Q&A: Bond yield curves

Michael Wright, head of fixed income at LV Asset Management, explains how bond yield curves operate.

Q. What is the yield curve?

A. It is a graph that plots the yield on a particular bond against the term to maturity and for one particular issuer. So, for example, if you take the UK gilt market, the UK government is the issuer and it has got many different bonds at different maturities, ranging from just a few months to 50 years, and there are all different yields.

The yield curve plots a line through all of those different yields. If you take the UK, for example, at the moment, it is an upward-sloping yield curve. It is a classic textbook-shaped yield curve. It will start yields at very short maturities of about 0.5%, which is very close to the bank-based rate, out to the 50 years yield, which is about 4.25%.

Q. And what does this tell us?

A. If we again take the UK government bond markets, it tells us a lot about market participants’ expectations for interest rates. For example, very short-dated bonds will be heavily influenced by where we expect bank rates to be over the next few years.

So, for example, if you took a five-year gilt, it is currently yielding about 2%, which means if you buy a five-year gilt, you will get 2% pa if you hold it until maturity. That means you have the choice of holding a five-year gilt and leaving it at 2%, or if you want to put the money in the bank, you will get about 0.5% now, and in five years’ time bank-based rates will probably have risen to about 4% or 5%, so it averages out to about the 2%. It is a sort of break-even between what you would get in a floating rate in the bank and a fixed rate from the UK government.

Q. What factors influence the shape of the yield curve?

A. Expectations about changes in the level of interest rates will change the yield on shorter-dated bonds. So, for example, if we go back to that five-year gilt example, if ­economic data came out that indicated growth was going to be very weak, or for some reason the Bank of England was far less likely to raise rates over the next few years, then a 2% rate on five-year gilts would certainly appear much more attractive. So those shorter-dated yields would fall to a level that is consistent with the outlook for interest rates.

Shorter-dated bonds are influenced very much by expectations for short-term interest rates. Longer-dated bonds are very different. The risk if you buy a 50-year bond gilt is that the fixed rate you are receiving is eroded by inflation in the long term. If inflation was to stay at 2%, a 4% return from a UK bond would look pretty attractive.

However, if you had reason to believe inflation was going to be more like 3% or 4%, that yield would look far less attractive, so yields would rise. Long yields will typically go up and down on expectations for long- term inflation, and short yields up and down on expectations for short-term interest rates. They can also be heavily influenced by general supply and demand dynamics.

Q. How does that work?

A. This tends to affect the long end of the market, particularly in the UK, where pension funds are very keen to match their assets against their liabilities. They are a bit less worried about the economic factors. They are more likely to buy long-dated gilts just because they like the idea of that stable cashflow. So yields can be pushed lower by strong demand from pension funds or, on the flipside, yields can go up when we get a period of heavy supply, heavy issuance of gilts, so normal supply and demand factors will also change the shape of the yield curve.

Q. Fundamentally, how important is the yield curve?

A. It is an important indicator of investors’ current thoughts. You can go out and ask investors where they think interest rates are going to be over the next four or five years, and you will get one answer. But if you actually look at the yield curve, the short end of the yield curve, you can work out using some fairly simple maths looking at the different yields from one-year gilt, two-year gilt, three-year gilts, what market participants actually expect and where they are actually placing their money in terms of interest rates.

It is a very important indicator of where the market expects interest rates to go. You can also get indications of where the market expects long-term inflation to be, and some yield curves are better than others at this.

The US Treasury yield curve is particularly good at indicating potential recession. A downward-sloping yield curve can be a sign that market expects rates to be falling and/or inflation to be very low over the long term, which are conditions that are quite often associated with a recession or lower economic growth.

I think the US yield curve, the US Treasury curve, has indicated correctly about six out of seven economic slowdowns since 1970. Other curves like the UK government curve are less good at predicting recessions because they tend to be more dominated by pension funds, which are buying for other reasons.