In this article, we look at what yields mean in the world of investing, and specifically, what a yield curve means. We cover what their significance is and what a yield curve can tell you about a company’s investment income and market expectations. We also look at different types of yield curves, from normal to flat yield curves, and address the issues of risk and control.
What is a yield curve?
A yield curve is a line plotting the relationship between bond yields and maturity.
A bond’s yield is the expected annual investment return to the owner of the bond. This typically consists of interest payments called coupons, and can also include expected capital gains or losses as the bond’s price moves towards its par value at redemption – the end of the loan period.
A bond’s maturity is the date at which it redeems and the bond issuer – the borrower – repays the owner of the bond – the lender.
A normal yield curve
When yields are plotted against maturities on a chart, the resultant curve is often upward-sloping.
One reason often given for this upward-sloping yield curve is the ‘term premium’ – the extra compensation that lenders might require to keep their investments locked up in a bond for a longer period of time.
Because the term premium causes bond yields to have a bias towards an upward-sloping shape, this is often called a ‘normal’ yield curve.
Another consideration in yield curve shape is bonds’ relationship with inflation and interest rate expectations. This link between yields and interest rate expectations is strongest for developed market government bonds as the default risk is seen as being minimal. Whereas a corporate bond yield will also be influenced by credit risk – with higher yields to compensate for more default risk – government bonds offer a purer relationship with interest rates. For this reason, yield curves are usually shown for government bonds.
If inflation and interest rates are expected to increase in the future, then this is likely to be reflected in bonds yields through an upward-sloping yield curve.
Longer duration bonds will have higher yields to compensate investors for owning them through higher inflation and rising interest rate environment. Shorter duration bonds would have lower yields that reflect lower near-term interest rate levels.
This upward-sloping shape is therefore associated with a growing economy in which rising demand is expected to eventually lead to higher inflation and the need to raise rates to keep price rises in check.
An inverted yield curve
By contrast, if interest rates are expected to fall in future, then this would be reflected in a downward-sloping, or inverted, yield curve. This would be consistent with expectations of a slowing or contracting economy. While short-term rates might be at high or normal levels, the curve’s downward slope suggests that investors expect future interest rates to be lower.
Inverted yield curves are rarer than upward-sloping curves. Because of their implication of falling interest rate, they are an oft-cited example of financial markets expecting an economic recession.
Flat yield curve
Yield curves can take on any shape, not just upward and downward sloping. Sometimes they are flat and sometimes they have upward-sloping and downward-sloping sections which form humps.
The yield curve will change over time as investors’ expectations change in response to economic conditions. These shifts in the curve can take any form: parallel shifts up or down that retain the curve shape but reflect higher/lower yields along all maturities; flattening or steepening in the curve; or even ‘butterfly’ shifts in which medium-duration bond yields move in a different direction from short and long duration bonds – affecting the level of hump in the yield curve.
What is yield curve risk?
Because the shape and level of the yield curve can change over time, investors will experience changes in the price of bonds they own. These changes could result in gains or losses.
In general, an upward shift in the yield curve will mean bond prices fall as yields rise; in this scenario, a bond owner would lose money. A downward shift in the curve would result in rising prices and gains for bondholders.
Because different parts of the curve can move in different directions at the same time, a bond owner’s exposure to yield curve risk will depend on price moves at the bond maturity that they own. For example, the yield curve could steepen, with short-maturity bond yields falling (and prices rising) while long-maturity bond yields rise (and prices fall); this scenario would see owners of short-dated bonds enjoy a rise in the value of their investments, while owners of long-dated bonds would experience a fall.
What is yield curve control?
Central banks seek to stimulate or cool down the economy by adjusting monetary policy to pursue a certain inflation target. There are various tools that can be used as part of monetary policy, including setting short-term ‘base rates’ at which they will led to commercial banks or enacting quantitative easing (QE), a bond-buying programme which aims to reduce interest rates and borrowing costs by pushing up bond prices.
Yield curve control (YCC) is another tool which targets interest rates. Similar to QE, it will involve purchasing bonds in order to influence the price and yield at which they trade in the market. In contrast to QE, YCC is more targeted and seeks to achieve particular yields at specific points (maturities) on the yield curve. YCC usually tries to target longer-term yields, which differs from base rates which are tools to affect shorter-term rates.
Liontrust bond funds
Liontrust bond funds are available via both the Global Fixed Income (GFI) and the Sustainable Investment (SI) teams.
The GFI team’s investment process aims to identify opportunities overlooked by other investors in the market by having a thorough understanding of the economic environment and conducting in-depth analysis of individual stocks. The team applies analysis based on fundamentals, valuations and technical factors to individual stocks and the wider economy. Funds offered by the GFI team include:
Liontrust Strategic Bond Fund – Invests in a range of government bonds and other credit securities globally. For more information, see here.
GF Absolute Return Bond Fund– Invests in corporate and government bonds worldwide, including developed and emerging markets, to generate a positive absolute return over a rolling 12-month period by aiming to minimise volatility and reduce the possibility of a significant negative return. For more information, see here.
GF High Yield Bond Fund– Invests at least 50% of its assets in bonds globally that are classified as below investment grade but offering higher rates of interest. The Fund may also invest in government and investment grade corporate bonds. For more information, see here.
Bond funds managed by the Liontrust Sustainable Future (SF) investment team include:
SF Corporate Bond Fund – Invests at least 80% of its assets in investment grade corporate bonds that are denominated in, or hedged back to, sterling. For more information, see here.
SF Monthly Income Bond Fund – Invests at least 80% of its assets in investment grade corporate bonds denominated in sterling or hedged back into sterling to reduce currency risk. For more information, see here.
GF SF European Corporate Bond Fund – Invests predominantly in euro-denominated investment grade corporate bonds or non-euro denominated corporate bonds hedged back into euros to maximise income and capital growth returns. For more information, see here.
