The yield curve for government bonds is animportant indicator in financial markets. It helps todetermine how actual and expected changes inthe policy interest rate (the cash rate in Australia),along with changes in other monetary policy tools,feed through to a broad range of interest rates inthe economy. This Explainer has two parts:
- The first part outlines the concept of a bond anda bond yield. It also discusses the relationshipbetween a bond's yield and its price.
- The second part explains how the yield curveis formed from a series of bond yields, and thedifferent shapes the yield curve can take. It thendiscusses why the yield curve is an importantindicator in financial markets and factors thatcan cause the yield curve to change.
Bonds
What is a bond?
A bond is a loan made by an investor to aborrower for a set period of time in return forregular interest payments. The time from whenthe bond is issued to when the borrower hasagreed to pay the loan back is called its ‘term tomaturity’. There are government bonds (where agovernment is the borrower) and corporate bonds(where a business or a bank is the borrower). Themain difference between a bond and a regularloan is that, once issued, a bond can be tradedwith other investors in a financial market. As aresult, a bond has a market price.
For example, in the diagram below the Governmenthas issued a bond to the value of $1 billion, whichwas purchased by an investor. The bond may thenbe traded with other investors in financial markets,at which point its market price can change (in thisinstance, it has become $1.01 billion).
What is a bond yield?
A bond's yield is the return an investor expectsto receive each year over its term to maturity. Forthe investor who has purchased the bond, thebond yield is a summary of the overall return thataccounts for the remaining interest payments andprincipal they will receive, relative to the price ofthe bond. For an issuer of a bond, the bond yieldreflects the annual cost of borrowing by issuinga new bond. For example, if the yield on three-yearAustralian government bonds is 0.25 percent, this means that it would cost the Australiangovernment 0.25percent each year for the nextthreeyears to borrow in the bond market byissuing a new three-year bond.
When a bond is issued, an investor has purchasedthe bond for the first time in a marketplace calledthe ‘primary market’. The initial price the investorpays for the bond depends on a number offactors, including the size of the interest paymentspromised, the term of the bond and the price ofsimilar bonds already issued into the market. Thisinformation (including the price paid) is used tocalculate the initial yield on the bond. Once abond is issued, the investor is then able to tradethat bond with other investors in the ‘secondarymarket’ and its price and yield may change withmarket conditions.
What is the relationship betweenthe price of a bond and its yield?
The prices at which investors buy and sell bondsin the secondary market move in the oppositedirection to the yields they expect to receive(see Box below on ‘Bond Prices and Yields – An Example’). Once abond is issued, it offers fixed interest payments toits owner over its term to maturity, which does notchange. However, interest rates in financial marketschange all the time and, as a result, new bondsthat are issued will offer different interest paymentsto investors than existing bonds.
For example, suppose interest rates fall. Newbonds that are issued will now offer lower interestpayments. This makes existing bonds that wereissued before the fall in interest rates more valuableto investors, because they offer higher interestpayments compared to new bonds. As a result,the price of existing bonds will increase. However, ifa bond's price increases it is now more expensive fora potential new investor to buy. The bond's yield willthen fall because the return an investor expects frompurchasing this bond is now lower.
Box: Bond Prices and Yields – An Example
To illustrate the relationship between bond prices and yields we can use an example. In this example,consider a government bond issued on 30 June 2019 with a 10year term. The principal of the bondis $100, which means that on 30 June 2029 the government must repay $100 dollars to the bond'sowner. The bond has an annual interest payment of 2percent of the principal (i.e. $2 each year). Ifthe yield on all 10year government bonds trading in the secondary market is 2percent (the sameas the interest payments in our bond), then the price of our bond will be $100 and the yield on ourbond will also be 2percent.
