What is a Normal Yield Curve?

Graphical Presentation of Normal Yield Curve

The yield curveYield CurveA yield curve is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis). The slope of the yield curve provides an estimate of expected interest rate fluctuations in the future and the level of economic activity. read more is created below on a graph by plotting yield on the vertical axis and time to maturity on the horizontal axis. When the curve is normal, the highest point is on the right.

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Different Theories of Interest Rates

#1 – Expectation Theory

Expectation theory says that long-term interest rates should reflect expected future short-term rates. It argues that forward interest rates corresponding to certain future periods must be equal to future zero interest rates of that period.

If the 1-year rate today is at 1%, and the 2-year rate is 2%, then the one-year rate after one year (1yr forward rateForward RateThe forward rate refers to the expected yield or interest rate on a future bond or Forex investment or even loans/debts.read more) is around 3% [1.02^2/1.01^1].

#2 – Market Segmentation Theory

There is no relationship between short-term, medium-term, and long-term interest rates. The interest rate at a particular segment is determined by demand and supply in the bond market of that segment. Under the theory, a major investment such as a large pension fundLarge Pension FundA pension fund refers to any plan or scheme set up by an employer which generates regular income for employees after their retirement. This pooled contribution from the pension plan is invested conservatively in government securities, blue-chip stocks, and investment-grade bonds to ensure that it generates sufficient returns.read more invests in a bond of a certain maturity and does not readily switch from one maturity to another.

#3 – Liquidity Preference Theory

Investor prefers to preserve liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more and invest funds for a short period. On the other hand, Borrowers prefer to borrow at fixed rates for long periods of time. This leads to a situation where the forward rate is greater than the expected future zero rates. This theory is consistent with the empirical result that the yield curve tends to be more upward-sloping than downward-sloping.

Changes or Shifts in Normal Yield Curve

  • Parallel Shifts – Parallel shift in the yield curve occurs if the yields across all the maturity horizons change (increase or decrease) by the same magnitude and similar direction. It represents when a general level of interest rate changes in an economy.Non Parallel Shifts – When the yield across different maturity horizons changes at a different level in both magnitude and direction.

Importance

  • The yield curve’s shape indicates the interest rate’s future direction. It forecasts the future direction of the interest rates: a normal curve means longer-term securities have a higher yield, and an inverted curve means short-term securities have a higher yield.Banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read morefinancial institutions accept deposits from customers and provide loans to corporate or retail clients in exchange for a return. The wider the difference between lending and borrowing rates, the more spread. The steeper upward sloping curve will provide higher profits. In contrast, the downward sloping curve will lead to lower profits if the major portion of bank assets are in the form of long-term loans after considering short-term customer deposits.A trade-off between maturity and yield- long-term bonds tend to be more volatile than short-term bonds and hence offer a greater premium to an investor in the form of higher yield to encourage them to lend. It indicates to investors whether the security is overpriced or underpriced based on its theoretical value. If the return is above the yield curve, security is said to be underpriced, and if the return is below the yield curve, security is overpriced.

Influence

  • Central banks target economic growth and inflation rate through changing interest rate levels. To respond to a rise in inflation, central banks increase interest rate levels wherein borrowing becomes expensive and erodes the purchasing power of consumers, which further leads to an inverted yield curve. Economic growth: strong economic growth provides the varying opportunity for investment and expansion in business, which leads to an increase in aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices.read more for capital; given a limited supply of capital, the yield curve increases, which results in the steeping of the yield curve.

Key Points to Remember

  • It is an upward-sloping normal curve from left to right, indicating that yield increases with maturity. It is often observed when the economy grows at a normal pace without any major interruptions of available credit; e.g., 30-year bonds offer higher interest rates than 10-year bonds.An investor investing in longer maturity bonds requires higher compensation for taking additional risks as there is a greater probability of unexpected negative events in the long term. In other words, the longer the maturity, the longer time it will take to get back the principal amount. The greater the risks involved, the higher the expected yield, which will lead to the upward sloping yield curve.·       The shape of the yield curve determines the current and future strength of the economy. It provides early warning signals on the future direction of the economy. It always changes based on shifts in the general market conditions.Every bond portfolio has different exposures to how the yield curve shifts — i.e., yield curve risk. The predicted percentage change in the price of a bond that occurs when yields change by one basis point is captured by an advanced concept called “durationDurationDuration is a risk measure used by market participants to measure the interest rate sensitivity of a debt instrument, e.g. a Bond. It tells how sensitive is a bond with respect to the change in interest rates. This measure can be used for comparing the sensitivities of bonds with different maturities. There are three different ways to arrive duration measures, viz. Macaulay Duration, Modified Duration, and Effective Duration.read more.”·       Duration measures the linear relationship between yield and bond price. It is a simple measure for small changes in yield, whereas convexityConvexityConvexity of a bond is a measure that shows the relationship between bond price and yield, and it helps risk management tools to measure and manage a portfolio’s exposure to interest rate risk and loss of expectation.read more measures the non-linear relationship and is more accurate for large changes in yields.

This has been a guide to what is a normal yield curve. Here we discuss different theories of interest rate, changes, or shifts in the normal yield curve, its influence, and its importance with a detailed explanation. You can learn more about fixed income from the following articles –

  • Debt Instruments DefinitionInverted Yield CurveCalculate Bond YieldNegative Yield Bond Example