The yield curve is a fundamental aspect of bond and fixed income investing. It offers a snapshot of future interest rate expectations and economic conditions. Its shape and movements can signal shifts in monetary policy and investor sentiment, making it an essential tool for both policymakers and investors.
What is the Yield Curve?
The yield curve is a visual representation of interest rates (yields) on government bonds of different maturities. The horizontal axis of the curve shows the time to maturity, while the vertical axis represents the yield or interest rate. In effect, this shows the cost for the government to borrow money for different periods of time.
What is the Shape of the Yield Curve?
The yield curve can take a number of shapes, each indicating different economic conditions and expectations for the future:
Normal Yield Curve: The yield curve is upward sloping with long-term bonds having higher yields than short-term bonds. Long-term bonds have a higher yield because investors who commit money for longer periods of time are taking on higher risk. The higher risk is reflected in the fact that there is greater uncertainty further into the future.
Inverted Yield Curve: The yield curve is downward sloping, with short-term bonds having higher yields than long-term bonds. This inversion can indicate deteriorating economic conditions and/or expectations of future interest rate cuts. The yield curve in Canada most recently inverted in July 2022. It has remained inverted since then.
Flat Yield Curve: When yields across different maturities are similar, the curve appears flat. This could indicate uncertainty or a transition between phases.
How Does the Yield Curve Impact Bonds?
Bonds are debt securities issued by governments or companies to raise capital. When you buy a bond, you are lending money to the issuer in exchange for financial compensation. This compensation typically is in the form of regular interest payments (coupons) and the receipt of your original investment at maturity. The yield curve is crucial for bond investors because:
Yield Comparison: It allows investors to compare yields across different bond maturities. For instance, a steep yield curve indicates higher yields for long-term bonds. This may offer higher returns for investors willing to lock-in their money for a longer period.
Interest Rate Expectations: Changes in the shape of the yield curve can reflect changes in interest rate expectations. If the curve flattens or inverts, it may signal potential shifts in monetary policy or economic conditions. Both of which could affect bond prices.
Risk Assessment: Long-term bond prices are generally more sensitive to changes in yields than short-term bonds. This is because there is a longer period before your original investment is returned and therefore a higher risk something unexpected may happen. Understanding the yield curve helps investors assess the risk associated with their bond investments.
With the Expectation of Rate Cuts, Why Not Just Buy Long-Term Bonds?
One key item to remember with the yield curve is that it reflects future expectations. Though changes to short-term interest rates by Central Banks will typically impact the short-end of the curve, they may not have as much of an impact on long-term rates. In fact, if an interest rate cut is already fully anticipated, it may not move long-term rates at all. It is when future expectations change and the market begins expecting more or less interest rate cuts/raises that long-term yields tend to shift.
In today’s interest rate and economic environment, the yield curve is inverted. The long-end of the curve is therefore already pricing in a specific amount of interest rate cuts. If economic conditions deteriorate and Central Banks are required to cut interest rates more than expected, then long-term bonds may see outsized gains. But this is also a one-dimensional analysis and does not consider the various other aspects of bond selection. There is also the risk that inflation persists and interest rates are not cut as much as currently anticipated. This would likely lead to weakness in long-term bonds.
Does the Yield Curve Impact Mortgage Rates?
One of the most notable roles of the yield curve, particularly here in Canada, is in determining mortgage rates. Fixed-rate mortgages are linked to the yields on government bonds of similar maturities. They are typically priced at a premium to government bond yields to reflect the credit risk of individual borrowers. Shifts in the yield curve can directly impact the affordability of mortgages for Canadians, influencing home buying decisions.
Because longer-term rates reflect future expectations, it is important to remember that changes to short-term interest rates by Central Banks may not immediately change fixed-rate mortgage rates. These changes may already be “priced-in” to the yield curve and therefore “priced-in” to mortgage rates.
Does Hemisphere Take the Yield Curve into Consideration?
As an investment firm in Calgary, the shape of the yield curve is something we take into consideration when making fixed income decisions. However, it is only one piece of the puzzle as part of our wealth management strategy. We view our fixed income holdings as a lower risk means of generating steady income. Fixed income also provides downside protection in the event of market weakness. We are not looking to speculate on potential movements in the yield curve by trying to estimate more or less rate cuts. We look to position along the yield curve where we believe we can achieve steady returns without taking on too much risk.
While the yield curve may initially appear complex, it serves as a vital tool for investors navigating the bond market. By understanding its implications and relationship to bonds, we can make more informed investment decisions to align with our clients’ financial goals. Whether you are aiming for income generation, capital preservation, or diversification, the yield curve remains a cornerstone of fixed income investing. To learn more about Hemisphere’s investment management services and our approach to fixed income investing, speak to one of our financial advisors in Calgary.
Disclaimer: This information is not intended to be comprehensive investment, tax or legal advice applicable to the individual circumstances of a potential investor and should not be considered as personal investment advice, an offer, or solicitation to buy and/or sell investment products. Every effort has been made to ensure accurate information has been provided at the time of publication, however accuracy cannot be guaranteed. Interest rates, market conditions, tax rules and other factors change frequently and past investment performance does not guarantee future results. The manager accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained herein. Please consult an investment manager prior to making any investment decisions.