02 August 2012
The yield curve is simply a graph illustrating the spectrum of interest rates at a particular moment in time. It is useful for anticipating funding obligations in business or even for looking at mortgage payment projections. Normally, the graph is an upward sloping curve reflecting higher yields for longer-dated fixed-income securities as investors generally like more reward for longer-term commitments. However, occasionally, we do see shorter-dated bonds with higher rates. This is referred to as an inverted curve. Such an inversion of rates is only seen when rates are likely to fall.
The yield curve is also influenced by market forces. For example, pension funds are more interested in long-dated gilts to offset their long-term funding requirements, whereas banks and financial institutions are often more interested in short-dated securities as a “parking lot” for spare cash. The shape of the curve may also be artificially affected by the range of gilts subject to buy back under “quantitative easing”.
Finally, the yield curve can be used to illustrate the differences between various types of fixed-income investment, reflecting default risk, the anticipated rate of inflation and expected movements in exchange rates.