investors should be interested in. Review these related concepts and explore how they are relevant to all investors.
A yield curve is a visual representation of the yield relationship between bonds of the same credit quality and different maturities—i.e., the time remaining until a bond's principal amount is repaid—at a single point in time. The resulting curve is a key bond market benchmark and a leading economic indicator. While investors plot yield curves for various types of bonds, the one that's most often referenced is the U.S. Treasury yield curve, reflecting the relationship between short-, intermediate- and long-maturity Treasuries.
Because yields change over time, the shape of the curve also changes. For example, the curve could be normal (upward sloping), inverted (downward sloping) or flat depending upon the prevailing yield environment. Investors often look to the shape and movement of the yield curve as a signal for where the economy is headed.
A normal yield curve is an up-sloped curve that shows yields gradually increasing as bond maturities increase. This reflects the general idea that money invested for longer periods of time is exposed to more risk and should therefore garner greater potential rewards, including higher yields. Normal or rising yield curves are typically apparent during periods of economic growth.
An inverted yield curve is a down-sloped curve that shows yields gradually declining as maturities increase. Why would long-term investors accept a lower yield for longer-term commitment? When the curve is inverting, investors may expect yields to continue to fall, so they invest to lock-in the current rate. Because of the association with lower interest rates, investors see an inverted yield curve as a sign of a slowing economy or recession.
A flat yield curve occurs when shorter- and longer-maturity yields are closer, creating more of a flat line than a curve. This may be because shorter-maturity yields have risen or because longer-maturity yields have declined, or both. Investors generally view a flat yield curve as an indicator of slower growth.
When discussing the yield curve, it's also helpful to refer to the yield spread. This number is the mathematical difference between the yields of short- and longer-maturity securities, typically the two- and 10-year Treasury notes. In general, a positive and rising yield spread indicates the curve is normal or steepening; a declining or negative yield spread would reflect a flattening or inverted curve.
Because the yield curve may signal where the economy is headed, it may also shed light on the expectations we have for bond and stock market returns. In general, the flattening of the yield curve suggests potentially slower growth and weaker longer-term inflation expectations, and a steepening indicates economic growth and inflation may be on the rise.
Keep in mind yield curves and yield spreads are always changing. They are one of many factors that experts watch to gauge the health of the economy and the direction of interest rates. While it's helpful to understand and follow these concepts, it doesn't mean that you need to make a move in your portfolio.
We believe the best approach to weathering various markets is creating a diverse portfolio with an investment mix suited to your investing time frame and comfort with risk.
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