The term structure of interest rates, also known as the yield curve, is a very common bond valuation method. Constructed by graphing the yield to maturities and the respective maturity dates of benchmark fixed-income securities, the yield curve is a measure of the market's expectations of future interest rates given the current market conditions. Treasuries, issued by the federal government, are considered risk-free, and as such, their yields are often used as the benchmarks for fixed-income securities with the same maturities. The term structure of interest rates is graphed as though each coupon payment of a noncallable fixed-income security were a zero-coupon bond that "matures" on the coupon payment date. The exact shape of the curve can be different at any point in time. So if the normal yield curve changes shape, it tells investors that they may need to change their outlook on the economy.
There are three main patterns created by the term structure of interest rates:
1) Normal Yield Curve: As its name indicates, this is the yield curve shape that forms during normal market conditions, wherein investors generally believe that there will be no significant changes in the economy, such as in inflation rates, and that the economy will continue to grow at a normal rate. During such conditions, investors expect higher yields for fixed income instruments with long-term maturities that occur farther into the future. In other words, the market expects long-term fixed income securities to offer higher yields than short-term fixed income securities. This is a normal expectation of the market because short-term instruments generally hold less risk than long-term instruments; the farther into the future the bond's maturity, the more time and, therefore, uncertainty the bondholder faces before being paid back the principal. To invest in one instrument for a longer period of time, an investor needs to be compensated for undertaking the additional risk.
Remember that as general current interest rates increase, the price of a bond will decrease and its yield will increase.
2) Flat Yield Curve: These curves indicate that the market environment is sending mixed signals to investors, who are interpreting interest rate movements in various ways. During such an environment, it is difficult for the market to determine whether interest rates will move significantly in either direction farther into the future. A flat yield curve usually occurs when the market is making a transition that emits different but simultaneous indications of what interest rates will do. In other words, there may be some signals that short-term interest rates will rise and other signals that long-term interest rates will fall. This condition will create a curve that is flatter than its normal positive slope. When the yield curve is flat, investors can maximize their risk/return tradeoff by choosing fixed-income securities with the least risk, or highest credit quality. In the rare instances wherein long-term interest rates decline, a flat curve can sometimes lead to an inverted curve.
3) Inverted Yield Curve: These yield curves are rare, and they form during extraordinary market conditions wherein the expectations of investors are completely the inverse of those demonstrated by the normal yield curve. In such abnormal market environments, bonds with maturity dates further into the future are expected to offer lower yields than bonds with shorter maturities. The inverted yield curve indicates that the market currently expects interest rates to decline as time moves farther into the future, which in turn means the market expects yields of long-term bonds to decline. Remember, also, that as interest rates decrease, bond prices increase and yields decline. You may be wondering why investors would choose to purchase long-term fixed-income investments when there is an inverted yield curve, which indicates that investors expect to receive less...
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