Introduction to Yield Curve
The yield offered by bonds is one of the biggest factors which encourages investors to invest in them. Liquidity preference states that if the interest rate is the same, then investors would prefer to invest in bonds that have shorter maturities. This is because they would prefer to have liquidity. Hence, it becomes obvious that investors would only agree to lock their funds in for longer periods of time if they were to be compensated in the form of higher yields.
Hence, there is a relationship between bond yields and the period of time for which investors lock their funds. This relationship is expressed in the form of a yield curve. A yield curve is an important tool that is used by bond investors all over the world to make strategic decisions. In this article, we will have a closer look at what a yield curve is as well as how it is used by investors to make key decisions.
What is the Yield Curve?
As explained above, the yield curve is a graphical representation of the different yields being offered in relation to the maturity of the bond. The yield curve is created by plotting the various yields on the Y-axis and the various maturities on the X-axis.
For instance, yields prevailing in the market for maturities of 3 months, 6 months, one year, two years, etc. will be mapped on the graph and then a curve will be drawn through those points.
It is important to note that the bonds used for this mapping must have similar risk profiles. This is to ensure that the interest rates being charged are comparable. For instance, the curve cannot be drawn using data from government treasury bonds as well as junk bonds simultaneously.
It is also important to note that the yield being mentioned above is the yield to maturity which is a composite factor including the coupon rate as well as any capital gain or loss which is being incurred.
This resultant curve is called the yield curve. It is considered to be very important since it shows the investors preference for liquidity at any given point in time.
Why is a Yield Curve Considered to be Important?
The yield curve is considered to be very important by almost all analysts and economic commentators. This is because of the following reasons:
- Insight Into Investors Mindset: The yield curve provides an insight into the mindset of the investors. Since the bond markets are large global markets where millions of investors invest their money regularly, the decision of the market can be considered to be the vote of the investing community. Individual investors constantly look at the changes in the yield curve to determine whether or not their decisions are in line with the larger market.
- Influences Liquidity: If the difference between yields across different time periods is high, then the yield curve is considered to be steep whereas if the yields across different time periods are low, then the yield curve is considered to be flat.
Whether the curve is flat or steep has a huge impact on the general liquidity in the market. This is because banks and other financial institutions are the main providers of liquidity in the overall market. These banks borrow at lower maturities and lend for longer periods of time.
If there is not much difference between the yields for lower maturities and higher maturities, then there is not much of an incentive for banks and financial institutions to take risks and lend money.
On the other hand, if the yield curve is very steep, it can be said that the economy is poised for high growth. This is because banks will be incentivized to lend more and more. For the overall economy, this would mean high consumption as well as high industrial growth during that time period.
- Compare Bonds Across Geographies: The yield curve is also commonly used to compare bonds across geographies in order to understand the spread which is implied in the curve.
For instance, investors can compare the yield curve of America which is considered to be a safe bond with almost no risk of default to a country like Greece which has a very high risk of default. This yield curve can be used to predict the implied probability of default.
For instance, if the spread between the three-month yield for the United States and Greece is narrow, then it can be said that the probability of default is lower in the three-month time frame. However, at the same time, the spread may be very wide for bonds with five-year maturities. This means that investors are concerned since they believe that there is a high probability of bankruptcy in the five-year duration.
- Compare Bond Yields Across Sector: The yield curve can also be used to compare yields across different sectors. This means that the yield curve of government bonds can be compared with the yield curve of private bonds. Once again, the spread of corporate bonds with varying maturities can be derived by comparing them to the government bonds of the same maturities. This provides some measure of riskiness that is associated with these bonds.
The bottom line is that the yield curve is a very important metric for every bond investor in the world. Changes in the yield curve are known for causing massive changes in the prices of bonds in the international markets.
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