What Is Yield Curve Risk?
Let me explain yield curve risk directly: it's the risk you face when market interest rates shift adversely while you're invested in fixed-income instruments. When yields change, they directly affect the price of your bonds—if rates go up, bond prices drop, and if rates fall, prices rise. This is a core reality of bond investing that you need to grasp.
Key Takeaways
- The yield curve is a graphical illustration of the relationship between interest rates and bond yields of various maturities.
- Yield curve risk is the risk that a change in interest rates will impact fixed income securities.
- Changes in the yield curve are based on bond risk premiums and expectations of future interest rates.
- Interest rates and bond prices have an inverse relationship in which prices decrease when interest rates increase, and vice versa.
Understanding Yield Curve Risk
As an investor, you should pay close attention to the yield curve because it signals where short-term interest rates and economic growth might head next. I see it as a graph plotting interest rates on the y-axis against bond maturities on the x-axis, from 3-month Treasury bills up to 30-year bonds.
Normally, short-term bonds yield less than long-term ones, so the curve slopes up from left to right—that's your standard positive yield curve. Remember, bond prices move opposite to interest rates: rising rates mean falling prices, and dropping rates push prices up. Any shift in rates moves the curve, creating what's called yield curve risk for you as a bond holder.
This risk ties specifically to the curve flattening or steepening, driven by yield changes in bonds of different maturities. If the curve shifts from its initial shape, the bond you bought based on that original curve will see its price adjust accordingly.
Special Considerations
If you're holding any interest-rate securities, you're exposed to this yield curve risk—it's unavoidable. To manage it, you can construct your portfolio anticipating rate changes and how they'll affect your holdings. Since curve shifts stem from bond risk premiums and future rate expectations, if you can forecast them accurately, you'll profit from the resulting bond price movements.
For short-term plays, consider exchange-traded products like the iPath US Treasury Flattener ETN (FLAT) or the iPath US Treasury Steepener ETN (STPP) to capitalize on these shifts.
Types of Yield Curve Risk
Let's break down the main types of yield curve shifts you need to know.
Flattening Yield Curve
When interest rates start converging, the yield curve flattens, narrowing the spread between long- and short-term rates. This shift changes bond prices: for a short-term bond like one maturing in three years, a drop in its yield means its price goes up.
Take this example: suppose a 2-year note yields 1.1% and a 30-year bond yields 3.6%. If the note's yield drops to 0.9% and the bond's to 3.2%, the spread tightens from 250 to 230 basis points. You can plot these in Excel to visualize the curve.
A flattening curve often points to economic weakness, with low inflation and interest rates expected to persist, alongside reduced bank lending.
Steepening Yield Curve
If the curve steepens, the gap between long- and short-term rates widens—long-term yields rise faster than short-term ones, or short-term yields fall while long-term rise. This hurts long-term bond prices more than short-term ones, posing a real risk if you're using a roll-down strategy to sell held bonds for profit.
Steepening signals stronger economic activity, higher inflation expectations, and thus rising rates. Banks benefit here, borrowing cheap and lending high. For instance, a 2-year note at 1.5% and a 20-year bond at 3.5% might shift to 1.55% and 3.65%, widening the spread from 200 to 210 basis points.
Inverted Yield Curve
Rarely, short-term bond yields exceed long-term ones, inverting the curve. This happens when investors accept low rates now, betting on even lower rates ahead, implying falling inflation and interest rates in the future.
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