What is the yield curve risk?

The risk of an unfavorable change in market interest rates while investing in a fixed-income instrument is known as the yield curve risk. The price of a fixed-income instrument will fluctuate in response to changes in market yields. Bond prices will fall in response to increases in market interest rates or products, and vice versa.

Knowing the Risk of Yield Curves

Investors closely monitor the yield curve because it shows where short-term interest rates and economic growth are likely to go. A graphical representation of the connection between interest rates and bond yields of different maturities, from 3-month Treasury bills to 30-year Treasury bonds, is called a yield curve. Plotting the graph involves using the y-axis to represent interest rates and the x-axis to represent rising periods.

The curve slopes upward from bottom left to bottom right because the yields on short-term bonds are often lower than longer-term bonds. This yield curve is either standard or positive. Bond prices and interest rates are inversely correlated; when interest rates rise, bond prices fall, and vice versa. As a result, the yield curve will fluctuate in response to changes in interest rates, posing a risk to bond investors known as the yield curve risk.

Because similar bonds with varying maturities have different rates, the yield curve may flatten or steepen, which is connected with yield curve risk. The bond’s price, which was first determined by looking at the initial yield curve, will fluctuate in value when the yield curve changes.

Particular Points to Remember

Yield curve risk affects all investors who own assets carrying interest rates. Investors might construct portfolios with the idea that should interest rates change, their holdings will respond in a particular manner as a hedge against this risk. An investor who can accurately forecast shifts in the yield curve will profit from matching changes in bond prices since changes in the yield curve depend on predictions of future interest rates and bond risk premiums.

Furthermore, by investing in one of two exchange-traded products (ETPs)—the iPath US Treasury Steepener ETN (STPP) or the iPath US Treasury Flattener ETN (FLAT)—short-term investors may profit from yield curve adjustments.

Yield Curve Risk Types

Shifting the Yield Curve

The yield curve flattens when interest rates approach convergence. The narrowing of the yield differential between long- and short-term interest rates is a flattening yield curve. In such a case, the bond’s price will adjust appropriately. The bond cost will rise if it is a short-term bond with a three-year maturity and the three-year yield falls.

Let’s examine a flattening example. Assume that the rates on a 30-year bond and a 2-year note are 3.6% and 1.1%, respectively, on Treasury securities. The yield on the longer-term asset has a considerably more significant decline than the yield on the shorter-term Treasury if the work on the note drops to 0.9% and the work on the bond drops to 3.2%. As a result, the yield differential would drop from 250 to 230 basis points. You may chart this and different yields with Excel and other tools to generate a yield curve.

Since it implies that inflation and interest rates will likely remain low for some time, a flattening yield curve is a symptom of economic weakness. The economy is not expected to expand, and banks should be lending more.

Curve of Steepening Yield

The difference in interest rates between long- and short-term instruments will increase as the yield curve steepens. Put another way, the yields on long-term bonds are growing more quickly than those on short-term bonds, or the products on short-term bonds are decreasing while those on long-term bonds are rising. The price of long-term bonds will thus drop compared to that of short-term bonds.

Generally, a steepening curve points to more economic activity, growing inflation expectations, and, ultimately, higher interest rates. Banks may borrow money at lower interest rates and lend it out at higher interest rates when the yield curve is steep. A 2-year note with a 1.5% yield and a 20-year bond with a 3.5% yield are two examples of a steepening yield curve. Should both Treasury rates rise to 1.55% and 3.65%, respectively, the gap will increase from 200 to 210 basis points after a month.

Inverted Yield Curve

The yield on short-term bonds may sometimes exceed the yield on long-term bonds. The curvature becomes reversed at this point. An inverted yield curve suggests that investors are willing to accept low rates for now if they think rates will drop even more. As a result, investors anticipate future interest rates and inflation rates to decline.

Conclusion

• A yield curve is a graphical representation of the connection between interest rates and bond yields of different maturities.
• The risk that a shift in interest rates will affect fixed-income assets is known as yield curve risk.
• The expectations of future interest rates and bond risk premiums drive changes in the yield curve.
• Bond prices and interest rates are inversely correlated; when interest rates rise, bond prices fall, and vice versa.