In economics, there exists a risk of the yield curve changing shape and inverting, an indicator that the economy may be entering a recession, which will alter investments. Yield curve risk in investing is the threat that interest rates on bonds of a similar quality will change. Bonds of similar quality but with different expiration dates (known as maturities) are plotted over time, along with their respective interest rates, on a curve. This is called a yield curve, and the chance that it may change is deemed to be “yield curve risk.” One of the risks that investors face is the possible inversion of the yield curve. This means the yield curve changes shape, and long-term interest rates become lower than short-term interest rates. Another related risk for investors is that their rates of return change when interest rates shift. This may mean that investors sell their holdings earlier or retain investments longer than initially planned for. Many yield curves exist for bonds of different quality and perceived risk. For example, there are bonds issued by state governments, small corporations, large manufacturing companies, and more. They issue bonds to borrow money now to pay for facilities, roads, equipment, buildings, etc. Bond issuers have different risk profiles and therefore are of different quality, so they will have varied yield curves. Yield curve risk exists for all bonds, although special attention is paid to the yield curve of U.S. Treasurys. Treasury bonds are considered some of the safest bonds in the world because they are backed by the U.S. government. The relationship between short-term and long-term Treasury bonds indicates the direction the economy is headed in the short, medium, and long run.
How Does Yield Curve Risk Work?
Interest rates are the percentage rates an investor can earn on a bond. The interest rate is determined when the bond is issued, and is locked in for a stated period of time called the bond’s maturity. When there are new issues of bonds of similar quality, the interest rate can change. For example, the U.S. Treasury 30-year bond had an interest rate—also called a coupon rate—of 1.66% in early January 2021 and 2.07% in early January 2022. When new bonds are issued with different interest rates, this can affect the yield curve. Yields are the rates of return over specified periods of time. Yields and interest rates can be different, depending on how long people hold a bond and at what price they purchase the bond. When interest rates change, the shape of the yield curve can change, which may make short-term investments more favorable than long-term investments, or vice versa. When this happens, investors may be incentivized to sell their bond early and use the cash to buy a different investment. Because interest rates change with each new issue of a bond, there is always yield curve risk that can occur. When the yield curve changes, investors may be better off with a bond they hold, or they may be worse off.
Types of Yield Curves
Let’s examine yield curve variations and what they signify.
Upward-Sloping Yield Curve
The most common type of yield curve is an upward-sloping yield curve. This is when short-term interest rates are lower than long-term rates. This occurs when investors expect the economy to grow over time. Long-term bonds tend to have higher interest rates due to the risk of holding a bond for 10, 20, or 30 years, causing the investor’s money to be tied up in the bond for a longer period of time. Therefore, investors will only want to invest in long-term bonds if there is a higher reward (i.e., a higher yield).
Flat Yield Curve
This occurs when short-term interest rates are equal to long-term interest rates. In this case, there is little incentive for investors to buy long-term bonds, as they do not earn a higher yield for the extra risk. A flat yield curve typically occurs when yield curves are about to switch between an upward-sloping yield curve and an inverted yield curve.
Inverted Yield Curve
If the yield curve is inverted, this means the interest rates for holding long-term bonds are lower than for short-term bonds. This indicates that the economy is going to grow less in the future and possibly enter a recession. If there is an inverted yield curve, inflation expectations usually are also low. Because long-term bond yields are lower than short-term bond yields, investors will prefer to buy short-term bonds that pay more. This hurts long-term investment and future economic growth.
What It Means for Investors
When interest rates change, investors may lose yield (meaning experience a lower rate of return) and alter their current investments. This is the yield curve risk that investors inherently face with fixed-income investing. Also, when the yield curve changes, it provides information to investors on future economic growth. If yield curves are upward-sloping, that tends to indicate strong economic growth, measured by gross domestic product (GDP). If yield curves are inverted, however, that flags an economic slowdown or a recession. The two most common types of U.S. Treasury bond spreads investors pay attention to are the difference between the 10-year and two-year Treasury bond, as well as the 10-year Treasury bond versus the three-month Treasury bill. An example of the relationship between yield curves and GDP growth is shown below. When the difference between the 10-year bond yield and the three-month bill yield (shown as the orange line) dips below zero, this means the yield curve has inverted. After this happens, GDP growth in the subsequent period is negative, as illustrated by the falling blue line that follows a dip in the orange line below zero. When there is an upward slope in the yield curve, shown by the orange line rising above zero, GDP growth tends to be positive and increasing. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
