Yield and yield curve are two terms that are used when investing in bonds. These terms were first used in America and are now fixed concepts in the investment world. The two terms are particularly important when investing in bonds. The yield is the return that a bond can deliver.
The yield curve shows how much the return is on a longer term. This can be displayed in a graph, which usually has a certain crooked or curved line. Based on this crookedness or curvature, investors can make their predictions for the future.
The yield curve in a graph
If the yield of a bond is recorded in a graph, the horizontal axis will be the maturity in years and the vertical axis will be the yield of the bond. The curvature of the line which indicates the yield is we call the yield curve. In this we can distinguish three different forms: the normal, inverse and flat yield curve.
Normal yield curve
The normal yield curve is a line on the graph that runs slowly from low to high. It is the normal situation where loans that run over a longer term will yield a higher return. Because the horizontal line is the term of a loan, the normal yield curve will be an upward curve.
Inverse yield curve
Should an unusual situation arise in which short term loans yield a higher return, the line in the graph will take a different form. The yield curve is then a line that runs slowly from high to low. We also call this an inverse yield curve. This yield is less common but is theoretically possible.
Flat yield curve
A totally flat line in the graph showing the yield of a bond means that a loan yields the same return for every possible term. In practice, this yield curve actually hardly ever occurs because this is practically impossible. The flat line is called the flat yield curve.
How can you use the yield curve when investing?
Investors can use the yield curve to make decisions about how they want to invest their money in bonds. If you are looking for an investment for the long term, you would like to see a normal yield curve. This indicates that your investment will generate more and more return over the long term.
However, if you are looking for investments for the short term, an inverse yield curve would be ideal. The situation is not very common, but can give you a great return in a short time. However, it must be remembered that there is often a higher credit risk involved.
Be careful with conclusions from a yield curve
The yield curve is very useful for making predictions about the yield of bonds. Nevertheless, one has to be careful with the conclusions drawn from this. The graph can indeed say that a loan will yield a certain percentage of return over a period of 5 years. This is by no means a guarantee that this will actually be the case in 5 years.
There are many factors that play a role that ultimately determine whether the return after the period is actually achieved. These factors were not included in the yield calculation. To calculate this, many more complex calculations have to be made.