Yield Curve Risk

What Is the Yield Curve Risk?

The yield curve risk is the risk of encountering an adverse shift in market interest rates associated with investing in a fixed income instrument. At the point when market yields change, this will impact the price of a fixed-income instrument. At the point when market interest rates, or yields, increase, the price of a bond will diminish, and vice versa.

Understanding Yield Curve Risk

Investors pay close consideration regarding the yield curve as it gives an indication of where short term interest rates and economic growth are going from now on. The yield curve is a graphical illustration of the relationship between interest rates and bond yields of different maturities, going from 3-month Treasury bills to 30-year Treasury bonds. The graph is plotted with the y-pivot portraying interest rates, and the x-hub showing the rising time spans.

Since short-term bonds normally have lower yields than longer-term bonds, the curve slants upwards from the base left to the right. This is a normal or positive yield curve. Interest rates and bond prices have an inverse relationship where prices decline when interest rates increase, and vice versa. Subsequently, when interest rates change, the yield curve will shift, implying a danger, known as the yield curve risk, to a bond investor.

The yield curve risk is associated with either a flattening or steepening of the yield curve, which is a consequence of changing yields among comparable bonds with various maturities. At the point when the yield curve shifts, the price of the bond, which was initially priced in light of the initial yield curve, will change in price.

Special Considerations

Any investor holding interest-rate bearing securities is presented to yield curve risk. To hedge against this risk, investors can build portfolios with the expectation that assuming interest rates change, their portfolios will respond with a specific goal in mind. Since changes in the yield curve depend on bond risk premiums and expectations of future interest rates, an investor that can foresee shifts in the yield curve will actually want to benefit from relating changes in bond prices.

Moreover, short-term investors can exploit yield curve shifts by purchasing both of two exchange-traded products (ETPs) — the iPath US Treasury Flattener ETN (FLAT) and the iPath US Treasury Steepener ETN (STPP).

Types of Yield Curve Risk

Flattening Yield Curve

At the point when interest rates unite, the yield curve flattens. A flattening yield curve is defined as the narrowing of the yield spread among long-and short-term interest rates. At the point when this occurs, the price of the bond will change appropriately. In the event that the bond is a short-term bond developing in three years, and the three-year yield diminishes, the price of this bond will increase.

We should take a gander at an illustration of a flattener. Suppose the Treasury yields on a 2-year note and a 30-year bond are 1.1% and 3.6%, individually. On the off chance that the yield on the note falls to 0.9%, and the yield on the bond diminishes to 3.2%, the yield on the longer-term asset has a lot greater drop than the yield on the shorter-term Treasury. This would narrow the yield spread from 250 basis points to 230 basis points.

A flattening yield curve can demonstrate economic weakness as it flags that inflation and interest rates are expected to remain low for some time. Markets anticipate minimal economic growth, and the ability of banks to loan is weak.

Steepening Yield Curve

Assuming the yield curve steepens, this means that the spread among long-and short-term interest rates extends. All in all, the yields on long-term bonds are rising quicker than yields on short-term bonds, or short-term bond yields are falling as long-term bond yields are rising. In this way, long-term bond prices will diminish relative to short-term bonds.

A steepening curve normally shows more grounded economic activity and rising inflation expectations, and subsequently, higher interest rates. At the point when the yield curve is steep, banks are able to borrow money at lower interest rates and loan at higher interest rates. An illustration of a steepening yield curve should be visible in a 2-year note with a 1.5% yield and a 20-year bond with a 3.5% yield. On the off chance that following a month, both Treasury yields increase to 1.55% and 3.65%, individually, the spread increases to 210 basis points, from 200 basis points.

Inverted Yield Curve

On rare events, the yield on short-term bonds is higher than the yield on long-term bonds. At the point when this occurs, the curve becomes inverted. A inverted yield curve shows that investors will endure low rates now assuming they accept rates will fall even lower later on. In this way, investors expect lower inflation rates, and interest rates, from now on.

Features

• Interest rates and bond prices have an inverse relationship wherein prices decline when interest rates increase, and vice versa.
• The yield curve is a graphical illustration of the relationship between interest rates and bond yields of different maturities.
• Yield curve risk is the risk that a change in interest rates will impact fixed income securities.
• Changes in the yield curve depend on bond risk premiums and expectations of future interest rates.