What is a Yield Curve?
This (a yield curve) is a line that plots the yields (interest rates) of bonds of the same credit quality but with different maturity dates. The yield curve slope gives an idea of the future development of interest rates and economic activity.
There are three main yield curves: normal (sloping upward), inverted (sloping downward), and flat.
How does a yield curve work?
This yield curve is usually used as a benchmark for other market debts, such as bank loan rates or mortgage rates, and is used to forecast changes in output and growth. The most commonly published yield curve compares U.S. Treasury debt over three months, two years, five years, ten years, and thirty years. The yield curve rates are generally available on Treasury interest rate sites at 6:00 p.m. E.T. every trading day. But ensure to talk to a professional, so you fully understand what you are looking at.
A normal yield curve is a curve in which long-term bonds have a higher yield than short-term bonds because of the risks associated with time. An inverted yield curve is a curve in which short-term yields are higher than long-term yields, which could signify an impending recession. Short-term and long-term yields are very close on a flat or uneven yield curve, which indicates an economic transition.
Types of yield curves:
Normal Yield curve
A normal or rising yield curve indicates that long-term bond yields may continually rise in response to periods of economic expansion. Hence, a normal yield curve begins with low yields for shorter-dated bonds, then increases for longer-dated bonds and slopes upward. This is the most usual type of yield curve because longer-dated bonds tend to have a higher yield to maturity than shorter-dated bonds.
For example, suppose a two-year bond has a yield of 1%, a five-year bond offers a yield of 1.8%, a 10-year bond offers a yield of 2.5%, a 15-year bond offers a 3.0% yield, and a 20-years bond offers a 3.5% annual bond yield. When these points are connected in a graph, they show the shape of a normal yield curve.
A normal yield curve suggests stable economic conditions and should prevail during a normal business cycle. A steep yield curve suggests strong economic growth in the future, often accompanied by higher inflation, which can lead to higher interest rates.
Inverted Yield Curve
In contrast, an inverted yield curve slopes downward and means that short-term interest rates exceed long-term rates. This yield curve corresponds to periods of economic recession when investors expect longer-term bond yields to be even lower in the future. Also, in times of economic crisis, investors looking for safe investments tend to buy these bonds over the long term rather than the short term, which increases the price of long-term bonds and reduces their yield.
An inverted yield curve is normally rare but strongly implies a severe economic downturn. Historically, the impact of an inverted yield curve has been a red flag for an impending recession.
Flat Yield Curve
Similar yields across all maturities define a flat yield curve. Some intermediate maturities may have slightly higher yields, causing slight swelling along the flat curve. These stacks generally relate to medium-term maturities of six months to two years.
As the word flat suggests, there is a small difference between short-term and long-term bonds yielding to maturity. A two-year bond can yield 6%, a 5-year bond at 6.1%, a 10-year bond at 6%, and a 20-year bond at 6.05%.
This flat or irregular yield curve implies an uncertain economic situation. It could come at the end of a period of strong economic growth, raising fears of inflation and a slowdown. This could come at a time when the central bank is expected to raise interest rates. In times of great uncertainty, investors demand similar returns at all maturities.
Yield Curve and Segment Rate
Section 430 specifies the least funding requirements that apply to single-employer plans (except CBSC plans under § 41(y)) in accordance with §412. Section 430 (h)(2) defines the interest rates to be used in determining the amount of a cost target and a fundraising target plan. Under this provision, present value is determined using three 24-month average interest rates (sector rates), each applied to cash flows over certain periods. To the extent provided in §430 (h)(2)(C)(IV), these sector rates are adjusted by the applicable percentage of the 25-year average sector rates for the period ending September 30 of the calendar year in which the plan year begins. However, in accordance with Article 430 (h)(2)(D)(ii), it is possible to choose to use the monthly rate curve instead of the monthly rates segment.
Notice 2007-81, 2007-44 I.R.B. 899 provides adequate guidelines for determining the monthly corporate bond yield curve, and the average 24-month corporate bond segment rates used to calculate the normal target cost and funding target. In accordance with the methodology specified in Notice 2007-81, the monthly corporate bond yield curve derived from July 2020 data is presented in Table 2020-7 at the end of this notice. The spot rates for the first, second, and third segments for July 2020 are 0.59, 2.25, and 3.01, respectively.
24-month average sector charges established in accordance with § 430 (h) (2) (C) (i) a (iii) are adjusted per § 430 (h) (2) (C) (IV) registers in the applicable minimum and maximum percentages of the 25-year average rates. The applicable minimum percentage for plans starting before 2021 is 90%, and the maximum applicable percentage is 110%. The 25-year average rates for plan years beginning with 2019 and 2020 were published in Notice 2018-73, 2018-40 I.R.B. 526, and Notice 2019-51, 2019-41 I.R.B. 866, respectively.
Summary
The rates of the yield curve are recorded on the Treasury website on each trading day.
There are 3-types of yield curves: normal, inverted, and flat. The upward slope (aka normal yield curves) is where long-term bonds have higher yields than short-term bonds.
The yield curves represent the interest rates on identical bonds with different maturities.
While normal curves indicate economic expansion, descending (inverted) curves indicate economic recession.
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