You may hear financial headlines announce that the yield curve is steepening, flattening, inverting, or returning to a more typical shape.
But what exactly is the yield curve, and what can it tell you about interest rates, the economy, and your investments?
At its simplest, a yield curve is a snapshot of the yields available on similar bonds with different maturities. Understanding how it works can provide useful context for what’s happening in the bond market, but interpreting it requires some perspective.
What Is a Yield Curve?
A yield curve plots the yields of similar bonds across different maturities at a particular point in time.
The U.S. Treasury yield curve is one of the most widely followed examples. It compares yields on Treasury securities ranging from very short maturities to 30 years.
A few terms can make the curve easier to understand:
Maturity: The amount of time until a bond’s principal is scheduled to be repaid. For example, a 2-year Treasury and a 10-year Treasury have different maturities.
Yield: A measure of the return associated with a bond. Several definitions of yield exist, so it’s important to understand which measure is being discussed. Yield to maturity, for example, estimates the annualized return an investor would receive if a bond were purchased at its current market price and held until maturity, assuming scheduled payments are made and certain other assumptions hold.
Spread: The difference between two yields. If a 10-year Treasury yields 4.5% and a 2-year Treasury yields 4.0%, the spread between them is 0.5 percentage points, or 50 basis points.
Credit quality: The issuer’s perceived ability to make interest and principal payments. Because Treasury securities are backed by the full faith and credit of the U.S. government, Treasury yields are commonly used as benchmarks when evaluating other fixed-income investments.
Together, these data points create the curve investors and economists follow.
What Does a “Normal” Yield Curve Look Like?
A yield curve is often described as normal when longer-term bonds offer higher yields than shorter-term bonds.
There are several reasons this can occur. Investors committing money for longer periods may require additional compensation for risks such as changing interest rates and inflation over time.
But the curve doesn’t always maintain the same shape.
Depending on interest rates, economic expectations, monetary policy, supply and demand, and other market forces, the yield curve can become steeper, flatter, or inverted.
Rather than thinking of one shape as inherently good or bad, it can be more useful to view the curve as a snapshot of how the bond market is pricing different maturities at a particular moment.
Understanding Different Yield Curve Shapes
Financial headlines commonly describe the yield curve in a few different ways.
Upward-Sloping Yield Curve
An upward-sloping curve occurs when longer-term yields are higher than shorter-term yields.
This is often considered the more typical shape of the Treasury yield curve, although the steepness can vary significantly.
Flat Yield Curve
A flatter curve occurs when short- and long-term yields are relatively close together.
Flattening can happen for several reasons, including changes in monetary policy, inflation expectations, economic expectations, and investor demand for bonds of different maturities.
Inverted Yield Curve
An inverted yield curve occurs when some shorter-term Treasury yields exceed longer-term yields.
Yield curve inversions attract considerable attention because certain Treasury yield spreads have historically preceded U.S. recessions.
However, an inversion doesn’t tell investors exactly when a recession will begin, how severe it might be, or what financial markets will do in the meantime.
Steepening Yield Curve
A curve steepens when the difference between shorter- and longer-term yields increases.
This can happen because long-term yields rise, short-term yields fall, or some combination of the two.
As with other changes in the curve, the underlying reasons matter. The same general shape can emerge under different economic circumstances.
Why Does the Yield Curve Change?
Interest rates at different maturities are influenced by a range of factors.
These may include:
- Federal Reserve monetary policy
- Expectations for future short-term interest rates
- Inflation expectations
- Economic growth expectations
- Supply and demand for Treasury securities
- Investor preferences for liquidity and safety
- Compensation investors require for holding longer-term bonds
Because so many variables affect yields, interpreting a change in the curve isn’t always straightforward.
For example, a decline in a long-term Treasury yield could reflect changing expectations about future interest rates, increased investor demand for longer-term bonds, changing inflation expectations, or a combination of factors.
The yield curve can provide information about market expectations, but it doesn’t provide certainty about what comes next.
Why Do Inverted Yield Curves Get So Much Attention?
One reason the yield curve regularly appears in financial news is its historical relationship with recessions.
Certain measures of the Treasury yield curve, including the spread between 10-year and shorter-term Treasury yields, have historically provided useful information about recession risk.
