What it means
The yield curve plots the interest rate on government bonds against how long until they mature, from a few months to thirty years or more. In normal times the curve slopes upwards, with longer loans paying more.
Over time the curve can rise, fall, steepen, flatten or even invert, with short rates above long rates. A portfolio holds bonds of different maturities, and each part responds to a different part of the curve.
A change in two-year rates will affect short bonds, while a change in ten-year rates will affect long bonds. If the curve twists rather than shifting evenly, some holdings lose more than others, and a portfolio that looked safe against a simple rate rise can still lose money.
For banks the risk appears in the margin between what they pay depositors and what they earn on loans. Banks typically borrow short and lend long, so a flat or inverted curve squeezes their profit.
Insurers face the opposite problem when long-dated liabilities are matched with shorter assets. Managers measure the risk with tools such as duration, which estimates how much a bond's price changes for a given move in yields, and key rate durations, which break that sensitivity into points along the curve.
Stress tests then apply scenarios such as a parallel shift, a steepening or a flattening. The results show where the portfolio is most exposed.
Management choices include matching the maturity of assets and liabilities, using interest rate swaps, which are contracts that exchange fixed and floating payments, and spreading holdings across the curve. A barbell strategy concentrates holdings at both ends, while a bullet strategy concentrates them in the middle.
Each responds differently to a change in the curve's shape.
In practice
Real-world examples.
Example
A regional bank holds long-term fixed-rate mortgages funded by short-term deposits. When the yield curve flattens and short-term rates rise, its funding costs rise faster than its loan income. The treasurer uses swaps to reduce the mismatch.
Example
A corporate treasurer invests surplus cash in a ladder of government bonds with maturities from one to five years. When the curve steepens, the longer bonds fall in value more than the shorter ones. The ladder structure limits the damage because part of the portfolio matures soon and can be reinvested.
Example
A pension fund must pay benefits many years from now, and holds bonds that are shorter than its liabilities. A fall in long-term yields increases the value of the liabilities more than the value of the assets. The trustees extend the bond maturities to reduce the gap.
Formula
Calculation
Approximate price change = -(modified duration) x (change in yield) x (value of the holding)
Suppose a portfolio has $4,000,000 in short bonds with a duration of 2 and $6,000,000 in long bonds with a duration of 8. Short-term yields rise by 0.25 percentage points and long-term yields rise by 0.75 percentage points, a steepening of the curve. Loss on short bonds = 4,000,000 x 2 x 0.0025 = $20,000. Loss on long bonds = 6,000,000 x 8 x 0.0075 = $360,000. Total loss = 20,000 + 360,000 = $380,000, which is 3.8% of the $10,000,000 portfolio.Case study
Seen in the real world.
Harlow Savings is an illustrative, fictional bank that built up a large portfolio of 10-year fixed-rate loans while funding itself with deposits that could reprice within a year. For some time the arrangement was profitable because the yield curve sloped upward.
When the central bank raised short-term rates and the curve flattened, the bank's deposit costs rose by 1.50 percentage points while its loan yields stayed fixed. On $500,000,000 of loans funded this way, the squeeze was worth about 500,000,000 x 0.015 = $7,500,000 a year.
The treasurer entered into interest rate swaps to receive fixed and pay floating on part of the book, and started offering longer-term deposit products. The illustrative lesson is that the shape of the curve, not just its level, drives profit for institutions that borrow short and lend long.
Watch out
Common mistakes.
- Assuming that rate risk only means rates going up or down together, when the curve can twist so that short and long rates move differently.
- Relying on a single duration number, which hides how the portfolio responds at different maturities.
- Treating an inverted curve as a one-off oddity, when it can persist and erode the margins of institutions that borrow short and lend long.
Questions
People also ask.
What is yield curve risk?
It is the risk of loss from changes in the shape of the yield curve, such as steepening, flattening or inversion.
How is it different from interest rate risk in general?
General interest rate risk often assumes a parallel shift, while yield curve risk focuses on changes in the slope and shape.
How can it be reduced?
By matching the maturities of assets and liabilities, using swaps and spreading holdings across different points on the curve.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%