Because interest rates do not always move in tandem, investors need to pay close attention to the yield curve and spreads to gauge risk.
A version of this article was originally published on Oct. 8, 2014.
The term "interest rate" continues to strike fear into the hearts of bond investors. These fears have only intensified as the timing of an increase to the federal-funds rate has (supposedly) drawn nearer. After all, as interest rates rise, most bonds' prices decline.
Investors often use duration to estimate a bond's interest-rate sensitivity. It approximates the change in a bond's price for an incremental interest-rate change. For example, a bond with a duration of five years might lose 5% of its value for a 1% increase in interest rates--holding all else equal. However, this approximation is only accurate for small and parallel changes in interest rates across the yield curve.
The yield curve, in its simplest form, shows interest rates at a point in time for U.S. Treasuries with differing maturities.
In normal markets, as the time to maturity increases so does the yield. This is intuitive because interest-rate risk tends to increase with maturity, and investors demand compensation for this risk. Investors' expectations of future short-term rates also influence the shape of the yield curve. If investors believe short-term rates will fall in the near term, the yield curve may become flat, or even inverted, where long-term interest rates are lower than short-term rates. A flattening or inverted yield curve is often interpreted as a sign that the economy is starting to cool and that the Fed may start to lower short-term rates. In contrast, a steepening yield curve usually points to a strong economy with increased inflation expectations.
With all of these variables at work, interest-rate changes are rarely linear. We can break changes in the yield curve into three components: changes in the level of rates (which is usually the most important), slope of the yield curve, and its curvature. The slope of the yield curve measures the difference between short- and long-term yields. When there is a twist in the yield curve, it is becoming flatter or steeper. The curvature of the yield curve can change when short- and long-term rates move more than intermediate-term rates, or vice versa.
In the chart above, the yield curve is considered steep because of the large difference between long- and short-term interest rates. This is partially due to the Fed's decision to keep the federal-funds rate near zero. With fear that the Fed may begin to increase the federal-funds rate, investors should pay close attention to how the yield curve moves.