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Understanding Yield Curves: The Spread is the Key for Investors

Inverted, flat or normal -- yield curves offer a slew of information

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A yield curve is a simple representation of the relationship between the interest rate that a bond pays and when that bond matures.

But as simple as that concept may be, understanding the significance of movement in a yield curve can be a complicated. Here are few key things to remember:

  • You can create a yield curve using any two bonds. But the most popular curves are the ones used as benchmarks by institutional investors.

    For example, most bond traders are intimately familiar with the yield curve on treasury securities. While traders of municipal bonds, or munis, closely follow the curve on AAA-rated general obligation muni bonds. Charts of both those curves are widely available on sites such as Bloomberg News.

  • In a sane and normal world, the line on a yield curve rises as it moves from left to right. What that is saying is that the interest rates are higher on bonds with a longer maturity. That's logical. If I were to lend you a $1,000 for two years, I might charge you 5% interest a year. But if I were to lend you $1,000 for 10 years, I'd require a higher interest payment to cover the risks associated with waiting longer to get my money back.

    But in the bond market, things aren't always logical. An inverted yield curve occurs when interest rates are lower for longer maturities than for shorter ones. It's rare when the curve on Treasuries inverts. Doing so is seen as a sign of recession.

  • The most important item in a yield curve is the spread. That's the difference between the interest rates paid on any two bonds in the curve.

    For example, if a 30-year bond pays 4.90% while a 10-year bond pays 3.95%, the spread is 0.95%.

    Fixed-income investors use spreads as a simple measurement by which to compare bonds -- similar to the way equity investors use price/earnings ratios to compare shares of stock.

You can spend a lifetime trying to understand the nuances of yield curves. Economists dedicate considerable effort to learning what moves a curve up or down. But average investors don't need to concern themselves with much more than the basics. Once you understand what the benchmarks are doing and what the spreads are on the bonds you're considering for purchase, you can make an educated decision about what to add to your portfolio.

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