What is the Inverted Yield Curve?

Investors often leverage their financial prowess and invest in debt instruments, more specifically–Bonds. They are debt instruments, which imply that they work on the principle of loans, where a company issues bonds to borrow money from the lender, also called the bondholder. The company promises the lender a regular predetermined interest on the principal amount. In bond terms, this interest rate is called a coupon. Since the interest payment is regular and the companies are legally bound to pay the debt instrument holder, they tend to hold the instruments for the long term. However, a situation called an Inverted Yield Curve can force long term investors to realise lower profits than short-term debt instruments.

Why does this happen? Don't long term debt instruments are considered to offer higher returns than short term debt instruments?

This blog elaborates vital knowledge on ways to protect your long term debt investments from offering you lower returns. But first, let’s understand instrument prices and their yields. Here, Bonds will be considered as an example as the preferred debt instrument.

The relationship between instrument price and their yield

Like most things in the secondary market, debt instruments also depend on the supply and demand equilibrium. Debt instrument yield has an inverse relationship with debt instrument prices.

For example, if you have a bond with 5-year maturity, 5% coupon rate and a face value of Rs 10,000, each year the bond will pay you an interest of Rs 500. Now, if the interest rates in the market rise above 5%, investors will not buy your bonds but buy the new ones that come with an interest rate higher than 5%.

As a result, you will have to reduce the price of your bond to increase its yield. When you lower the price, the coupon rate increases because of lower face value, thus increasing the bond’s yield.

What is an Inverted Yield Curve?

An inverted yield curve is a graphical curve that represents a financial situation where long term debt instruments offer lower yields to investors when compared to short term debt instruments’ yield. In both cases, the comparison is made on debt instruments having the same credit quality but different maturity periods. The inverted yield curve is considered negative, and hence, it is sometimes referred to as a negative yield curve.

Understanding Inverted Yield Curve

It is a common financial principle that long term debt instruments have a higher potential to offer better yields to investors than short term debt instruments. However, this depends on external factors and economic growth. The yield curve measures the relationship between time to maturity and risk. Normally, the 10-year bond is taken as the benchmark to plot the yield curve, and this is a practice across the world.

So if you take the X-axis of the yield curve, you start with a 1-year bond and then go all the way towards a 30-year bond. As bond maturity increases, the risk increases and therefore, investors demand higher returns. That means the yield curve should typically have an upward slope.

For example, a bond with ten years of maturity will have a higher yield than a bond with five years of maturity. However, the possibility of economic factors such as recession, high rate of unemployment etc., can trigger the graph to go downwards, making the short term interest rates higher than the long term interest rates. Such a situation of a negative downwards graph is called the inverted yield curve.

How can inverted yield curves help in forecasting recession?

If empirical data is any benchmark, every yield curve inversion in the last 50 years has been followed by a growth slowdown. Due to this regular historical correlation, analysts and experts use an inverted yield curve as a way to forecast a recession. If they see that the yield curve, which was positive sometime ago, is heading downwards and becoming an inverted yield curve, they know that the interest rates may fall. As a recession also brings about a sharp fall in interest rates, an inverted yield curve is almost always followed by a recession.

What can an inverted yield curve tell an investor?

The shape of the yield curve is directly related to the state of the economy of a country. If the country’s economic growth is positive and is believed to continue in the same direction, the yield curve will be positive and upwards. However, if the state of the economy is negative and is believed to slide down further, the yield curve will be an inverted yield curve with a downward slope. In such a case, investors can start analysing their investments , especially in debt, and adjust them according to an inevitable recession and fall in interest rates.

Final Words

Debt instruments are highly affected by the state of a country’s economy. As these economic factors regulate the interest rates in a way, investors can use the inverted yield curve to predict the sharp fall in interest rates and a nearing recession. Once the yield curve becomes negative, it is advised to adjust the investments accordingly as the future can bring a high risk for the investors.