Why investors should follow shifts and twists in the yield curve
Shifts and twists in the yield curve
Yields on bonds don’t remain constant. When they change by the same magnitude across maturities, we call the change a “parallel shift.” When they change in different magnitudes across maturities, we call the change a “non-parallel twist or shift.”
When the different between yields of short-term (BIL) and long-term (TLT) bonds decrease, we call the change a “flattening of the curve.” On the contrary, when the difference increases, we call it a “steepening of the curve.” In flattening and steepening, the yields across maturities don’t change by equal magnitudes.
Another type of shift is the change in the curvature of the yield curve. In butterfly shifts, the magnitude of change in the yield of short-term (BIL) and long-term (TLT) bonds is higher or lower than the magnitude of change for intermediate-term (IEF) bonds.
When the short- and long-term yields increase by greater magnitude than intermediate-term yields, we call the change a “positive butterfly yield.” When short- and long-term yields decrease by a greater magnitude than intermediate-term yields, we call the change a “negative butterfly shift.”
The shifts and twists also affect investment-grade corporate bonds (LQD) and high-yield bonds (HYG), as the yield on these bonds is nothing but the yield on corresponding Treasury bonds plus a credit spread to compensate for the credit risk associated with these bonds.
While the yield curve is normally upward-sloping, the shifts and twists cause the yield curve to take different shapes under special conditions. In the next parts of this series, we’ll discuss the shapes a yield curve can take and the implications for fixed income and ETF investors.