Imagine that investors require a yield of 2percent to invest in a government bond. They will be willingto pay $100 to invest in a government bond that offers an annual interest payment of $2, because thiswill provide them with their required yield. Imagine now that the yield investors require to invest in agovernment bond falls from 2percent to 1percent. This would mean that investors now only require a $1annual interest payment to invest in a bond worth $100. However, our bond still offers a $2 annual interestpayment, $1 in excess of what they now require. As a result, they will be willing to pay more than $100to purchase our bond. The price of our bond will therefore increase up until the point where it providesinvestors with their required yield of 1percent. This occurs when the price of our bond is $109.50.
The Yield Curve
What is the yield curve?
The yield curve – also called the term structureof interest rates – shows the yield on bonds overdifferent terms to maturity. The ‘yield curve’ isoften used as a shorthand expression for the yieldcurve for government bonds.
To graph the yield curve, the yield is calculatedfor all government bonds at each term tomaturity remaining. For example, the yield onall government bonds with oneyear remaininguntil maturity is calculated. This value is thenplotted on the y-axis against the oneyear termon the x-axis. Similarly, the yield on governmentbonds with threeyears remaining until maturityis calculated and plotted on the y-axis, againstthreeyears on the x-axis, and so on. The policyinterest rate (the cash rate in Australia) formsthe beginning of the government yield curve,because it is the interest rate with the shortestterm in the economy (overnight).
The yield curve for government bonds is alsocalled the ‘risk free yield curve’. The expression‘risk free’ is used because governments are notexpected to fail to pay back the borrowingthey have done by issuing bonds in their owncurrency.
Other issuers of bonds, such as corporations, generallyissue bonds at a higher yield than the government,as they are more risky for an investor. This is becausethe loan or interest payments in the bond may notbe paid by the corporation to its owner at the agreedtime. When this occurs, it is called a ‘default’.
What are the different shapes ofthe yield curve?
Two main aspects of the yield curve determine itsshape: the level and the slope.
The level of the yield curve measures the generallevel of interest rates in the economy and isheavily influenced by the cash rate(see Explainer: Transmission of Monetary Policy). For this reason, thecash rate is often referred to as the ‘anchor’ for theyield curve. Changes in the cash rate tend to shiftthe whole yield curve up and down, because theexpected level of the cash rate in the future influencesthe yield investors expect from a bond at all terms.
The slope of the yield curve reflects the differencebetween yields on short-term bonds (e.g. 1year)and long-term bonds (e.g. 10year). The yields onshort and long-term bonds can be different becauseinvestors have expectations – which are uncertain– that the cash rate in the future might differ fromthe cash rate today. For example, the yield on a fiveyear bond reflects investors' expectations for thecash rate over the next fiveyears, along with theuncertainty associated with this.
Normal yield curve
A so-called ‘normal’ shape for the yield curve iswhere short-term yields are lower than long-termyields, so the yield curve slopes upward. This isconsidered a normal shape for the yield curvebecause bonds that have a longer term are moreexposed to the uncertainty that interest rates orinflation could rise at some point in the future (ifthis occurs, the price of a long-term bond will fall);this means investors usually demand a higheryield to own longer-term bonds. A normal yieldcurve is often observed in times of economicexpansion, when economic growth and inflationare increasing. In an expansion there is a greaterlikelihood that future interest rates will be higherthan current interest rates, because investors willexpect the central bank to raise its policy interestrate in response to higher inflation(see Explainer: What is Monetary Policy?).
Inverted yield curve
An ‘inverted’ shape for the yield curve is whereshort-term yields are higher than long-term yields,so the yield curve slopes downward. An invertedyield curve might be observed when investorsthink it is more likely that the future policy interestrate will be lower than the current policy interestrate. In some countries, such as the United States,an inverted yield curve has historically beenassociated with preceding an economiccontraction. This is because central banks reducepolicy rates in response to lower economicgrowth and inflation, which investors maycorrectly anticipate will happen.
