In this video I explain the very important skill of reading a yield curve.
VIDEO SUMMARY
The yield curve for US treasuries is an incredibly important concept to understand. It doesn’t matter what area of finance you are in, this is the one chart that everybody looks at and I think it’s important to understand why everybody watches this chart. So what is it? This is a chart you can find on most financial websites. It shows what US treasuries are trading at on the market and you can really draw this chart for the bonds of any organization. But usually when we talk about the yield curve, we are talking about US treasuries. I am going to put up an example. This is what a typical yield curve looks like, and this is just an example because these prices change over time depending on what is going on in the market. Along the bottom of the chart, you see different durations. These are different maturities of bonds. Along the side you see different yields. So what we mean by yield is, you should think of it in terms of what the return you should expect to receive by purchasing this investment at the current market price. We are talking about bonds here and so a bond is a loan agreement for a principal payment amount and set interest payments. That set principal amount is known as the face. Since these are trading on the market, you can actually pay more or less than the face amount, or purchase bonds for a premium or discount. Depending on what price you pay for them in the market, determines how much profit you are going to make. If you pay a higher amount, you are going to make less profit. If you pay a lower amount you are going to make more profit. So the yield is kind of a combination of the difference from the face amount that you make when you purchase the investment plus the interest that you can expect to receive.
I showed you an example of what would be a normal looking curve. If you look at the shape of the curve it is gradually increasing with longer durations. So let’s think about why that makes sense. I have talked about how the higher the risk, the higher the return you should expect to receive. In this case, a US treasury is essentially you giving your money to the US government and they will give you an IOU that they will give you set interest payments over time. If you are giving somebody your money for a short period of time, that is less risky than if you give somebody your money for a long period of time. So when you look at a yield curve, what you would expect to see is that as durations increase, the yields, or the return, should also generally increase over time. That’s what you generally see in a normal yield curve.
The reasons why people care is that what we have historically seen when we watch the yield curve for US treasuries is that at certain periods of time, the yield curve inverts. An inverted yield curve means that securities at shorter durations are actually trading with higher yields than securities of longer durations. So this is a little different than what you would expect and historically this has happened directly before a large recession. So this is proven to be a useful predictor for downturns in the economy. There is a couple different reasons why this occurs, but just to give you a simplified explanation… right before a recession, there is going to be a lot of uncertainty in the market. So people are shifting their asset allocations for their investments. There is a higher demand for risk-free investments. And so this change in supply and demand is going to impact the prices in the marketplace, and so the yield curve inverts. But what you want to do is when you are looking at the yield curve, it is kind of a barometer for how the bond markets are doing. If the yield curve is in a normal shape you know that you are looking at a healthy normal bond market. If it is inverted you know that you want to look more into what is going on. So that is one reason why people care about the yield curve. But that is not the most important reason. The most important reason people watch the yield curve is because US treasuries are used as the benchmark for the risk free rate. I am going to explain more about the risk free rate in my next video.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.