Cash Equivalents and Fixed Income Securities - Yield Curves


Ayield curve is simply a graph that plots bond yields against their time period to maturity. The curve will show whether short-term interest rates are higher or lower than long-term rates.

  • Normal Yield Curve
    • Most of the time, the yield curve will be positively sloped, which means lower interest rates are correlated with shorter maturities.

    • As maturity lengthens, interest rates increase.

    • For instance, if two-year Treasury notes yield 3%, five-year Treasury notes yield 4% and 10-year Treasury bonds yield 5.5%, then the yield curve will be sloped positively. This would be a normal yield curve.

    • The following diagram is of a normal yield curve, exhibiting a positive slope.
Figure 9.1: Normal Yield Curve


  • Inverted (or Negative) Yield Curve
    • Occurs when there is weak demand for bonds with short maturities, which drives yields up, while a strong demand for long-term bonds drives these yields down

    • An inverted yield curve means short-term interest rates are higher than long-term rates. This is an unusual situation, but it does happen.

    • An inverted yield curve may be an indication of economic decline.

    • An inverted yield curve would result if the two-year Treasury note yielded 3%, the five-year Treasury note 2.75% and the 10-year Treasury bond 2.5%.

    • This would occur if rates were high but expected to fall.

    • The following diagram represents an inverted yield curve.


Figure 9.2: Inverted Yield Curve

  • Flat Yield Curve
    • Occurs where yields are the same for short-, intermediate-, and long-term bonds.
    • This type of curve is a rare occurrence.
    • The flat yield curve is essentially a flat line.

Figure 9.3: Flat Yield Curve


Look Out!
Generally, questions about yield curves relate either to demand or to where interest rates are heading based on the current curve. Read these questions carefully, since one of the incorrect choices may refer to where interest rates are at the time of the yield curve.


Yield Spreads
This refers to the difference in interest rates between different classes of bonds. For example, corporate bonds always have a higher yield than government bonds due to their higher risk. However, the spread is not constant - it can fluctuate over time, based on factors such as:

  • Investor expectations about the economy
  • Issuer activity when a larger or smaller than usual amount of Treasuries is issued, it affects supply, which can affect yields and spreads
  • Institutional investors (such as mutual funds or pension funds) heavily buying or selling a particular type of bond, which can also affect supply. and thus spreads


Exam Tips and Tricks
You might encounter a question like this on the exam:

If a bond is bought at a discount, the yield to maturity would be:

  1. The same as the nominal yield
  2. Lower than the nominal yield
  3. Higher than the nominal yield
  4. Not enough information to determine the answer

The correct answer is "c" - since the buyer paid less than par, the yield to maturity will be higher than the nominal yield.

Corporate Bonds


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