Yield Curve

Also known as the term structure of interest rates, yield curves are typically used depict the relationship between interest rates and the time to maturity of a debt security such as a bond. The shape of the curve provides the analyst-investor with insights into the future expectations for interest rates, as well as possible increases or decreases in macroeconomic activity.

While the most common yield curve is that generated by U.S. Treasury securities, they can also be constructed for bonds carrying similar ratings, as well as those securities issued by individual companies. When constructed, the maturity of the curve is plotted on the x-axis (horizontal axis). Since the line plot is constructed from a fixed number of data points, the yields of various maturities can be estimated through interpolation.

The shapes of these curves are illustrated below. Generally, all yield curves fall into the following five types, and are a function of supply and demand as well as risk premiums:

• Normal: an upward sloping line that initially rises sharply, and then flattens out at longer maturities.

• Inverted: a downward sloping line that initially falls sharply, and then flattens out at longer maturities.

• Steep: an upward sloping line that initially rises very sharply, and then quickly flattens out at longer maturities.

• Flattened: a horizontal line running parallel to the x-axis, indicating the same yield regardless of the maturity.

• Humped: an upward sloping line that initially rises sharply, and then begins to fall at longer maturities.

The following illustration demonstrates the shapes of the five types of yield curves.

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