Yield Curves: Examples and Factors

This document is going to illustrate the yield curve, its different types, along with different real time examples of the different types and the factors that influence or made these curves. Yield Curve Definition: First of all let us define that what is a yield curve? A yield curve is defined as: A plot of yields on bonds with differing terms to maturity but the same risk, liquidity and tax considerations is called a yield curve (Fredric S Mishkins). Graph used to show yields for different bond maturities and used for determining the best value in bonds and as an economic indicator (Business Dictionary.com) According to these definitions the yield curves have the following aspects to them: 1. It is a relation between the time to maturity and the interest rate paid to that level of maturity for different bonds. 2. The bonds maturity maybe different but they will have the same level of risk, liquidity and tax considerations. Types of Yield Curve: According to (Fredric S Mishkins) there are three types of slopes, upward sloping, flat and downward sloping. Primarily these three types of curves are patronized into different other variations. One from the very prominent variation is the humped curve. In this document we are going to see the following types, examples and their factors. 1. 2. 3. 4. Upward Slopping Downward Slopping Flat Humped Curve

Empirical Facts about Yield Curves: (Fredric S Mishkins) gives the following empirical facts about yield curves: 1. Interest rates on bonds of different maturities move together over time. 2. When short term interest are low, yield curves are more likely to have an upward slope, when short term interest rates are high, yield curves are more likely to slope downwards and be inverted. 3. Yield curves almost always slope upwards. Keeping these empirical facts in mind we will be moving towards the different examples of the yield curves.

Upward Slopping Yield Curve: The upward slopping curve also referred to as the normal curve keeping in mind the empirical facts given by (Fredric S Mishkins). It is defines as That situationwhere longterm rates are higher than short-term ratesis considered a normal curve (Franklin Templeton Investments, 2009). In an another definition it is defined as A yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. This gives the yield curve an upward slope. This is the most often seen yield curve shape. (Investopidia.com). According to these definitions it indicates the normal state of affairs where the expectation on of return on a bond is higher in the long term because of the compounding effect of the interest rate. Example: Here is a picture of the yield curve on the UK of April 2nd 2012.

(Bloomberg, 2012) Here it is apparently seen that as the time increase so does the interest rate on the bond and therefore the return on the UK Bonds is increasing. This is the normal way a bond should react. If we look at it closely the bond has rising positive rate till the 20 year maturity date. That makes a positive curving slope on the different maturity dates till this point. After this point on the 30 year bond there is the same rate. Heuristically on can say that the curve has flattened out but the thirty year mark has been said by most economists as the illiquidity point where the resale of the bond does not bring much of a return to the holder. Therefore a tendency of flattening out will happen at the 30 mark. Factors for the Normal (Positive Sloping) Curve: Keeping in mind that the bond taken above is a Government bond, so there are certain factors that influence the yield curves in a different way then Corporate bonds but most of the factors

are almost similar. Keeping the taxation, risk and liquidity factors constant the following factors will influence these government bonds of different maturity: 1. Level of confidence shown by the holders of the securities on the bond. This confidence can be realized by instruments like inflation rate and GDP. Let us have a look into the inflation rate of UK of 2012. Inflation Rate: Till February the inflation rate of UK has reduced from 3.6% in January to 3.4% in February bringing green signals for people with money to invest in Government bonds as they are working on the rise. A demining inflation rate means that the gap for the real interest rate is increasing and therefore is increasing the return on the bond. GDP: UKs GDP went down by the 0.3% in the last quarter but activity in construction and financial institutions in this quarter has given it up a rise. (Cambridge Econometrics) 2. The other factors that influence the yield curve are socio, economic and political conditions pertaining to the government and the country. It is a simple equation that says. Yield on bond = f(level of confidence of holders)= Political + social+ economic conditions. There are two prime factors going on in Europe that will influence the confidence of people holding the government bonds. One is the recession of the market in Europe which thankfully to the joint fiscal policy has been for the short, dealt with. The other major issue is the movement of the UK forces from Afghanistan. Positive steps on these behalfs have increased confidence of the people of the country on its government. That will lead to a larger investment in the securities and therefore options for the government to spend on development and growth options and therefore increase the GDP and thus put in position the multiplier effect. Downward Slopping Yield Curve: The downward Slopping Yield Curve are defined as A yield curve depicting a situation in which yields for shorter-term maturities are higher than those for longer-term maturities. Downward sloping yield curves are atypical. (Finance Glossary) According to this definition the negative yield curve looks like opposite to an upward slopping curve where the people will try to make money fast because the interest rates on the shorter maturities are high and the long term confidence in the security issuer is low. Let us have a look into an example of the downward slopping yield curve. Example: In the 1970s and early time of 1980s the US economy suffered from high inflation and high interest rate. What happened with that was that securities with shorter maturity had more level of yield then those of longer maturities. The negative sloping yield curve is most times an indicator of high economic growth because people try to invest in securities that can give

them quick returns so that they can invest it in further securities to earn short term interests. Here is picture of the yield graph of 1979 that shows a downward slop

