All about yield curves

What is yield? YIELD is an amount earned from an investment and is expressed as annual percentage. Lets say you have invested Rs 100 in a bond that entitles you to an interest payment of 12 per cent at the end of every year and you recover your entire investment when the bond is redeemed, your yield on the investment is 12 per cent. But if the interest payments on the bond are made more than once a year, the yield will work out to be slightly more. This is because while calculating yield you also take into account that little bit of interest which is earned on the various interest payments you receive during the year. In instruments such as deep discount bonds, and zero coupon bonds, where there is no regular interest payment, but a lumpsum premium paid on maturity, the yield is calculated by taking into account the capital gains and tenor of the bond. In short, interest payment is one of the components that determines the yield. The other components include the frequency of interest payment and the gain or loss made by the investor that is calculated as a difference between the acquisition price and the sale price. There are many different ways to calculate yields under a wide variety of names such as current yield and yield to call. But unless specifically mentioned, the word yield means yield to maturity and represents the return on a fixed income instrument based on the spread between the original cost of the instrument and total proceeds up to and including the maturity date. Yield to Maturity serves as the bottomline, based on which the returns on various instruments can be compared. How do yields change on bonds even when interest payments are constant? As mentioned earlier, the rate of interest is one of the components that determine yield on a fixed income instrument, such as a bond. For instance, you may have invested in a bond that provides interest at 15 per cent, a few months later when interest rates have fallen you can sell the bond at a premium over the face value. The buyer who purchases at a premium will continue to get the same interest payments, however, he will suffer a capital loss as the acquisition cost will be higher than the redemption payment. This loss will make up for the higher interest payment and thus bring down the effective yield on his investment. What is a yield curve? A yield curve is a graphic representation of yields on fixed income securities of various maturities that has yields points plotted on the Y axis and maturity term on the X axis. For a yield curve to give a proper picture two elements are essential. One, there

should be enough securities across various maturities, and two, the securities should be actively traded or issued. Since these conditions are best fulfilled by government securities (G-secs), they are often used for charting out a yield curve. A G-secs yield curve is often used by corporates as a benchmark to calculate the rate of interest at which they can raise funds through bonds. A normal yield curve is represented through a chart or graph that shows long-term debts having higher yields than short-term debt. This is because in a growing economy, demand for funds is expected to rise in the future so borrowers are willing to pay more for longterm funds. As an economy matures, the inflation rate falls and the growth rate also stabilises, demand for funds is expected to stay flat as a result of which there is a marginal or no difference between short-term and long-term rates which results in a flat yield curve. What is a negative or inverted yield curve? A negative yield curve is a situation in which long term debt has lower yields than short-term debt. This represents the unusual situation where short-term interest rates are higher than long-term interest rates. This can be a sign of an unhealthy economy characterised by high inflation and low investor confidence. Negative yield curves are also seen as a sign of recession. However, there can be exceptions. For instance to tackle volatility in the foreign exchange market, the Reserve Bank of India may make short-term money expensive while maintaining the interest rate at the longer end.