The yield curve plots the yields of bonds with the same credit quality — usually government securities — against their time to maturity. It is one of the most watched charts in finance. Its level shows the general cost of borrowing; its slope reflects what markets expect for interest rates, inflation and growth; and changes in its shape affect bank profits, bond portfolios and the cost of mortgages and business loans.
What you will learn
- Explain what the yield curve shows and how it is built
- Recognise normal, flat, inverted and humped curves
- Explain the expectations, liquidity premium and market segmentation theories
- Interpret what the curve may signal and how it is used
Building the curve
The government yield curve uses treasury bills for short maturities and treasury bonds for longer ones. Because all are issued by the same government in the same currency, differences in yield mainly reflect time to maturity, not credit risk. Analysts often derive a zero-coupon (spot) curve from coupon bond prices, because each point then represents the yield for a single payment at that maturity. The government curve is the benchmark: corporate bonds and loans are priced as a spread over it — see bond basics.
The main shapes
Illustrative yield curve shapes
Show the data
| Maturity | Normal (upward) | Flat | Inverted |
|---|---|---|---|
| 3m | 6.0% | 7.5% | 9.0% |
| 1y | 6.5% | 7.6% | 8.8% |
| 2y | 7.0% | 7.6% | 8.4% |
| 5y | 7.8% | 7.5% | 7.8% |
| 10y | 8.5% | 7.5% | 7.3% |
| 20y | 9.0% | 7.6% | 7.0% |
- Normal (upward-sloping): long-term yields above short-term. This is the most common shape: investors usually require extra return to lend for longer.
- Flat: similar yields across maturities, often during transitions between policy cycles.
- Inverted (downward-sloping): short-term yields above long-term. Typically appears when central banks have raised short-term rates and markets expect rates — and perhaps growth and inflation — to fall in future.
- Humped: medium-term yields above both short and long.
The figures in the chart are illustrative, not actual market data.
Theories of the term structure
Expectations theory
Long-term rates reflect expected future short-term rates. If investors expect one-year rates to rise, two-year yields will be higher than one-year yields, because rolling over two one-year bills should earn about the same as one two-year bond.
Implied forward rate (two periods)
(1 + y₂)^2 = (1 + y₁) × (1 + f₁,₂), so f₁,₂ = (1 + y₂)^2 ÷ (1 + y₁) − 1
y₁ and y₂ are one- and two-year spot yields; f₁,₂ is the one-year rate expected (implied) for year two.
Worked example: an implied forward rate
The one-year yield is 6.5% and the two-year yield is 7.0% (illustrative figures).
f = 1.07² ÷ 1.065 − 1 = 1.1449 ÷ 1.065 − 1 = 7.50%.
Under the pure expectations theory, the market expects one-year rates to be about 7.5% a year from now.
Liquidity premium theory
Investors prefer shorter maturities because long bonds carry more interest rate risk. They require a term premium for lending longer. So even if rates are expected to stay flat, the curve tends to slope upward. Implied forward rates therefore overstate expected future rates by the term premium.
Market segmentation and preferred habitat
Different investors prefer particular maturities — banks favour short-term securities, pension funds and insurers favour long-term ones to match their liabilities. Supply and demand within each segment influence yields. The preferred habitat version allows investors to move between segments if compensated enough.
In practice, all three play a part.
What the curve may signal
- Monetary policy expectations: the short end follows the central bank’s policy rate; a steepening or flattening often reflects expected policy moves — see central banks and monetary policy.
- Inflation expectations: higher expected inflation raises longer-term yields.
- Growth: in several major economies, an inverted curve has historically preceded recessions, which is why it is treated as a leading indicator — see economic indicators. It is not a reliable timing tool, and its signal can be distorted by central bank bond purchases, regulation and global capital flows.
- Fiscal conditions and risk: heavy government borrowing or concerns about debt can raise long-term yields.
In markets where government securities trade less actively, the curve may also reflect liquidity conditions and the structure of investor demand, so interpretation needs care.
How the curve is used
| User | Use |
|---|---|
| Banks | Borrow short and lend long; a steeper curve generally widens their margins, a flat or inverted one squeezes them |
| Bond investors | Choose maturities; position for steepening or flattening |
| Companies | Decide between short- and long-term borrowing, fixed or floating rates |
| Valuers | Use government yields as risk-free rates for discounting, matched to the timing of cash flows |
| Policy makers | Gauge market expectations and financial conditions |
Common mistakes
- Treating an inverted curve as a certain and precisely timed recession forecast.
- Comparing yields of bonds with different credit quality as if they formed one curve.
- Using a single short-term rate to discount long-term cash flows.
- Ignoring term premiums when reading forward rates as forecasts.
Key terms
- Yield curve — yields of bonds of the same credit quality plotted against maturity.
- Term structure of interest rates — the relationship between yield and maturity.
- Inverted curve — short-term yields above long-term yields.
- Forward rate — an interest rate for a future period implied by today’s yields.
- Term premium — extra yield required for holding longer-maturity bonds.
Frequently asked questions
Why does the yield curve usually slope upward?
Investors normally require extra compensation for the greater interest rate and inflation risk of lending for longer.
Does an inverted yield curve always mean a recession?
No. It has often preceded recessions in some major economies, but it has also given false signals, and the time lag varies.
Where can I see Bangladesh’s government securities yields?
Bangladesh Bank publishes auction results and yields for treasury bills and bonds.
Key takeaways
- The yield curve plots same-quality bond yields against maturity.
- Normal, flat, inverted and humped shapes reflect expectations, term premiums and demand by segment.
- Implied forward rates can be calculated from spot yields but include term premiums.
- The curve guides bank margins, borrowing decisions, valuation and economic forecasting.
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