Yield Curve Risk Explained: Types and Insights

Gordon Scott brings over two decades of experience as an investor and technical analyst. He holds the Chartered Market Technician (CMT) designation.

What Is Yield Curve Risk?

Yield curve risk refers to the possibility of unfavorable changes in market interest rates that affect fixed income securities. When market yields fluctuate, the value of bonds and similar instruments adjusts accordingly. Specifically, an increase in interest rates typically causes bond prices to drop, while a decrease in rates tends to boost bond prices.

Key Highlights

• The yield curve graphically depicts the relationship between interest rates and bond yields across different maturities.
• Yield curve risk arises from interest rate changes impacting fixed income investments.
• Movements in the yield curve are driven by bond risk premiums and expectations about future interest rates.
• Interest rates and bond prices move inversely — prices fall when rates rise, and vice versa.

Deep Dive Into Yield Curve Risk

Investors closely monitor the yield curve as a barometer for future short-term interest rates and economic growth trends. The curve plots interest rates on the vertical axis against increasing maturities on the horizontal axis, spanning from 3-month Treasury bills to 30-year Treasury bonds.

Typically, short-term bonds offer lower yields than long-term bonds, resulting in an upward sloping or positive yield curve. Since bond prices inversely relate to interest rates, any shifts in the yield curve translate to changes in bond valuations, posing risks to investors.

Yield curve risk manifests when the curve either flattens or steepens due to varying yield changes among bonds of different maturities. This causes bond prices, initially set based on the original curve, to adjust accordingly.

Important Considerations

Any holder of interest-bearing securities faces yield curve risk. To manage this, investors can construct portfolios designed to respond predictably to interest rate shifts. Those who anticipate curve movements can capitalize on resulting bond price changes.

Short-term traders can also leverage exchange-traded products like the iPath US Treasury Flattener ETN (FLAT) and Steepener ETN (STPP) to profit from yield curve dynamics.

Types of Yield Curve Risk

Flattening Yield Curve

A flattening yield curve occurs when the difference between short- and long-term interest rates narrows. For example, if a 2-year Treasury yield drops slightly and a 30-year yield declines more sharply, the spread tightens. This shift can increase the price of short-term bonds.

Consider Treasury yields of 1.1% for 2-year notes and 3.6% for 30-year bonds. If these fall to 0.9% and 3.2%, respectively, the spread shrinks from 250 to 230 basis points, signaling a flatter curve. Such a pattern often reflects economic slowdown expectations, low inflation forecasts, and cautious lending by banks.

Steepening Yield Curve

A steepening curve happens when the gap between long- and short-term rates widens, either because long-term yields rise faster or short-term yields fall while long-term yields climb. This causes long-term bond prices to decline relative to short-term bonds, posing risks for investors relying on roll-down strategies.

This scenario typically signals robust economic growth and rising inflation expectations, leading to higher interest rates. For instance, if a 2-year note yield moves from 1.5% to 1.55% and a 20-year bond yield rises from 3.5% to 3.65%, the spread grows from 200 to 210 basis points. Banks benefit by borrowing at lower short-term rates and lending at higher long-term rates.

Inverted Yield Curve

Occasionally, the yield on short-term bonds surpasses that of long-term bonds, creating an inverted yield curve. This rare occurrence suggests investors expect future interest rates and inflation to decline, accepting lower returns now in anticipation of even lower rates ahead.

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