1. Advanced Bond Concepts: Introduction
  2. Advanced Bond Concepts: Bond Type Specifics
  3. Advanced Bond Concepts: Bond Pricing
  4. Advanced Bond Concepts: Yield and Bond Pricing
  5. Advanced Bond Concepts: Term Structure of Interest Rates
  6. Advanced Bond Concepts: Duration
  7. Advanced Bond Concepts: Convexity
  8. Advanced Bond Concepts: Formula Cheat Sheet
  9. Advanced Bond Concepts: Conclusion


The term structure of interest rates – known as the yield curve – is the relationship between interest rates or bond yields that differ in their length of time to maturity. The term structure reflects investor expectations about future changes in interest rates and their assessment of monetary policy conditions. The term structure of interest rates is constructed by graphing the YTM and respective maturity dates of benchmark fixed-income securities. Because U.S. Treasuries are considered risk-free, their yields are often used as the benchmark.

The term structure of interest rates is graphed as though each coupon payment of a noncallable fixed-income security were a zero-coupon bond that matured on the coupon payment date. If the normal yield curve changes shapes, it can be a signal to investors that it’s time to update their economic outlook.

Three Main Patterns

There are three main patterns created by the term structure of interest rates:

Normal Yield Curve

normal yield curve forms during normal market conditions, when investors believe there won’t be any significant changes to the economy (e.g., interest rates) and the economy will continue to grow at a normal rate. During these conditions, investors expect higher yields for bonds with long-term maturities than those with short-term maturities. This is a normal expectation since short-term instruments generally carry less risk. The further out a bond’s maturity, the more time and uncertainty investors face before being paid back the principal. As current interest rates increase, a bond’s price will decrease and its yield will increase.

A normal yield curve


Flat Yield Curve

flat yield curve indicates that the market is sending mixed signals to investors, who are interpreting interest rate movements in various ways. In these situations, it’s hard for the market to determine whether interest rates will move significantly in either direction. A flat yield curve generally happens when the market is making a transition between normal and inverted curves. When the yield curve is flat, you can maximize your risk/return tradeoff by choosing fixed-income securities with the least risk, or highest credit quality

A flat yield curve


Inverted Yield Curve

Inverted yield curves are uncommon; they form when long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. Bonds with maturity dates further into the future are expected to offer lower yields than bonds with shorter maturities. Some investors interpret an inverted curve as an indication that the economy will experience a slowdown, leading to even lower yields. The idea is that before a slowdown, it’s better to lock money into long-term investments at present prevailing yields because future yields will be even lower. 

An inverted yield curve


Theoretical Spot Rate Curve

Another type of yield curve is the theoretical spot rate curve, which is constructed using Treasury spots instead of yields. This curve accounts for the fact that many Treasuries offer varying coupons and would, as a result, not accurately represent similar noncallable fixed-income securities.

If you compare a 10-year bond paying a 7% coupon with a 10-year Treasury bond paying a coupon of 4%, your evaluation wouldn’t mean much: While both bonds have the same 10-year maturity, the 4% Treasury coupon would not be an appropriate benchmark for the bond paying 7%. The spot rate curve offers a more accurate measure since it adjusts the curve to reflect variations in the interest rate of the plotted benchmark. The interest rate taken from the plot is known as the spot rate.

A theoretical spot rate curve

The Credit Spread

The credit spread (or quality spread) is the difference in yield between a U.S. Treasury bond and a debt security with the same maturity, but lesser quality. Credit spreads between U.S. Treasuries and other bonds are measured in basis points, with a 1% difference in yield equal to a spread of 100 basis points. For example, assume a 10-year Treasury note has a yield of 2.54%. If a 10-year corporate bond has a yield of 4.6%, then the corporate bond offers a spread of 206 basis points over the Treasury note.

Credit spreads vary based on the credit rating of the bond issuer. Debt issued by the U.S. Treasury is used as the benchmark (because it’s risk-free). As the default risk of the issuer increases, its spread widens. In general, when interest rates are declining, the credit spread narrows. The spread is demonstrated as the yield curve of the corporate bond and is plotted with the term structure of interest rates. 

The credit spread between an "ABC Company" corporate bond and a Treasury security

Advanced Bond Concepts: Duration
Related Articles
  1. Investing

    Trade Bond ETFs Using Yield Curves

    Different types of yield curves provide important insights for trading bond-based securities.
  2. Insights

    U.S. Recession Without a Yield Curve Warning?

    The inverted yield curve has correctly predicted past recessions in the U.S. economy. However, that prediction model may fail in the current scenario.
  3. Investing

    How Bond Market Pricing Works

    Learn the basic rules that govern how bond prices are determined.
  4. Investing

    Interest Rates And Your Bond Investments

    By understanding the factors that influence interest rates, you can learn to anticipate their movement and profit from it.
  5. Investing

    Bond Yield Curve Holds Predictive Powers

    This measure can shed light on future economic activity, inflation levels and interest rates.
  6. Insights

    Is a Recession in the Works? Ask an Inverted Yield Curve

    An inverted yield curve has predicted the last seven recessions. Is number eight around the corner?
  7. Investing

    A Flattening Yield Curve Is Good For The Economy and Stocks

    Wall Street is concerned because the yield curve is flattening, but that doesn't mean a recession is near.
  8. Investing

    Understanding Interest Rates, Inflation And Bonds

    Get to know the relationships that determine a bond's price and its payout.
Frequently Asked Questions
  1. What is PMI, and does everyone need to pay it?

    No – PMI is only required of those who can't make a 20% down payment on the home they're purchasing.
  2. Why is the 1982 AT&T breakup considered one of the most successful spinoffs in history?

    Find out why the breakup of AT&T into a number of spinoffs called the Baby Bells was one of the most successful spinoffs ...
  3. How does the required rate of return affect the price of a stock, in terms of the Gordon growth model?

    Find out how a change in the required rate of return adjusts the price an investor is willing to pay for a stock. Learn about ...
  4. What is the difference between the cost of capital and required return?

    Take a look at the primary conceptual differences between an investor's required rate of return and an issuing company's ...
Trading Center