Key takeaways: Why is the yield curve normally upward-sloping?

Upward sloping yield curve

In normal conditions, the yield curve is upward-sloping. As bonds pay only interest (the coupon) until maturity and pay face value at maturity, investors take longer to recover their principal. The longer time to recover the principal leads to a higher risk to bondholders, as the bonds become more susceptible to interest rate changes than shorter-term bonds. The added risk prompts investors to seek higher returns from longer-term bonds, leading to an upward-sloping yield curve, just like the current Treasury yield curve.

The Fed has maintained an extremely low short-term interest rate regimen since 2008 to boost consumption, investments, and economic growth. While short-term rates are low, yields are exhibiting an increasing trend with maturity. So yields on longer-term Treasuries (TLT) are higher than intermediate-term (IEF) yields, which are in turn greater than yields on T-bills (BIL).

The normal upward-sloping yield curve follows the “Liquidity Preference Theory,” which suggests that investors wish to be compensated for holding longer-term securities.

Investor takeaways

As an upward-sloping yield curve is normal, the arbitrage opportunities it offers are limited. If a recession is on the anvil, the rates across maturities may drop, resulting in a downward shift in the yield curve. This movement of the yield curve would benefit investors, as bond prices rise with falling yields. During a recession, investors should stay away from high yield bonds (HYG), as the credit risk associated with these bonds is generally higher during a recession.

When the economy is expanding, investors risk a rise in yields as the Fed increases interest rates in response to rising inflationary pressures. In a rising economy, the credit spreads on high yield bonds (HYG) and investment-grade bonds (LQD) contract. Investors in corporate bonds should carefully gauge the positives of a contracting credit spread and the negatives of a rising interest rate to make an informed investment decision in this scenario.

To learn about the flat yield curve, read on to the next part of this series.