PArT 2: VALUATION, rISk AND reTUrNUsually, long-term bonds offer higher yields than do short-term bonds, and the yield curve slopes
upward as the maturity lengthens. That was the case for the curves at 30 June 2014, and for the average
shape over the period 2014–30, and is regarded as a ‘normal’ slope for an interest rate yield curve; but
it is interesting to note that the average shape for 2014–18 suggests that there is very little difference in
yields for bonds between one and four years from 2014.
There are occasions when the yield curve slopes downward rather than upward. In September 2006,
the Australian government bond yield curve was quite negatively sloped. Why the yield curve sometimes
slopes up and at other times slopes down is a complex problem. However, there is an interesting link
between the slope of the yield curve and overall macroeconomic growth. Historically, when the yield
curve inverts – that is, switches from an upward slope to a downward slope – a recession usually follows.
In fact, several research studies show that economic forecasts based on the yield curve’s slope more
accurately predict recessions than many forecasts produced using complex statistical models. One
reason for this pattern is as follows. Suppose a company receives new information from its sales force
indicating that orders for the company’s products are likely to fall in the near term. This prompts the
company to cut back on planned investment. That means the company’s need for long-term borrowing
to finance new investment is diminished. If this happens to just a few companies, it is not likely to have
a noticeable effect on financial markets. But if it happens to many companies simultaneously (because
demand is falling for many products at once, as happens during a recession), the aggregate demand
for new financing to pay for investment will fall. Companies will not need to issue long-term bonds to
borrow money for new factories or new equipment. A reduction in the demand for long-term borrowing
can cause long-term interest rates to fall relative to short-term rates, and the yield curve may invert. The
yield curve may also invert because short-term rates rise above long-term rates. This may occur when
the Reserve Bank of Australia increases short-term rates to fight inflation. In 2006, the RBA had raised
short-term interest rates to address increasing concerns about inflation in Australia, and this may have
produced the inverted yield curve on this occasion. The global financial crisis erupted in mid-2007, so a
worldwide slowing of economic growth did occur after that.4-5b USING THe YIeLD CUrVe TO FOreCAST INTereST rATeS
Economists have studied the yield curve intensely for several decades, trying to understand how it
behaves and what it portends for the future. As a result of that research, we know that economic growth
forecasts which include the slope of the yield curve perform well relative to forecasts which ignore the
yield curve. Can the yield curve also tell us something about the direction in which interest rates are
headed? The answer is a highly qualified yes. To understand the logic underlying the hypothesis that the
slope of the yield curve may predict interest rate movements, consider the following example.
Russell wants to invest $1,000 for two years. He does not want to take much risk, so he plans to
invest the money in government securities. Consulting the Australian Office of Financial Management
(AOMF) website, Russell learns that one-year Treasury bonds currently offer a 2% YTM, and two-year
bonds offer a 2.5% YTM. At first, Russell thinks his decision about which investment to purchase is easy.
He wants to invest for two years, and the two-year bond pays a higher yield, so why not just buy that
one? Thinking further, Russell realises that he could invest his money in a one-year bond and reinvest
the proceeds in another one-year bond when the first bond matures. Whether that strategy will ultimately
earn a higher return than that of simply buying the two-year bond depends on what the yield on a one-
year bond will be one year from now. For example, if the one-year bond rate rises to 4%, Russell will earn
2% in the first year and 4% in the second year, for a grand total of 6% (6.08% after compounding). OverSee the concept explained
step by step on the
CourseMate website.SMArT
CONCEPTS