Flat yield curve
A ‘flat’ shape for the yield curve occurs whenshort-term yields are similar to long-term yields. Aflat curve is often observed when the yield curveis transitioning between a normal and invertedshape, or vice versa. A flat yield curve has alsobeen observed at low levels of interest rates or asa result of some types of unconventionalmonetary policy.
Why is the Yield CurveImportant?
The yield curve receives a lot of attention fromthose who analyse the economy and financialmarkets. The yield curve is an importanteconomic indicator because it is:
- central to the transmission of monetary policy
- a source of information about investors'expectations for future interest rates, economicgrowth and inflation
- a determinant of the profitability of banks.
Monetary policy transmission
The yield curve is involved in the transmission ofchanges in monetary policy to a broad range ofinterest rates in the economy. When households,firms or governments borrow from a bank orfrom the market (by issuing a bond), their cost ofborrowing will depend on the level and slope ofthe yield curve. For example, a household takingout a mortgage might decide to fix the interestrate on their loan for threeyears. The bank wouldcalculate the interest rate on this mortgage bytaking the relevant term on the risk-free yieldcurve – in this case the three-year term – andthen add an amount to cover costs and tocompensate for the risk that the borrower mightnot repay the loan (credit risk). The yield curvesimilarly influences the interest rate on savingsproducts with a fixed term, such as term deposits.
Different terms of the yield curve are importantfor different sectors of the economy. For example,Australian households that borrow usingfixed-rate mortgages usually only lock in theirinterest rate for 2–3years, so this part of theyield curve is important for fixed mortgage rates.Many Australian households have mortgageswith variable interest rates, so the cash rate isimportant for them. On the other hand, firms andgovernments often wish to borrow for a muchlonger term, say 5 or 10years, so this part of theyield curve is important for them.
Investors' expectations
In financial markets, the slope of the yield curve(e.g. normal, inverted, flat) provides an importantsignal of investors' expectations for future interestrates, and by extension their expectations forfuture economic growth and inflation. The slopeof the yield curve is considered to be a ‘leadingindicator’ of future economic growth and inflationbecause financial market data is more forward-lookingthan many other sources of information.
Bank profitability
The level and slope of the yield curve can alsoinfluence the profits of the banking sector,although its importance varies across economies.Profitable and stable banks support the growthof credit in the economy, which is an importantfactor for economic growth and in particular forinvestment. Profitable and stable banks also helpto reduce the risk of financial market disruptionsin a crisis (see Explainer: The Global FinancialCrisis). Banks earn profit from lending funds ata higher interest rate than they pay to borrowfunds from depositors and other sources. Banksusually lend for longer terms than they borrowso part of this profit comes from the differencebetween long-term and short-term interest rates(i.e. the slope of the yield curve). If the yield curveis normal, all else equal, a steeper slope will meana larger margin and higher profits for the bankingsystem.
The slope of the yield curve is particularlyimportant for bank profitability in countrieswhere bank loans tend to be based on very long-terminterest rates, such as in the United States.In Australia, the interest rate on many loans isbased on the shorter-term end of the yield curve(e.g. variable rate mortgages) and so the slopeof the yield curve has less of an effect on bankprofitability.
What Can Cause theYield Curve to Change?
There are many factors that could lead to changesin the yield curve. Some of them include:
Changes in monetary policy
Different monetary policy tools (conventionaland unconventional) influence the economy inpart through their effect on particular segmentsof the yield curve. Understanding the effect ofdifferent monetary policies on the yield curve isimportant because of the yield curve's role in thetransmission of monetary policy to other interestrates in the economy.
Conventional monetary policy
Changes in thecash rate tend to shift the level of the yield curveup and down, particularly at the short end.
Unconventional monetary policies
Someunconventional monetary policies influenceinterest rates through their effect on the yieldcurve. Changes in unconventional monetarypolicies can either work by changing thelevel of the yield curve (e.g. through negativeinterest rates that lower the entire yield curve)or by changing its slope (e.g. through forwardguidance, asset purchases).(See Explainer: Unconventional Monetary Policy.)
