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What is a Yield Curve & Why Do You Need to Know?

Debts and investments are not created equal. They mature and accrue interest at different rates. If you have borrowed money for your business, or have investments outside of your business, yield curves are an important concept to wrap your head around. Not only can a yield curve show you how hard your investment is working for you, it can also help you gain a better understanding of the broader economy in which your business operates. 

Understanding yield curves is crucial in understanding how different rates of interest, and how they behave over time. Something that can benefit you in your business and personal finances. They can help you understand the risk of an investment, potential yields, and even broader economic outcomes

Yield curves explained

A yield curve illustrates the interest on debt using a graph. It’s a great way to visualize the risk and potential return represented by any given bond. The bond’s yield / interest rate (expressed as a percentage) accounts for the vertical axis while the term to maturity is measured along the horizontal axis. 

The concept of the yield curve is most often applied to national treasury securities. However, it can be used as a benchmark for other lending rates such as mortgage, personal, or business loan rates.  

Different kinds of yield curves

Yield curves are generally upward-sloping, but the activity within their economic cycles can lend them lots of different shapes. They broadly fall into the following categories:

Normal yield curve

A normal yield curve rises gradually before eventually flattening. The logic behind this is clear enough. Lending over a longer period represents a greater degree of risk. So, lenders will want more compensation in the form of higher interest. The longer the maturity, the more vulnerable it becomes to market volatility and risk, which needs to be offset by higher interest rates. 

Inverted yield curve

An inverted yield occurs when short-term yields are higher than in the long term. A decline in inflation is the most common cause of this. Inverted yield curves are usually seen as an indication of an impending economic downturn and tend to affect economic expectations and market sentiment.

Steep yield curve

A steep yield curve means that yields rise at a rate that is higher than usual. They historically mean that economic expansion is imminent, although a steep yield curve is based on the same market conditions as a normal yield curve.

Flat yield curve

A flat yield curve occurs when long and short-term bonds have the same yield. These curves typically occur in the transitional period between a normal and inverted yield curve. 

Humped yield curve

The rarest type of yield curve, a hump occurs when medium-term yields are higher than either long or short term. This tends to indicate sluggish economic growth. 

What influences a yield curve?

There are a number of broader economic factors that influence the changes in yields that generate the different types of curves. These include:

  • Economic growth and the rise in demand and competition for capital

  • Rising inflation, which tends to result in higher short-term yields

  • Rising and falling interest rates precipitated by the above

Why it’s important to understand yield curves

Understanding yield curves can benefit you and your business in a number of ways. It can help you to forecast interest rates, allowing you to time business or personal borrowing to coincide with favorably low rates. It can help financial intermediaries to better understand and preempt their profits. It can also give a broader understanding of the market, and help you to steer clear of overpriced securities that are less likely to benefit your investment portfolio. 

We can help

If you’re interested in finding out more about yield curves, investments and anything to do with your business finances, then get in touch with the financial experts at GoCardless. Find out how GoCardless can help you with ad hoc payments or recurring payments.

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