October 2, 1998

FOOL ON THE HILL
An Investment Opinion
by Paul Larson

A Yield Curve Primer

With all the attention being given to interest rates the past few weeks, I thought it would be appropriate to touch on a topic very thinly covered here in The Fool -- the yield curve. Interest rates are of importance to all of us, whether you are discounting cash flows for analytical purposes or looking to buy a house using a mortgage for financing. Of course, the stock market is also very sensitive to changes in interest rates, as can be seen from the action over the past several weeks. The yield curve is important because looking at and knowing how to read it can often give insights into where interest rates are headed in the near future.

First, let's talk about what exactly the yield curve is. Maybe you're new to investing, heard it mentioned on CNBC or at a cocktail party, but never really understood what it was. The yield curve is simply a graph showing bond yields on the vertical axis and different length maturities of government bonds and notes on the horizontal axis.

A table of the current yields looks something like this:

(As of the close of trading 9/30/98)

Security        Yield 
 3-month Bill     4.25% 
 6-month Bill     4.32% 
 1-year Bill      4.20% 
 2-year Bond      4.29% 
 3-year Bond      4.38% 
 5-year Bond      4.24% 
 10-year Bond     4.42% 
 30-year Bond     4.98%
A yield curve is nothing more than a graphical version of the above table. Generally, the longer the maturity of the debt an investor is buying, the greater the yield any given bond will carry. This is because there is more risk to principal the longer the maturity of the debt. Simply said, the more risk an investor carries, the higher return he should expect.

While there is a microscopic chance that Uncle Sam is going to renege on his debts, the risk is omnipresent that interest rates will rise before maturity, thereby decreasing the current principal value of the bonds being bought. The best way to explain this is probably through a simple example.

Let's say that Joe Average today bought a 30-year bond for $1000 (par value) that had a 5% coupon attached to it. That's to say that Joe will get $50 every year in interest payments, and that 30 years down the line Joe can cash in his bond and get his $1000 back.

Coupon rates do not change, but yields and market prices of bonds fluctuate with the free market. Let's say two years from now that Joe needs his money back for an unexpected reason. If the prevailing interest rates jumped up to 7% between now and then, the most Joe could expect to sell the bond for on the open market would be $714.28, for a principal loss of over 28%. This is because his coupon rate of $50 has not changed, but the market rate has. In this example, a $50 annual interest payment on a $714.28 bond yields 7%.

Of course, Joe could decide to hold his bond for the full 30 years, collect his 5% a year, and get the full $1000 back when the bond matures. In other words, there is virtually no risk to principal if government bonds are held to maturity, but a great amount of risk if an investor plans on selling the security on the open market. If rates are higher when than when an investor bought, a loss of principal can be expected. Likewise, if yields are lower, the value of the underlying bond increases.

Getting back to the yield curve, there are essentially three ways to describe the yield curve at any given time -- steep, flat, and inverted. A steep curve happens when the longer-term bonds have much higher yields than the short-term notes. The yield curve can be called flat when there is little difference between the long and short-term securities. An inverted curve describes when the curve is just that -- inverted. An inverted curve happens when the long-term bonds actually yield less than the short-term notes. Easy enough, right?

Ok, so now we know what a yield curve is and how to describe the shape, but how is this useful? It is of utility because it gives insight into where interest rates are going. A steep yield curve happens when long-term bonds yield much more than short-term notes. This tells us that the market is expecting rates to increase in the future. The market does not want to be like Joe Average in our example and lose current principal value, so the market is generally selling the longer-term bonds, thereby raising their yield.

On the other hand, a flattening or inverted curve, where long-term rates are falling relative to or below the short-term rates, means that the bond market expects interest rates to decline in the near future. This is due to traders bidding up (reducing the yield of) the longer-term bonds because the market expects the higher-yielding bonds to have a higher principal value in the near future. Just as Joe's bonds would decline in current value if interest rates were to increase, falling interest rates actually raise the value of the longer-term bonds.

If one wants to check the theory out in the real world, one only has to look as far as this link. It shows a snapshot of the yield curve at different times over the past several months. Throughout the summer the yield curve had been flattening, indicating that the market expected rates to drop in the future. Lo and behold, look at what happened this past Tuesday.

Of course, the yield curve only represents the bond market's expectation of where interest rates and the economy are headed, and the bond market, just like the stock market, is never truly efficient. In other words, the yield curve is not exactly perfect in predicting rates and should not be treated as gospel. Nevertheless, the yield curve is as good an indicator as any concerning where interest rates are headed.

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