The yield curve risk is the risk of experiencing an adverse shift in market interest rates associated with investing in a fixed income instrument. When market yields change, this will impact the price of a fixed-income instrument. When market interest rates, or yields, increase, the price of a bond will decrease, and vice versa.
Key Insights
- The yield curve visually represents the relationship between interest rates and bond yields of various maturities.
- Yield curve risk means changes in interest rates impact fixed income securities.
- Fluctuations in the yield curve derive from bond risk premiums and future interest rate expectations.
- An inverse relationship exists between interest rates and bond prices; as one increases, the other decreases.
Understanding Yield Curve Risk
Investors closely observe the yield curve as it offers foresight into future short-term interest rates and economic growth. This curve plots interest rates on the y-axis against various time durations on the x-axis, from 3-month Treasury bills to 30-year Treasury bonds.
Typically, shorter-term bonds have lower yields compared to longer-term bonds, thus creating an upward-sloping curve – the normal or positive yield curve. As bond prices inversely relate to interest rates, any shift in rates triggers a change in the yield curve, posing a risk, known as yield curve risk, to bond investors.
This risk emerges from either flattening or steepening of the curve, as comparable bonds with different maturities experience varying yield shifts. These changes impact the bond’s price, initially set by the existent yield curve.
Special Considerations
Any investor holding interest-rate-bearing securities faces yield curve risk. To hedge against this risk, strategic portfolio adjustments can ensure a predefined reaction to interest rate changes. Since yield curve shifts depend on bond risk premiums and anticipated future interest rates, accurately predicting these shifts can lead to capitalizing on bond price changes.
Short-term investors can leverage yield curve movements by trading specific exchange-traded products such as the iPath US Treasury Flattener ETN (FLAT) and the iPath US Treasury Steepener ETN (STPP).
Types of Yield Curve Risk
Flattening Yield Curve
When interest rates converge, the yield curve narrows. This occurs as the yield spreads between long- and short-term interest rates tighten. Picture a 2-year Treasury note initially yielding 1.1% and a 30-year bond at 3.6%. If yields drop to 0.9% for the note and 3.2% for the bond, the yield spread decreases from 250 to 230 basis points, suggesting potential economic stunting with prolonged low inflation and interest rates.
Steepening Yield Curve
In a steepening yield curve, the spread between long and short-term yields widens. This might surface if long-term bond yields rise faster than short-term ones, hinting at robust economic activity and higher future inflation. For instance, a scenario where a 2-year note at 1.5% and a 20-year bond at 3.5% increase to 1.55% and 3.65% respectively escalates the spread from 200 to 210 basis points.
Inverted Yield Curve
On rare occasions, short-term bond yields surpass long-term bond yields. This inversion indicates investor expectations of lower future interest rates and inflation, preferring low yield now over even lower yield prospects.
Related Terms: fixed income, yield spread, treasury bills, treasury bonds, bond risk premiums.
