Almost everybody who follows financial markets has heard, at some point, a reference to the yield curve. Most have nodded sagely as an advisor prattles on about it, but, I suspect, not that many people understand what it is or any implications that shifts in the curve may have.
Following the last minute, cobbled together deal on the budget and debt ceiling this week, speculation has already begun on what the implications are for Fed policy, and therefore for interest rates. The yield curve will be back in the news.
In the not too distant past the only reason retail investors would have been interested in the curve was in order to draw conclusions about the stock market or the optimal split between stocks and bonds in their portfolio. Now, however, with the advent of quite specific ETFs, it is possible for anybody with a view on the shape of the curve and any possible shifts to profit from it. In order to do that, though, you have to understand it.
And, in order to understand the curve, you have to understand what it shows; the yield on Treasuries. Yield on a Treasury (or any other) bond is the annual return you can expect, should you hold that bond until it matures. It takes into account any interest payments you would receive and what you will be paid back at maturity. (In terms of US Government debt, technically speaking only debt that matures in more than 10 years is a bond. Short term issues are T-Bills and medium term are T-Notes, but for the sake of ease, I will use the term bond to cover everything.)
When a bond is issued, there are two important things set. The maturity date tells you for how long the borrower wants to borrow the money, and the coupon tells you how much interest, expressed as a percentage of the initial value, the borrower will pay to the lender. Bonds have differing initial values, but for ease of trading, each issue is priced as if it has an initial, or face value of 100. If a bond is issued for 10 years with a 3.0% coupon, the buyer can expect $3 per year for those 10 years for each $100 invested, after which the $100 will be repaid. At issue, that bond has a 3% yield.
The $3 payments don’t change for the life of the bond. What does change is the price of the bond in the secondary market. If you were to buy a bond with five years left until maturity for, say $90 you would be paid the $3 annual interest for that time, plus get $100 back for your $90 investment at the end of the five years. The total return on the bond would therefore be $3 per year for five years, plus an additional $10 at the end, giving $25, or $5 per year overall. On your initial $90 investment, this represents a 5.55% total annual return, or yield.
As you can see, the opposite would also be true, if the price of the bond had gone up and you paid $110 for it, then the yield would be lower than the 3% coupon. You would still get $3 x 5 in interest, but would lose $10 at maturity, giving a total return of $5 over 5 years, or about a 1% annualized yield. The actual calculations are a little more complex, but you should get the general idea.
What yield the market demands for holding government debt is influenced by many things; the perceived risk, if any, of not getting paid at maturity, how projected inflation will affect the real value of future payments and several others. One of the most important factors is time. Because there are unknowns, then in a normal market, the longer the loan is for the larger the annual return investors will seek, and thus each maturity has a different yield.
Plot all of those yields on a chart, with time to maturity along the bottom and yield up the side and you get something that looks like this…
A yield curve! It tells you where yields are now for different maturities, and the relationship between them. If interest rates in general move up, then the whole curve will move up, but if the relationship between long and short dated bonds changes, then the curve will change shape…it will get steeper or flatter.
Trades based on these curve steepening or flattening moves are, as I mentioned, now easily available to retail investors. By using ETFs that track Treasuries of different maturities, such as the SPDR Barclays Short Term ETF (SST) and the i-Shares Long Term Treasury fund (TLT) it is possible to trade the moves.
For example, should the Fed decide that the recent shenanigans in Washington make a continuation of QE necessary, then short term yields will be held down by continued Fed buying and long term yields will rise, given the fear of possible future inflation. If you think this is a likely scenario, then you could short TLT and use the proceeds to buy SST. If it plays out as you expect, then yields on long term Treasuries will be forced upward, meaning prices go down and TLT loses value, while the opposite happens in the short dated paper, giving a steeper curve and giving you a profit on both ends of the trade.
I set out today to write a piece about whether curve flattening or steepening trades were warranted in the current environment, but, as I wrote I became aware that I was throwing around terms that many people wouldn’t understand. Some will undoubtedly already know all of the above, but I would bet there are at least as many who have heard the term, but never really understood it. If you started in the second group, then hopefully you are now in the first.