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The yield curve is a graph depicting the relationship between yield and the length of time to maturity for debt securities with comparable degrees of risk. The horizontal scale measures years to maturity, while the vertical axis presents yield to maturity. This relationship is also called the term structure of interest rates.

The shape of the yield curve plays a critical role in the decisions of individuals and corporations, and in the conduct of monetary policy by central banks, such as the U.S. Federal Reserve Bank. Individuals choosing between an adjustable and fixed-rate mortgage, and corporations deciding whether to issue short- or long-term debt, can make sensible decisions only if they understand the factors that shape the yield curve. Central banks, which operate in the short-term market, need to understand the likely effect of their activities on long rates.

Generally, the yield curve approximates one of three shapes. The curve may display the lowest yields on short-term issues, then rise and become relatively flat in the longest maturities, forming an ascending curve. Alternatively, yields may be highest on short-term securities, forming a descending (or inverted) curve. Sometimes, yields are the same for all maturities. Three economic theories—the expectations, liquidity-preference, and institutional or hedging pressure theories—explain the shape of the yield curve.

The Expectations Theory

For expectations theorists, the shape of the yield curve is a reflection of investors’ anticipations of future interest rates. Suppose that lower rates are likely in the future. Long-term bonds will appear more attractive than short-term ones if both maturities sell at equal yields. Long-term bonds allow an investor to earn a relatively high rate for a longer time period than shorter issues permit. Short-term bond investors risk having to reinvest their funds later at lower yields. Also, since bond prices move inversely to interest rates, buyers of long-term bonds realize capital appreciation if yields decline.

If investors act in accordance with these expectations, they will tend to bid up prices (force down the yields) of long-term bonds and sell short-term securities, causing their prices to fall (yields to rise). These operations will produce a descending yield curve with short-term issues yielding more than long-term bonds. Similarly, the expectations theory predicts the yield curve will be upward-sloping when investors expect interest rates to rise. The yield curve will be flat when no change is expected in rates.

The Liquidity-Preference Theory

The liquidity-preference theory agrees that expectations are important but argues that short-term issues are more liquid and thus inherently more desirable to investors than longer-term bonds. Short-term issues can be converted into cash on short notice without appreciable loss in principal. Long-term issues tend to fluctuate in price with unanticipated changes in interest rates and hence ought to yield more than shorts by the amount of a risk premium.

If no premium were offered for holding long-term bonds, most individuals and institutions would prefer to hold short-term issues. Borrowers, however, prefer to issue long-term debt to assure themselves of a steady source of funds. This leaves an imbalance in the pattern of supply and demand for the different maturities. Thus, even if interest rates are expected to remain unchanged, the yield curve should be upward-sloping, since the yields of long-term bonds will be augmented by risk premiums necessary to induce investors to hold them. The “normal relationship” is assumed to be an ascending yield curve.

The Institutional Or Hedging-Pressure Theory

Liquidity is critical for some investors, but not for others. Commercial banks care about liquidity and prefer short-term issues, but liquidity is not important for life insurance companies and pension funds, which typically hedge against risk by purchasing long maturities.

That is precisely the thrust of the hedging-pressure argument. Different groups of investors have different maturity needs that lead them to concentrate their security purchases in restricted segments of the maturity spectrum. Flows of funds to particular investors, as well as changes in those preferences, will then influence the curve independent of expectations. So will the preference of international investors recycling Petro and Sino dollars. In 2005 foreigners invested over $350 billion in U.S. Treasury bonds while they were net sellers of Treasury bills, depressing the yields of long-term U.S. bonds.

Empirical Studies Of The Yield Curve

Empirical studies of the yield curve suggest that all three theories have an influence on the shape of the yield curve. Expectations of future rates are important, but so are liquidity and institutional considerations. The average shape of the yield curve is ascending, suggesting that holders of long-term bonds do earn (il)liquidity premiums. The yield curve also appears to be a predictor of future economic activity. Inverted yield curves, while not invariably followed by a recession, have preceded all recessions experienced in the United States during the last forty years. Such a signal is consistent with the logic of the expectations theory. An inverted curve suggests that investors expect lower future rates. Recessions usually lower rates by lowering business loan demand and encouraging expansionary monetary policy.

Bibliography:

Bodie, Zvi, Alex Kane, and Alan J. Marcus. 2005. Investments. 6th ed. New York: Irwin/McGraw-Hill. See Chapter 15, “The Term Structure of Interest Rates.”
Rubenstein, Mark. 2006. A History of the Theory of Investments. New York: John Wiley. See pp. 218–219.