Skip to main content
Business LibreTexts

9.2: Yield Spreads and the Yield Curve

  • Page ID
    79787
  • \( \newcommand{\vecs}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}} } \) \( \newcommand{\vecd}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash {#1}}} \)\(\newcommand{\id}{\mathrm{id}}\) \( \newcommand{\Span}{\mathrm{span}}\) \( \newcommand{\kernel}{\mathrm{null}\,}\) \( \newcommand{\range}{\mathrm{range}\,}\) \( \newcommand{\RealPart}{\mathrm{Re}}\) \( \newcommand{\ImaginaryPart}{\mathrm{Im}}\) \( \newcommand{\Argument}{\mathrm{Arg}}\) \( \newcommand{\norm}[1]{\| #1 \|}\) \( \newcommand{\inner}[2]{\langle #1, #2 \rangle}\) \( \newcommand{\Span}{\mathrm{span}}\) \(\newcommand{\id}{\mathrm{id}}\) \( \newcommand{\Span}{\mathrm{span}}\) \( \newcommand{\kernel}{\mathrm{null}\,}\) \( \newcommand{\range}{\mathrm{range}\,}\) \( \newcommand{\RealPart}{\mathrm{Re}}\) \( \newcommand{\ImaginaryPart}{\mathrm{Im}}\) \( \newcommand{\Argument}{\mathrm{Arg}}\) \( \newcommand{\norm}[1]{\| #1 \|}\) \( \newcommand{\inner}[2]{\langle #1, #2 \rangle}\) \( \newcommand{\Span}{\mathrm{span}}\)\(\newcommand{\AA}{\unicode[.8,0]{x212B}}\)

    Video - Audio - YouTube

    Yield Spreads

    Yield spreads are the differences in interest rates that exist among various sectors of the bond market. The shorter the maturity, the lower the rate. The longer the maturity, the higher the rate. The higher the rating of the bond, the lower the interest rate and vice versa. Treasuries carry the lowest rates. Municipal bonds are next with general obligation bonds carrying rates lower than revenue bonds. Corporate bonds yield the highest rates, especially distressed “junk” bonds. In general, non-callable bonds carry lower rates than callable bonds.
    Table of bond yields for various types of bonds for April 7, 2023

    Source: Fidelity https://fixedincome.fidelity.com/ftgw/fi/FILanding, April 7, 2023

    Often, investors will speak about the bond spreads as being “tight” or “wide.” A “tight” spread signifies the interest rates among the bonds they are evaluating are very close to one another. An example of a “tight” spread would be if Treasury bonds were paying 4.8% and corporate bonds were paying 5.1%. A “wide” spread denotes there is a big difference between the bond interest rates. An example of a “wide” spread would be if Treasury bonds were paying 3.2% and corporate bonds were paying 8.2%. In yet another attempt to confuse the general population and show how smart they are, experts in the media use the term "basis point" to signify 0.01 of a percentage. 100 basis points equals 1%. The first “tight” spread example has a 30-basis points spread, 0.30%. The second “wide” example has a 500-basis point spread. For several years, bond yield spreads were very tight. During the turmoil of 2008/2009, the yield spreads widened to levels not seen in decades. They narrowed significantly during the 2010’s and now have widened somewhat since 2022 as interest rates rose.

    The Yield Curve

    The yield curve is a graph that represents the relationship between a bond’s maturity and its yield at a given point in time. The yield curve is also used to make comparisons among types of bonds. Normally, the yield curve is upward sloping. Longer term bonds have higher interest rates than shorter term bonds and bills. However, sometimes the yield curve is downward sloping. Shorter term bonds and bills have higher interest rates than longer term bonds. This is called an “inverted yield curve.” When bond yields follow an inverted yield curve, the investment world sits up and takes special notice as we shall see.

    Normal Upward-sloping Yield Curve

    The upward-sloping yield curve is considered normal. Indeed, for the vast majority of time, the yield curve is upward-sloping and is often called a normal upward-sloping yield curve.