(Dr.Econ, 2004) The prime reasons for the negative slopped curve in the 1979 1. A very high inflation rate. A double digit inflation rate is a bad indicator for the economy and therefore gives the idea that the expectations on the longer yield securities will be less. Therefore people invest in bonds which are short in terms of maturity so that they can get early returns. The demand for these bond rises and so does the interest rate on short term bonds. The drop in the interest rate was a reaction to deflation. 2. Tight monetary policy was in response to the rising inflation rate. To bring it down the flow of money into the market was restricted so that the dollar value rises. 3. As the inflation was increasing so were the interest rates but people had the expectation that although the interest rates are rising, in future long term bonds the interest rate may not be able to give future value for money because the interest rates will be even higher. Therefore the interest rates on the short term securities are much higher. Humped Yield Curve: The humped yield curve is defined is A relatively rare type of yield curve that results when the interest rates on medium-term fixed income securities are higher than the rates of both long and short-term instruments. Humped yield curves are also known as bell-shaped curves (Investopidia) This curve is figuratively a combination of both the upward slopping and downward slopping curves. Unlike the downward slopping curve which at most times is an indicator of economic growth, this curve is an indicator of slowing economic growth. In this state the middle term

bonds have a high interest rate other then the short term: less than one year and more than ten years bond that are known as lone term bonds. Example: 2-Year Portugal government bond yields are trading at 5.24 percent, an increase of 45 basis points while the 5-year is higher by 38 basis points to 5.72 percent. The 10-Year is at 5.77 percent, a move higher of 10 basis points. There is a rise till 15 year maturity and then a sudden drop off to the 30 year maturity

(Badilla, 2010)

1.

One investors expect Portuguese to restructure its debt and investors to get lower that the promised pay-off (called as Private sector involvement but is just another word for default). Now it has so happened that though investors expect a partial default, the yields still incorporate a full pay-off. So, though the price of bonds has declined anticipating default. The yields still factor a full pay-off. Another prime reason was the announcement of the bailout plan for Greece andPortugal by the EU in 2010 that increased the confidence of the investors in the 5 year term bond because of the issues over that they were receiving from that bond.

2.

3.

Flat Yield Curve: Flat yield Curve is defined as At a particular time, similar yields on bonds of similar risk at all maturity lengths. During a period of a flat yield curve an investor would receive approximately the same yield on a long-term bond as he or she would on a short-term bond, although the former would be subject to greater price fluctuations. (FreeDictionary) In the flat curve what happens is that the investor gets similar return on long term and short term bonds. The fluctuations can happen while making a shift in short term curve moving towards the long term curve or vice versa. This shift in the curve if is of inverting nature meaning the short term interests are rising to meet the long term rates, that generally means a growth shift in the economy. If they long term interest rates are shifting that means there is a trend of slowness coming in the economy. Example:

(Dr.Econ, 2004) This yield curve in 1989 and 2000 in the US economy was flat. The prime reasons for these years going flat was: 1. The economy was coming out of a period of high inflation rate and the economy was turning flat because the growth period had finished and there was a trend of stability generating in the economy. In 1989 where the consumer price index was 4.6 which was on the fall till the 2000 era till 2.6. 2. In 1989 where the economy was stabilizing but in 2000 after some period the 9/11 happened which had huge dent into the confidence in the government bonds bringing an ensure dynamic environment in the economy and therefore increasing the interest rate on short term bonds.

Works Cited
Badilla, R. (2010, May 6). Denail is the EU's Enemy. Retrieved 4 6, 2012, from BondSquawk: http://www.bondsquawk.com/tag/flat-yield-curve/ Bloomberg. (2012, 4 2). Goverment Bonds. Retrieved 4 2, 2012, from Bloomberg: http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/ Business Dictionary.com. (n.d.). Yield Curve. Retrieved 3 31, 2012, from Business Dictionary.com: http://www.businessdictionary.com/definition/yield-curve.html Cambridge Econometrics. (n.d.). UK economics. Retrieved 4 3, 2012, from Cameco.com: http://www.camecon.com/UK/UKEconomySectors/EconomicReview.aspx Dr.Econ. (2004, july). Educational Resources. Retrieved 4 6, 2012, from Federal Reserve Bank of San Francisco: http://www.frbsf.org/education/activities/drecon/2004/0407.html Finance Glossary. (n.d.). Downward Slopping Yield Curve Finance Glossary. Retrieved 4 3, 2012, from FinanceGlossary.net: http://www.financeglossary.net/definition/1180Downward_Sloping_Yield_Curve Franklin Templeton Investments. (2009). A simple Guide to yield curves. Fredric S Mishkins, S. G. Financial Institutions and Markets. FreeDictionary. (n.d.). Flat Yeild Curve. Retrieved 4 6, 2012, from FreeDictionary.com: http://financial-dictionary.thefreedictionary.com/Flat+Yield+Curve Investopidia. (n.d.). Humped Yield Curve. Retrieved 4 6, 2012, from Investopidia.com: http://www.investopedia.com/terms/h/humped-yield-curve.asp#axzz1rFVIJcKg Investopidia.com. (n.d.). Normal Yield curve. Retrieved 3 30, 2012, from Investopidia: http://www.investopedia.com/terms/n/normalyieldcurve.asp#axzz1qu7uK4Sj