the yield curve allows fixed income
investors to compare similar Treasury
investments with different maturity
dates as a means to balance risk and
reward
additionally investors use its shape to
help forecast interest rates in this
video we'll discuss how to calculate the
yield curve identify its different
shapes and explain what these shapes
mean you calculate the yield curve by
plotting Treasuries according to
maturity date and yield you can use any
combination of maturity dates to form a
yield curve for example you could
combine a 3-month one-year two-year
five-year ten-year and 30-year
maturities in a single yield curve the
display of yields across different
maturities helps investors measure the
risks and potential rewards of
Treasuries lower yields are typically
associated with shorter maturities and
higher yields with longer maturities but
the application of the yield curve
extends well beyond Treasuries investors
also use the yield curve as a reference
for virtually all other types of fixed
income investments that's because the
actual shape of the yield curve can help
provide insight into the future of
interest rates the yield curve has three
shapes upward sloping or positive
downward sloping or inverted and flat a
positive upward sloping yield curve
occurs when yields of shorter maturities
are lower than yields of longer
maturities conversely an inverted
downward sloping yield curve forms when
yields of shorter maturities are higher
than longer maturities a flat yield
curve results when yields for short and
long term maturities are roughly equal
the yield curve is normally in a
positive slope because shorter
maturities typically yield less than
longer maturities when the yield curve
is in a positive slope investors might
expect economic growth which can lead to
inflation and ultimately higher interest
rates higher interest rates are negative
for longer maturities so investors
demand a higher yield to compensate for
this risk since the financial crisis of
2009 investors have been expecting
economic growth and higher interest
rates these expectations resulted in a
positive
sloping yield curve but occasionally
yields of shorter maturities are greater
than yields of longer maturities so the
slope of the yield curve turns negative
or inverted an inverted yield curve
forms when investors expect economic
growth to slow if economic growth slows
investors might also expect interest
rates to fall these expectations
increase the demand for higher yielding
maturities which actually drives the
yields of longer maturities lower
historically inverted yield curves have
been leading indicators of recessions
this was the case well before the
financial crisis starting in 2006 the
yield curve inverted and warned of the
coming recession now that you understand
positive and inverted yield curves let's
look at the third shape a flat yield
curve this shape forms when yields of
short and long maturities are roughly
equal a flat yield curve is usually a
transition from positive to inverted or
from inverted to positive for example as
the financial crisis took hold the yield
curve transitioned from inverted to flat
and then turned positive coming out of
the crisis while changes in the shape of
the yield curve can be informative
they don't necessarily translate to
taking action in a fixed income
portfolio that's because speculating
about the future of interest rates based
on the yield curve is risky and can lead
some fixed income investors astray from
their goals one way to manage changes in
the yield curve is to consider
diversifying a fixed income portfolio
across maturities and even among
different issuers and credit qualities
another way to consider managing changes
is aligning time horizons and risk
tolerances with appropriate investments
for example an investor with a short
time horizon and low risk tolerance
might invest in a mix of short
maturities with high credit quality
conversely an investor with a long time
horizon and high risk tolerance might be
willing to accept more risk with long
maturities and low credit quality
another potential solution to managing
changes is laterals which are fixed
income portfolios that can adjust more
dynamically to changes in interest rates
these potential solutions are
a few ways to manage changes in the
yield curve while keeping sights set on
your investment goal
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