That doesn’t make the yield curve a perfect forecasting tool.
There can be a considerable delay between an inversion and a recession, and an inversion by itself doesn’t tell investors what will happen to stocks, bonds, interest rates, or individual portfolios.
The specific spread being discussed also matters. Economists and investors monitor several combinations of Treasury maturities rather than a single universally accepted “yield curve indicator.”
For investors, the distinction is important: an economic indicator can provide useful information without providing a reliable market-timing signal.
What Does the Yield Curve Mean for Bond Investors?
The yield curve can be particularly relevant when evaluating fixed-income investments because it shows how much additional yield the market is offering for extending maturity.
Suppose longer-term bonds offer only slightly higher yields than shorter-term bonds. An investor might evaluate whether that additional yield adequately compensates for taking additional interest-rate risk.
If longer maturities offer substantially higher yields, the tradeoff may look different.
But maturity isn’t the only consideration when evaluating a bond.
Investors may also need to consider:
- Credit risk.
- Interest-rate risk.
- Inflation risk.
- Liquidity.
- Call risk.
- Tax treatment.
- Income needs.
- The bond’s role within the broader portfolio.
Higher yield generally comes with some form of additional risk or different investment characteristics, which is why comparing yield alone can provide an incomplete picture.
Bond Prices and Interest Rates Move in Opposite Directions
Understanding the yield curve is also easier when you understand the relationship between bond prices and interest rates.
Generally, when market interest rates rise, the prices of existing fixed-rate bonds fall. When market interest rates decline, existing fixed-rate bond prices generally rise.
Longer-maturity bonds are typically more sensitive to changes in interest rates than comparable shorter-maturity bonds, although other characteristics also affect a bond’s sensitivity.
This relationship matters whether you own individual bonds or bond funds, although the way returns and principal are experienced can differ between the two.
Individual Bonds and Bond Funds Aren’t Identical
Investors can gain fixed-income exposure through individual bonds, bond mutual funds, exchange-traded funds, and other vehicles.
An individual bond generally has a stated maturity date when principal is scheduled to be repaid, assuming the issuer doesn’t default and subject to any applicable call provisions.
A traditional bond fund, by contrast, typically holds a portfolio of bonds and doesn’t have a single maturity date on which an investor’s original principal is returned. Its value fluctuates as the underlying portfolio changes and market conditions evolve.
Both can play a role in a diversified portfolio, but understanding the distinction can help investors evaluate how interest rates and changes in the yield curve may affect their holdings.
Should You Change Your Portfolio When the Yield Curve Changes?
Not necessarily.
The yield curve provides information about current bond-market conditions and market expectations, but it’s only one piece of a much larger financial picture.
Making significant investment changes based solely on whether the curve is steep, flat, or inverted can amount to making a prediction about what will happen next.
Instead, changes in interest rates and bond yields can provide an opportunity to review questions such as:
- Does my fixed-income allocation still reflect my goals?
- How much interest-rate risk am I taking?
- What role are bonds intended to play in my portfolio?
- Do I have upcoming income or liquidity needs?
- Am I appropriately diversified?
- Have my financial circumstances or time horizon changed?
The answers may or may not result in a portfolio change.
Keep the Yield Curve in Perspective
The yield curve can tell investors quite a bit about current bond-market conditions. It can show the relationship between short- and long-term yields, illustrate how investors are pricing different maturities, and provide information that economists use when evaluating economic conditions.
What it can’t do is tell you with certainty what markets or the economy will do next.
For long-term investors, the yield curve may be most useful as one source of information within a broader investment process rather than as a signal to move in or out of particular investments.
The Bottom Line
The yield curve is essentially a snapshot of the relationship between bond yields and maturities at a particular point in time. Its shape changes as interest rates, economic expectations, inflation expectations, monetary policy, and investor demand evolve.
Understanding the curve can help investors make sense of financial headlines and better understand the risks and opportunities within fixed-income markets. But no single curve shape determines what an individual investor should do next.
Investment decisions are generally better considered in the context of your goals, time horizon, income needs, risk tolerance, tax circumstances, and broader portfolio.
At Navalign Wealth Partners, we help clients evaluate fixed-income investments as one part of a comprehensive investment and financial planning strategy.