Exploring the Principles of Fixed Income: Rates and Yield Curves
Interest rates reflect both the cost of borrowing money and the reward for saving it. Because they are central to the functioning of an economy, a country’s central bank is responsible for setting the benchmark interest rate (also known as the base or policy rate). This rate – used by the central bank when lending to domestic commercial banks – is adjusted in response to the central bank’s assessment of current economic conditions.
- Economic expansion: When the economy grows rapidly or inflation runs too high, the central bank may raise interest rates to temper borrowing and moderate demand. Retail banks typically follow suit by increasing lending (and often deposit) rates, which can make saving and bond investments more attractive.
- Economic contraction: When economic activity slows, the central bank may lower the benchmark rate to encourage borrowing and stimulate growth. Lower policy rates generally make cash savings and bonds less appealing relative to other opportunities.
How short- and long-term rates differ
Central banks directly influence only short-term interest rates, which can change as policymakers adjust monetary conditions. Longer-term interest rates, by contrast, are determined by market forces.
For example, if investors believe a central bank has kept the benchmark interest rate too low, potentially stoking future inflation, issuers of longer-maturity bonds may need to offer higher yields to compensate for this risk. This dynamic can cause the yield curve to steepen.
When interest rates decline, existing bonds with higher coupons become more valuable, allowing investors holding these bonds to sell at a premium.
Are rising rates always bad?
In the short term, rising interest rates typically reduce the value of existing bonds, since prices fall as yields rise. However, over time, the proceeds from coupon payments or maturing bonds can be reinvested in newly issued bonds offering higher yields. This reinvestment effect can help rebuild returns and support stronger long-term income generation. As the chart below highlights, reinvestment can play a meaningful role in sustaining portfolio returns during periods of rising‑rates.
The upside of rising rates
Generally, when interest rates are rising, investors may prefer bonds with shorter maturities (or lower duration) because these bonds are less sensitive to changes in rates. As a result, their prices tend to fluctuate less than those of longer‑maturity bonds, offering a more defensive profile in a rising‑rate environment.
Understanding the yield curve
The shape of the yield curve is a key reference point for fixed income investors. Indicating the relationship between bond yields and maturities, it helps investors anticipate interest rate trends, determine fair bond prices, and position portfolios to enhance total returns. Historically, the yield curve has also served as a valuable indicator of future economic conditions.
- Curve steepening: A steep, upward-sloping yield curve often signals expectations of stronger economic growth. It indicates that the market anticipates that sustained growth will push inflation, and therefore interest rates, higher in the near term. Investors demand higher yields for longer maturities because faster growth can lead to higher inflation and higher interest rates.
- Curve inversion: When investors expect rates to fall, yields on short-term bonds can rise above those of longer-term bonds, creating an ‘inverted yield curve’. This usually occurs when the market expects interest rates to fall, often during or approaching a recession. Historically, yield curve inversions have preceded economic downturns by roughly 12 to 18 months.
Two main factors determine the slope of the yield curve: market expectations for future interest rates and the risk premiums investors require to hold longer-maturity bonds, often called the ‘term premium’.
The shape of the yield curve can be a good indicator of the economic climate
How to use the yield curve
The shape and slope of the yield curve can offer insight into whether bonds appear relatively cheap or expensive. Since a bond’s price reflects the present value of its future cash flows – its coupon payments and principal - discounted at prevailing interest rates, shifts in the yield curve directly affect valuations.
By applying different assumptions about future interest rates, investors can estimate what a bond should be worth. Comparing this estimate with the market price helps determine whether the bond offers good value, appears overpriced, or is fairly valued - guiding buy, sell, or hold decisions.
Beyond serving as a tool for anticipating changes in the economic environment, the yield curve has two important key uses:
- Pricing: Because U.S. Treasuries are perceived as having minimal credit risk, the yield curve serves as a benchmark for valuing other bonds. Most bonds trade at a yield spread above Treasuries. For instance, a five-year corporate bond might yield 0.5% more than a five-year U.S. Treasury. Investors would refer to it as trading 50 basis points “over the curve”.
- Predicting: By anticipating yield curve movements, fixed income managers may seek to enhance returns through strategic portfolio positioning.
Several strategies have been developed to help investors position their portfolios to benefit from changes in the shape of the yield curve:
- Bullet strategy: Concentrating bond maturities at a single point on the yield curve (10 years, for example).
- Barbell strategy: The portfolio is split between short-maturity and long-maturity bonds (for example, 2- and 20-year maturities). This approach is often used when the curve is expected to flatten, when short- and longer-term yields move towards each other.
- Ladder strategy: A portfolio holds a variety of bonds maturing at regular intervals, often annually, spreading exposure across the yield curve. This helps reduce reinvestment risk, particularly the risk of reinvesting a large portion of an investor’s assets during a lower-rate environment.