    Normal upward-sloping yield curve and an atypical downward-sloping yield curve

    Why do longer term debt securities normally have higher interest rates than shorter term debt securities? There are three hypotheses. The Expectations Hypothesis states that the shape of the yield curve reflects investors’ expectations of future interest rates. The Maturity Preference Hypothesis, also called the Liquidity Preference Hypothesis, states that investors tend to prefer the liquidity of short-term securities and, therefore, require a premium to invest in long-term securities. The Market Segmentation Hypothesis believes that the market for debt is segmented on the basis of maturity. Supply and demand within each segment determine the prevailing interest rate. Each of these three theories makes sense and each has some merit. But how do we account for the times when the yield curve is inverted? What factors could cause an inverted yield curve to occur? And what can an inverted yield curve tell us about the future of the economy?

    Atypical Downward-sloping Yield Curve, the Dreaded Inverted Yield Curve

    Since World War II, every time the yield curve has inverted when short-term rates were higher than long-term rates, the economy has fallen into a recession. The only exception was 1966. The yield curve inverted in 2019, ever so slightly, causing renewed fears of an imminent recession. But then the yield curve reversed strongly as the virus turmoil hit.

    For about two years before the beginning of 2008, the yield curve was slightly inverted. The bond market was predicting a recession for over two years. The stock market, for the most part, didn’t believe them. It wasn’t until fall of 2008 that the officials charged with tracking the economy acknowledged that we were in a recession. It took over two years, but the bond “ghouls” were finally proven right.

    That’s odd. Why are bond investors sometimes referred to as the “bond ghouls?” Think about the dynamics of the economy. When do interest rates rise? Interest rates usually rise when the economy is growing and getting stronger. Wages are rising, corporate earnings are healthy, life is good … but not for the bond investors! They see their bond prices falling. When do interest rates fall? Interest rates invariably fall when the economy falls into recession. Unemployment rises, corporate earnings are weak, life is not good … except for the bond investors! They see their bond prices rising. Of course, “bond ghouls” is a somewhat pejorative term. Luckily, it is usually used in jest because as we shall see, if bond investors keep a long-term perspective, rising interest rates means that newer bonds will be paying higher interest. Life is good for prudent long-term oriented investors.

    Here was the current yield curve as of later 2021:

    The Yield Curve as of October 25, 2021

    Source: GuruFocus.com, October 25, 2021

    Notice how the yield curve was slightly inverted in 2019. Although there was much talk of a coming recession during 2019, many experts were quick to point out that the yield curve could be inverted for quite some time before the economy actually fell into recession. Covid-19 came onto the scene and the short-term end of the yield curve collapsed as the Federal Reserve lowered short-term interest rates back to zero and bond investors braced for a pandemic-induced recession.

    Here was the yield curve as of April 2023:

    The Yield Curve as of April 7, 2023

    Source: GuruFocus.com, April 7, 2023

    In late March 2022, the yield curve started to invert. As mentioned, the whole investment world sat up and started to take notice. The pundits began spinning their narratives about why the yield curve is inverting and what were the chances for a recession in the following months. The challenge this particular time was the unprecedented events that were taking place. Many believed we were finally emerging from the Covid pandemic while others suggested that the virus was not quite done with us, thank you very much. On top of that, there was the invasion into Ukraine by Russia that at first appeared to be Blitzkrieg 2.0 but bogged down into a messy and bloody stalemate. The West’s response was to place staggering sanctions on Russia which resulted in a significant loss of global trade. The Federal Reserve Bank and central banks around the world have risen short-term interest rates to curtail inflation. It has been a very murky and uncertain time. Since then, the yield curve has inverted even more dramatically. Is a recession just around the corner from this morass? Stay tuned!


    This page titled 9.2: Yield Spreads and the Yield Curve is shared under a CC BY-NC-SA 4.0 license and was authored, remixed, and/or curated by Frank Paiano.