Yield Curve Introduction

What is an yield curve and how is it made. The yield curve, is a graph that depicts the relationship between bond yields and maturities, is an important tool in fixed-income investing and attempting to predict future recessions given its track record. Investors use the yield curve as a reference point for forecasting interest rates, pricing bonds and creating strategies for boosting total returns. The yield curve has also become a reliable leading indicator of economic activity.(PIMCO) A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing in maturities. The most frequently reported yield curve compares the three-month, two year, five year and the 30 year U.S. Treasury debt. The yield curve is used as a benchmark for other debt in the market; debts such as mortgage interest rates, bank lending rates and so on. A yield is the interest earned if the bond was purchased at par value and held to maturity. The yield curve takes the spread between the yields paid by short and long term debt. Economists use the yield curve to gage the overall movement in interest rates. (Schwartz 108-109, 115) Yield refers to the annual return on an investment. The yield on a bond is based on both the purchase price of the bond and the interest, or coupon, payments received. Although a bond's coupon interest rate is usually fixed, the price of the bond fluctuates continuously in response to changes in interest rates, as well as the supply and demand, time to maturity, and credit quality of that particular bond. After bonds are issued, they generally trade at premiums or discounts to their face values until they mature and return to full face value. Because yield is a function of price, changes in price cause bond yields to move in the opposite direction. The yield curve is a visual representation of not only the Federal Reserves attitude about the future but also participants in the bond market as well.