What it means
A yield curve shows how interest rates change as the time to maturity gets longer. Governments issue new bonds regularly, and the newest bond at each maturity, such as the latest 2-year, 5-year or 10-year note, is called on the run.
Older bonds of similar maturity that were issued earlier are called off the run. Traders favour on-the-run issues because they are the most actively traded, which means they can be bought and sold in large amounts at tight prices.
That heavy trading makes their yields a clean, up-to-date reading of what the market currently demands. The curve built from them is therefore the starting point for pricing corporate bonds, mortgages and loans.
The shape of the curve carries information. A normal curve slopes upwards, with longer maturities paying more, while an inverted curve slopes downwards and is often read as a signal that investors expect weaker growth or lower interest rates ahead.
Finance teams watch the slope because it affects the cost of borrowing and the return on cash. The on-the-run curve can be slightly lumpy.
Because the securities are issued at set points, each point on the curve is a different bond with its own quirks, and the pattern changes when a new bond is auctioned and replaces the old one. For this reason, some analysts smooth the points into a continuous curve, which is called a fitted or zero-coupon curve.
The on-the-run bonds usually trade at a small premium to off-the-run bonds because of their liquidity. This means their yields are a little lower, and the curve can understate the return available on older bonds.
A careful user keeps that gap in mind when comparing prices.
In practice
Real-world examples.
Example
A corporate treasurer is about to issue a ten-year bond. Her bankers quote the price as a spread over the on-the-run 10-year Treasury note, so she watches that yield each morning. When it rises by 0.15%, she knows the annual interest on $50 million of debt will rise by about $75,000.
Example
A bank economist plots the on-the-run curve each week for the credit committee. When the two-year yield moves above the ten-year yield, the committee tightens its lending standards for long-term projects. The curve is treated as a warning sign, not a certainty.
Example
A bond fund manager notices a new 10-year note has been auctioned and the yield on the old one is now a little higher. He sells part of his holding of the new note and buys the old one at a slightly better yield. The trade picks up a small return for accepting lower liquidity.
Formula
Calculation
Curve slope = yield on long-maturity on-the-run bond - yield on short-maturity on-the-run bond
The yields below are illustrative only. Suppose the on-the-run 2-year note yields 4.00% and the on-the-run 10-year note yields 4.40%.
Slope = 4.40% - 4.00% = 0.40%, which is 40 basis points (one basis point is one hundredth of a percentage point).
The curve is upward sloping. If the 10-year yield were instead 3.70%, the slope would be 3.70% - 4.00% = -0.30%, or -30 basis points, and the curve would be inverted.
For a company planning to borrow $5,000,000 for ten years at a spread of 2.00% over the 10-year note, the rate would be 4.40% + 2.00% = 6.40%, or 5,000,000 x 0.064 = $320,000 of interest a year.Case study
Seen in the real world.
Greystone Manufacturing is an illustrative, fictional company that planned a $30 million loan to fund a new plant. Its lender quoted a rate of the on-the-run 7-year yield plus 2.25%.
The chief financial officer saw that the curve was flat between 5 and 7 years, and that the 3-year yield was higher than both. She chose a loan with a 5-year term instead of 7 years, saving 0.10% on the base rate, which was worth $30,000 a year on the full amount.
She also asked the bank to fix the rate only after the next auction, since the new note would reset the benchmark. The illustrative lesson is that the timing and the maturity chosen against the curve both affect the real cost of borrowing.
Watch out
Common mistakes.
- Assuming the on-the-run curve is the same as the curve of all Treasury bonds, when it uses only the newest issue at each maturity.
- Reading a single day's inversion as proof that a recession is coming, when the curve is an indicator and not a forecast.
- Ignoring that the benchmark bond changes after each auction, which can cause small jumps in the curve that are not market moves.
Questions
People also ask.
What does on the run mean?
It describes the most recently issued security of a given maturity, which is usually the most heavily traded.
Why do analysts use this curve as a benchmark?
The securities are liquid and have the lowest credit risk, so their yields give the cleanest view of the market's required return at each maturity.
How is it different from a fitted curve?
The on-the-run curve connects actual bonds, while a fitted curve uses a mathematical model to build a smooth line through many bonds.
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