Monetary Policy and the Yield Curve
If the central bank provides forward guidanceabout its future monetary policy, this influencesthe yield curve by shaping investors' expectationsabout future policy interest rates. Forwardguidance has tended to involve a commitment bycentral banks to keep policy interest rates low fora time or until the central bank has achieved ameasurable goal (such as an increase in inflationand/or fall in unemployment). In response toforward guidance that policy interest rates areexpected to remain low, the yield curve could beexpected to flatten between the short end andthe term of the yield curve that matches the termof the guidance, and lower the yield curvefurther out.
Asset purchases involve the outright purchaseof assets by the central bank in the secondarymarket, including government bonds. Bypurchasing assets the central bank adds todemand for them, so their price increases andtheir yield falls. As a result, asset purchases canchange the slope of the yield curve, usually bylowering the additional yield investors require tocompensate for the uncertainty that interest ratesor inflation could rise in the future (term risk). Ifthe central bank targets a quantity of assets topurchase, then its goal is often to lower yieldsacross the whole yield curve.[1] On the other handthe central bank may target a yield on a specificsegment of the curve, purchasing whateverquantity of assets is necessary to achievethat target.
Changes in investors' perceptionsof risks
Over time investors may change how theyperceive the risks of owning bonds. This includes:
- Credit risk. If investors think that the issuerof a bond is less likely to pay the interestor amount borrowed in the bond at theagreed time, then they will demand a higheryield to own the bond. Government bondsare typically perceived as having very lowcredit risk.
- Liquidity risk. Bonds that investors think willbe difficult to sell to other investors in themarket will have a higher yield. Governmentbond markets are often the most liquid in acountry and only face significant liquidity risksin times of financial distress.
- Term risk. Investors require a higher returnfor loaning funds at a fixed rate of interest,because doing so exposes them to the riskthat interest rates might rise. If interest rates dorise, including because inflation is higher thanexpected, then the return from lending onetime at a fixed interest rate will be lower thanthe return the investor could have receivedfrom lending for a shorter term, multiple times(for example, lending once for fiveyears asopposed to lending five times for oneyeareach). Term risk is measured by an indicatorcalled the term premium (learn more in theStatement on Monetary Policy Box on Whyare Long-term Bond Yields So Low?).
Investors' assessment of these risks may changeover time as they receive new information orchange their perceptions of existing information.The yield curve may respond differently tochanges in risk – shifting up or down or changingslope – depending on the type of risk and howpersistent investors expect risks to be.
Changes in the demand for orsupply of bonds
A related way to analyse bond prices and yieldsis by using a demand and supply framework.Like any market, the price (and yield) of bondsis influenced by the amount of bonds investorsdemand and the amount of bonds that theborrowers of funds decide to supply.
Investors' demand for bonds will reflect theirpreferences for owning bonds as opposed toother types of assets (shares, physical property,commodities, cash, etc.), which are influencedby their expectations of future monetary policyand their perceptions of risks. When the demandfor a particular bond increases, all else equal, itsprice will rise and its yield will fall. The supply ofa bond depends on how much the issuer of abond needs to borrow from the market, such asa government financing its expenditure. If thesupply of a particular bond increases, all elseequal its price will fall and its yield will increase.
The response of the yield curve to changes inthe demand for, or supply of, bonds will dependon the nature of the change. Changes that affectthe whole yield curve will cause it to shift up ordown, while changes that only affect a particularsegment of the yield curve will influence its slope.For instance, the government might decide toincrease its issuance of 10year bonds, keepingthe supply of all other bonds the same. All elseequal, this increase in the supply of 10year bondswould cause their yield to increase relative toother terms, and so steepen the yield curve.
Endnotes
Except for the cash rate at the very front of the yield curve,which may have reached its lowest practical level. [1]
