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All about yield curvesWhat is yield?YIELD is an amount earned from an investment and is expressed as annualpercentage. Lets say you have invested Rs 100 in a bond that entitles you to aninterest payment of 12 per cent at the end of every year and you recover yourentire investment when the bond is redeemed, your yield on the investment is 12per cent.

But if the interest payments on the bond are made more than once a year, the yieldwill work out to be slightly more. This is because while calculating yield you alsotake into account that little bit of interest which is earned on the various interestpayments you receive during the year.

In instruments such as deep discount bonds, and zero coupon bonds, where thereis no regular interest payment, but a lumpsum premium paid on maturity, the yieldis calculated by taking into account the capital gains and tenor of the bond.

In short, interest payment is one of the components that determines the yield. The

other components include the frequency of interest payment and the gain or lossmade by the investor that is calculated as a difference between the acquisitionprice and the sale price.

There are many different ways to calculate yields under a wide variety of namessuch as current yield and yield to call.

But unless specifically mentioned, the word yield means yield to maturity andrepresents the return on a fixed income instrument based on the spread betweenthe original cost of the instrument and total proceeds up to and including thematurity date.

Yield to Maturity serves as the bottomline, based on which the returns on various

instruments can be compared.

How do yields change on bonds even when interest payments are constant?As mentioned earlier, the rate of interest is one of the components that determineyield on a fixed income instrument, such as a bond.

For instance, you may have invested in a bond that provides interest at 15 percent, a few months later when interest rates have fallen you can sell the bond at apremium over the face value.

The buyer who purchases at a premium will continue to get the same interestpayments, however, he will suffer a capital loss as the acquisition cost will behigher than the redemption payment.

This loss will make up for the higher interest payment and thus bring down theeffective yield on his investment.

What is a yield curve?A yield curve is a graphic representation of yields on fixed income securities ofvarious maturities that has yields points plotted on the Y axis and maturity term onthe X axis.

For a yield curve to give a proper picture two elements are essential. One, there

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should be enough securities across various maturities, and two, the securitiesshould be actively traded or issued.

Since these conditions are best fulfilled by government securities (G-secs), theyare often used for charting out a yield curve. A G-secs yield curve is often used bycorporates as a benchmark to calculate the rate of interest at which they can raise

funds through bonds.

A normal yield curve is represented through a chart or graph that shows long-termdebts having higher yields than short-term debt. This is because in a growingeconomy, demand for funds is expected to rise in the future so borrowers arewilling to pay more for longterm funds.

As an economy matures, the inflation rate falls and the growth rate also stabilises,demand for funds is expected to stay flat as a result of which there is a marginal orno difference between short-term and long-term rates which results in a flat yieldcurve.

What is a negative or inverted yield curve?A negative yield curve is a situation in which long term debt has lower yields thanshort-term debt. This represents the unusual situation where short-term interestrates are higher than long-term interest rates.

This can be a sign of an unhealthy economy characterised by high inflation and lowinvestor confidence. Negative yield curves are also seen as a sign of recession.

However, there can be exceptions. For instance to tackle volatility in the foreignexchange market, the Reserve Bank of India may make short-term moneyexpensive while maintaining the interest rate at the longer end.