The Yield Curve

Title: The Yield Curve

{See also our Fixed Income Primer: “Demystifying Interest Rates”} Link 

All bonds are issued with a specific rate of interest they will pay, typically semi-annually, and a specific maturity date when they will repay the bond principal (a.k.a the borrowed money, also referred to as the “face value” or “par value” of the bond).  The interest rate a bond pays (referred to as its “coupon”) is driven by the rates that are prevailing in the market when it is issued.  

Over time, interest rates will fluctuate: the Fed can raise or lower rates, the economy can grow or shrink, fiscal policy can change.  Also over time, the maturity date of a bond gets closer; a 10 yr bond that was issued 5 years ago now has only 5 years to maturity.  

Bond prices are expressed as a percent of the face value. A 10 year bond issued at par (100% of face value) with a 5% coupon has a yield of 5%.  But three years later, if the Fed raised rates, the market might demand a yield of 6% on this now 7 year bond.  In order for a buyer of that bond, which has a 5% coupon, to get a 6% yield, they will demand a price that is lower than par: 96.7% of par to be precise (or simply “96.7”).  

Prices and yields of bonds always move inversely to each other: the lower the price of a specific bond (as a % of par) the higher the yield and the higher the price, the lower the yield.  Here’s an exercise: do it in your mind or with an actual object.  Take a pencil and hold it in the middle with your right hand.  At the eraser end is the yield and at the writing end is the price.  Take your left hand and push the writing/price end down while continuing to hold it steady in the middle with your right hand.  What happens to the eraser/yield end?  It goes up! Price down, yield up.  Now move your left hand to the eraser end and push that end down.  What happens to the writing/price end? It goes up! Yield down, price up. That’s bonds, baby!

Of course, not all bonds and loans have 10 year maturities and, as explained above, time ticks inexorably away causing the maturity of every bond and loan ever issued to grow shorter every day.  

Fortunately for the capital markets, the U.S. Treasury also issues 20 and 30 year bonds, 5 and 2 year notes as well as Treasury bills with maturities of 1 year, 6 months, 3 months and 1 month.  Bills are issued weekly, notes out to 3 years are issued monthly and 10 year notes and the longer bonds are issued quarterly.  

This constant issuance (all via auctions) and range of maturities available results in the U.S. Treasury yield curve (the “yield curve”) - a reference curve for U.S. government borrowing rates for maturities ranging from 1 month to 30 years, determined on a continuous and ongoing basis by market supply and demand.  The rates represented by the yield curve serve as the basis for all other U.S Dollar fixed income instruments, which will have some additional yield premium, or “spread,” on top of the Government’s rate.

In addition to serving as a basis for borrowing rates, the yield curve also serves as the basis for “discount rates.”  Discount rates are also interest rates, but work in reverse. Instead of starting today and figuring out how much you will owe on a loan, or have to pay on a bond you issued, or what you will earn from a deposit, or from a bond investment you made; a discount rate will start with a future cash flow, and tell you what it’s value is today.  This math is the determinant of bond pricing and valuation.

Discounting math is also very useful in evaluating other potential investments, and for companies making decisions about expansion and capital expenditures like building a new factory, buying a new machine or hiring a new team.  Just like borrowing/lending rates, discount rates start with a reference rate and have spreads on top that depend on the riskiness of the cash flow being discounted.  A company with a history of steady earnings growth and strong brand adoption (e.g. Apple Computer) will use a lower discount rate in its analysis than a startup or a company with volatile earnings (e.g. Amazon, in its early years).

Discount rates are also relevant to the valuation of the equity market as a whole.  At any given time, a stock’s price should reflect the discounted value of all the future cash flows associated with that company’s business. If interest rates rise, all else equal, discount rates will also rise, causing that calculated value to fall.  That is why rising rates are often associated with falling stock valuations and more volatile stock prices.

The Litmus Finance 101 Bootcamp covers a detailed discussion about the pricing and valuation of stocks and bonds, including a broader context for calculating and evaluating the risk and return of various investments. Click here for access to the Bootcamp’s landing page.