Owning Bonds

Yield Curve

Interest rates affect bond risks and bond returns. If you plan to hold a bond until maturity, interest rates also affect reinvestment risk. If you plan to sell the bond before maturity, you face interest rate risk or the risk of a loss of market value. When you invest in bonds, then, you want to be able to forecast future interest rates.

Investors can get a sense of how interest rates are expected to change in the future by studying the yield curve. The yield curve is a graph of U.S. Treasury securities compared in terms of the yields for bonds of different maturities. U.S. Treasury securities are used because the U.S. government is considered to have no default risk, so that the yields on its bills and bonds reflect only interest rate, reinvestment, and inflation risks – all of which are reflected in expected, future interest rates.

The yield curve illustrates the term structure of interest rates, or the relationship of interest rates to time. Usually, the yield curve is upward sloping – that is, long-term rates are higher than short-term rates. Long-term rates indicate expected future rates. If the economy is expanding, future interest rates are expected to be higher than current interest rates, because capital is expected to be more productive in the future. Future interest rates will also be higher if there is inflation because lenders will want more interest to make up for the fact that the currency has lost some of its purchasing power. Figure 16.6 "Upward-Sloping Yield Curve" shows an upward-sloping yield curve.

Figure 16.6 Upward-Sloping Yield Curve

Depending on economic forecasts, the yield curve can also be flat, as in Figure 16.7 "Flat Yield Curve", or downward sloping, as in Figure 16.8 "Downward-Sloping Yield Curve".

Figure 16.7 Flat Yield Curve

Figure 16.8 Downward-Sloping Yield Curve

A flat yield curve indicates that future interest rates are expected to be about the same as current interest rates or that capital will be about as productive in the economy as it is now. A downward-sloping yield curve shows that future interest rates are expected to be lower than current rates. This is often interpreted as a signal of a recession, because capital would be less productive in the future if the economy were less productive then.

The yield curve is not perfectly smooth; it changes every day as bonds trade and new prices and new yields are established in the bond markets. It is a widely used indicator of interest rate trends, however. It can be useful to you to know the broad trends in interest rates that the market sees.

For your bond investments, an upward-sloping yield curve indicates that interest rates will go up, which means that bond yields will go up but bond prices will go down. If you are planning to sell your bond in that period of rising interest rates, you may be selling your bond at a loss.

Because of their known coupon and face value, many investors use bonds to invest funds for a specific purpose. For example, suppose you have a child who is eight years old and you want her to be able to go to college in ten years. You might invest in bonds that have ten years until maturity. However, if you invest in bonds that have twenty years until maturity, they will have a higher yield (all else being equal), so you could invest less now.

You could buy the twenty-year bonds but plan to sell them before maturity for a price determined by what interest rates are in ten years (when you sell them). If the yield curve indicates that interest rates will rise over the next ten years, then you could expect your bond price to fall, and you would have a loss when you sell the bond, which would take away from your returns.

In general, rising interest rates mean losses for bondholders who sell before maturity, and falling interest rates mean gains for bondholders who sell before maturity. Unless you are planning to hold bonds until maturity, the yield curve can give you a sense of whether you are more likely to have a gain or loss.