What Is The Bond Yield Curve?

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Exhibit 1Yield Curve for U.S. Treasury STRIPS, January 3, 2017

Source: Wall Street Journal Market Data Center

Exhibit 1 shows the yield curve for Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) from January 3, 2017. STRIPS represent a collection of zero-coupon bonds which are sold at a discount of their face value.

The return they provide is reflected as the growth rate on price paid, so face value is realized at the maturity date. The price of a zero-coupon bond slowly gravitates toward its face value as the maturity date approaches.

The Treasury facilitates the creation of STRIPS by “stripping” the coupon payments and face value payment from Treasury bonds and selling them as separate securities. Each coupon payment becomes a standalone zero-coupon security providing the one coupon payment at its specified date (Coupon STRIPS).

The return of the face value at the maturity date also becomes a zero-coupon security (Principal STRIPS).

Bonds with more distant maturity dates typically offer higher interest rates than bonds with earlier maturity dates. While that is not always the case, Exhibit 1 shows us it was true in January 2017, as thirty-year STRIPS were yielding 3.1%.

Longer-term bonds experience bigger price fluctuations as interest rates change, which explains why January’s yield is noticeably higher than earlier maturities.

When interest rates increase, the price of existing bonds on the secondary market falls in order to calibrate the yield investors will receive from owning existing bonds with the yields being offered by newly issued bonds at the higher interest rates.

Bonds that mature sooner are less exposed to this price risk. Thus, shorter-term U.S. Treasury securities are generally considered to be among the lowest-risk investment assets when annualized volatility represents the measure of risk, which means they tend to be offered at a lower yield.

Higher yields accompany longer-term bonds as investors need an added incentive to accept the higher price risks.

The shape of the yield curve is molded by two theories. First, expectations theory suggests that the shape of the yield curve should be reflected by beliefs about future short-term interest rates. Investing in bonds over ten years can be done in two ways:

(1) buy a 10-year bond, or

(2) buy a one-year bond and then reinvest in a new one-year bond after one year, continuing with a succession of ten one-year bonds.

For markets to be in balance, these two strategies should offer the same expected return to an investor, meaning that the combined impact of one-year rates over ten years should match the rate for a ten-year bond.

An inverted yield curve where short-term rates exceed long-term rates can be understood as a clear expectation that short-term interest rates will fall in the future.

Since interest rate fluctuations are extremely difficult to predict, the expectations theory alone would probably leave the average yield curve relatively flat.

The other theory to determine yield curve shape is the liquidity preference theory, which suggests a need for a risk premium to be offered for longer-term bonds to account for their increased interest rate risk and price volatility.

Longer-term bonds are less liquid, as well, since this price risk could force them to be sold at a loss if an unexpected expense arose.

With this risk premium added to the expectations theory, the typical or neutral shape for the yield curve becomes upward sloping (like in Exhibit 1).

The bond yield curve provides a reality check on retirement spending. Spending beyond what the bond yield curve can support introduces the risk that future spending will need to be cut if higher returns are not realized.