What it means
A yield curve plots the interest rate (yield) on bonds of the same credit quality, usually government bonds, against how long until they mature. In a normal curve, a 2-year bond yields less than a 10-year bond, which yields less than a 30-year bond.
Investors usually demand extra yield for lending their money for longer. There are several reasons for the upward slope.
Longer bonds carry more risk, because there is more time for inflation or rising rates to reduce their value. Investors may also expect growth and inflation, and therefore higher short-term rates in future, and the curve reflects those expectations.
For businesses, a normal curve means that long-term borrowing is more expensive than short-term borrowing. A company can save interest by borrowing for short periods, but it takes on the risk that rates will rise before it has to refinance.
Fixing the rate for a longer term costs more now in return for certainty. The shape of the curve is also watched as a signal.
A normal curve suggests that markets expect steady growth, while a flat or inverted curve, where short-term rates are higher than long-term rates, has often preceded economic slowdowns. It is a guide and not a guarantee, since many other factors are at work.
Banks also care about the curve because they typically borrow short and lend long. A steep, normal curve can make lending more profitable, as the gap between what they pay depositors and what they earn on loans widens.
The curve moves daily, and its slope can steepen or flatten as central bank policy and investor expectations change. Finance teams use it to price loans, value long-term liabilities such as pensions and decide whether to fix or float their borrowing.
In practice
Real-world examples.
Example
A treasurer sees that 1-year borrowing costs 3% while 10-year borrowing costs 4.8%. She decides to fix half of a $20,000,000 loan for 10 years and leave the rest on short-term funding. That gives her $10,000,000 of fixed cost certainty and keeps $10,000,000 flexible if rates fall.
Example
A bank takes deposits at 2% and lends mortgages at 5%. When the yield curve is normal and steep, the margin of 3 percentage points on its lending is wide, and it can grow its loan book profitably. If the curve flattened, the margin would shrink and the bank would lend more cautiously.
Example
A pension fund discounts its long-term liabilities using higher long-term rates in a normal curve environment. The present value of its obligations falls, improving its reported funding position. The trustees remind members that the change reflects market rates and not any improvement in the underlying business.
Formula
Calculation
Term spread = Long-term yield - Short-term yield
Suppose a 2-year government bond yields 3.0% and a 10-year bond yields 4.5%. Term spread = 4.5% - 3.0% = 1.5 percentage points, which is a normal, upward-sloping curve. On a $1,000,000 loan, locking in the 10-year rate would cost $1,000,000 x 0.045 = $45,000 a year, against $1,000,000 x 0.03 = $30,000 a year at the 2-year rate, a difference of $15,000 a year for the certainty of a longer fixed rate. Over five years that certainty costs $15,000 x 5 = $75,000, which the borrower must weigh against the risk of rates rising.Case study
Seen in the real world.
Marlowe Foods is a fictional food producer invented to illustrate this idea. Its treasurer needed to borrow $15,000,000 to build a new plant and compared a 3-year loan at 3.2% with a 10-year loan at 4.6%.
The normal yield curve meant the longer loan cost an extra 1.4 percentage points, or $15,000,000 x 0.014 = $210,000 more a year in interest. The board weighed this against the risk that rates would rise before a 3-year loan matured.
They decided on a mix, borrowing $9,000,000 for 10 years and $6,000,000 for 3 years. That blend kept the average cost lower than fixing everything for the long term, while limiting the exposure to rising rates on the larger part of the debt. The treasurer will review the shorter loan well before it matures, so that refinancing is not rushed.
Watch out
Common mistakes.
- Assuming a normal curve always means a booming economy. It is a positive sign but not a forecast.
- Choosing the shortest borrowing just because it is cheaper. The interest cost may rise sharply when the loan is refinanced.
- Reading the curve across different credit qualities. A proper curve compares bonds of similar risk, usually government bonds.
Questions
People also ask.
Why is the curve normally upward sloping?
Investors usually want more return for locking their money away for longer and bearing more risk.
What is the opposite of a normal curve?
An inverted yield curve, where short-term yields are higher than long-term yields, which has often been followed by slower growth.
Does a normal curve affect me if I am not an investor?
Yes. It influences mortgage rates, business loan pricing and the cost of long-term financing, so it affects almost any company that borrows or lends.
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