SMSF Investing Education & Strategies

What is the Yield Curve?

by Elizabeth Moran
FIIG Securities.

A yield curve is also called the term structure of interest rates, as it shows the relationship between interest rates and the term to maturity. In other words, the yield curve is the market’s current view of interest rates for various terms to maturity.

When constructing a yield curve it is important to use interest rates for the same currency, credit quality and industrial sector as these factors will affect interest rates at different maturities. The most frequently referenced yield curves are the Commonwealth bond curve which plots yields for risk-free Commonwealth Government bonds versus maturity and the swap curve which plots yields for current coupon interest rate swaps versus maturity.

It is important to remember that the yield curve is for a consistent issue, issuer or at least a consistent credit rating spectrum. It would not make sense to construct a yield curve using the rates for one and six year Commonwealth Government bonds, a three year finance company bond and a ten year semi-government bond.

In a normal or positive yield curve environment (see Figure 1), long term fixed income securities offer higher yields than short term fixed income securities. This is intuitive since investors require a premium to compensate for the uncertainties associated with the general economic climate and the financial viability of the issuer over the longer term. It is often said that a steep, positively shaped yield curve is positive for fixed income investors as they are ‘paid’ for the additional risk of making a longer term investment.

Generally, yield curves in the short end are most affected by monetary policy and in the longer term, inflation.

Figure 1 shows a normal yield curve where, in this particular instance, a one year investment will yield 5.5%, a three year 6.25% and a six year 6.75%.

Figure 1

Inverse yield curves

In an inverse or negative yield curve environment the market expects interest rates to decline as time progresses, which is represented by shorter dated yields being higher than longer dated yields (see Figure 2). Remember also, that as interest rates decrease, fixed rate bond prices increase and yields decline.

Inverse yield curves usually occur when the central bank, in our case the RBA, is aggressively tightening monetary policy in an attempt to slow the economy and limit inflation. This was seen in Australia in 2007-08 where long term bonds were yielding up to 1.5% less than cash rates which rose above 7%.

Figure 2

Elizabeth Moran
Director – Education and Fixed Income Research - FIIG Securities.

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