Download Understanding Yield Curves

Yield to Maturity %
PRUDENTIAL INVESTMENTS, A PGIM BUSINESS
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An
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UNDERSTANDING
YIELD CURVES
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A yield curve is a line graph that illustrates the relationship between the yields
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and maturities of fixed income securities.
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The chart6 below shows aAA
“normal” yield curve. As you can see, it is upward sloping.
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The longest-maturity
securities offer the highest returns while the shortest maturities
offer the 4lowest returns. This scenario is considered “normal” because longer-term
securities3 generally bear the greatest investment risks and, as a result, “should” offer
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higher interest rates.
Of course
this 3is not always
the case.
In addition
to a normal,
Term to Maturity: Years
upward sloping curve, a yield curve may also be inverted, or downward sloping, or
it may be “humped,” as we will discuss later in this paper.
Yield to Maturity %
Yiled
Yield to Maturity %
Yield curve graphs provide a quick way to review and compare the yields that
different types of fixed income securities offer, and to determine investor
expectations for market conditions in the future. They are created by plotting the
yields of different maturities for the same type of bond. The “spreads” between
the yields9 of different maturities are what create the slope, or shape, of the yield
Government
curve for8a given type ofAAA
security.
Normal Yield Curve
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Term to Maturity: Years
For illustrative purposes only.
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Yield to Maturity %
Ask your financial professional.
Inverted Yield Curve
TYPES OF YIELD CURVES
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ld to Maturity %
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Yield curves
may be created for any type of fixed income security, including
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US Treasury
securities, investment-grade and high yield corporate securities,
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global bonds,
and municipal bonds. The yield curve for US Treasury securities is
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considered
a
market
benchmark, as it is often used as a basic reference point by
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fixed income
investors to evaluate market conditions. It is also used as a benchmark
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to evaluate
the relative attractiveness of investing in non-US Treasury securities.
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8 credit
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This is because
US
in
have
no
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to Maturity:
Years
offered by a similar maturity,
non-US
Treasury
security should offer adequate
compensation for any additional risks incurred by the investor.
Humped Yield Curve
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The yield curves for corporate securities are more typically
known as “credit curves” because, unlike yield curves that
plot the yield and maturity of a specific security, credit curves
plot the yields available on a universe of corporate bonds
of a specific credit quality, such as AAA-rated (the highest
investment-grade credit quality) through BBB-rated (the lowest
investment-grade credit quality), as well as for lower-quality,
high yield bonds.
Investors can also evaluate spreads from a “current vs.
historical” standpoint. In other words, let’s say the spread
today between a 10-year US Treasury bond vs. a 10-year
AAA-rated corporate bond is +50 basis points. Is that typical?
Perhaps not. Perhaps the spread was only +35 basis points a
year ago. If that’s the case, the AAA-rated corporate bond, with
the +50 basis points yield advantage today, looks particularly
attractive.
COMPARING YIELD CURVES
Finally, investors also use yield curves to compare the
relationship between maturities within the same type of
security, such as between 2-year and 10-year US Treasury
securities (often called “2s/10s” for short). In the above
example, that spread is +175 basis points (4.25% vs. 6.00%).
Another maturity relationship that is frequently evaluated is
the spread between the ultra-short 3-month US Treasury bill
versus the ultra-long 30-year US Treasury bond. This spread
tells investors whether they are being paid enough in extra
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yield to compensate them for the additional interest rate
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risks
4 of security.
type
One way to do this is to review the “spread,” or the difference
in yields between different types of securities. The “spread”
columns in the chart below show the difference between the
yields on the benchmark US Treasury yield curve and the
AAA- and AA-rated corporate bond curves, respectively.
Investors can use this data to determine if the amount of
spread available today on a AAA- or AA-rated bond offers
enough additional yield over US Treasuries to make the
security an attractive investment.
Yield to Maturity %
Comparing the yield curves of different types of securities can
help investors determine the “relative value” of a bond and
can also help to create strategies to increase a portfolio’s total
return. Investors may wish to compare the US Treasury yield
curve against AAA-rated and AA-rated corporate bonds, for
example, to see how much additional yield they could capture
by assuming some credit risk. (See charts below.)
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Term to Maturity
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Govt
AAA
1-Year
4.00%
4.15%
4.45%
AA
0.15%
AAA
AA
2-Year
4.25
4.45
4.90
0.20
0.65
0.45%
3-Year
4.50
4.75
5.20
0.25
Yiled
0.70
5-Year
5.00
5.30
5.90
0.30
0.90
10-Year
6.00
6.50
7.25
0.50
1.25
30-Year
7.00
7.70
8.50
0.70
1.50
For illustrative purposes only.
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Government
AAA
AA
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Normal Yield Curve
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Term to Maturity: Years
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Spread over Govt Bonds
Yield to Maturity %
Yield to Maturity
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US Government vs. AAA-/AA-Rated Credit Curves
Inverted Yield Curve
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Finally,
a “humped” yield curve indicates an expectation of
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higher rates in the middle of the maturity periods covered,
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uncertainty
Term to Maturity: Years
Yield to Maturity %
Yield to Maturity %
Inverted Yield Curve
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2 CURVE
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5A STORY
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EVERY1 YIELD
TELLS
Term to
Maturity
The shape of a yield curve provides
valuable
information to
Yield to Maturity %
Yield to Maturity %
economic policies or conditions, or it may reflect a transition
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Each
yield curve shape tells a different story. A normal,
of the yield curve from a normal to inverted, or vice versa.
upward-sloping
yield curve implies that investors expect the
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economy
to grow in the future, and for this stronger growth to
Humped Yield Curve
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Government
lead to
higher
inflation
and higher interest rates. They will not
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commit
longer-term securities without getting
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a2 higher
than those offered by shorter-term
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securities.
A2normal3 yield4curve 5typically
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banks4 (such as the Federal Reserve
the United States) are
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“easing” monetary policy, increasing the supply of money and
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the availability of credit in the economy.
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A normal yield curve signals that investors expect the economy
to expand. An illustration of this is shown below.
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investors as to what other investors believe will take place in
the fixed income market in the future.
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Normal
Government
AAA
Yield Curve
AA
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An inverted yield curve, on the other hand, occurs when longterm yields fall belowNormal
short-term
yields.
An inverted yield curve
Inverted
Yield
Curve
Yield
Curve
indicates
that investors expect the economy to slow or decline
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and
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curve
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monetary
policy, limiting the money supply and making credit
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a harbinger
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accept a lower interestTerm
rate now
in return for being locked in for
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Years
years to come. An illustration of this is shown below.
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Inverted Yield Curve
Humped Yield Curve
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Humped Yield Curve
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CONCLUSION
Term to Maturity: Years
Yield
to Maturity
Yield
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% %
d
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Yield to Maturity %
Yield to Maturity %
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Term to Maturity: Years
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Yield curves are created by illustrating the yields for a
particular type of security at different maturities. The US
Treasury yield curve is used as a benchmark to which yield
curves for other types of bonds can be compared. The shape
of the yield curve for a fixed income security reflects market
factors including the direction of interest rates, risk, and
investor demand. Yield curves are widely used by investors
and portfolio managers as a snapshot of market conditions
and to compare different investment options.
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