Understanding the Fed’s yield curve can impact your bond returns

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The Fed yield curve

Primary portfolio risks for bond portfolios must match their benchmarks for effective portfolio indexing. We’ll discuss each of these risks in an upcoming series, but in order to better understand these risks, we must first consider one of the most important concepts in bond markets: the yield curve.

 

What is the yield curve?

The yield curve is a graph that plots interest rates at different maturities with the same credit quality that can range from a month to 30 years or more. Yield curves are used as benchmarks for other debt in the market, such as lending rates and mortgage rates. Shifts in the yield curve are also used to predict changes in economic output and growth.

Why does the yield curve slope upwardly under normal circumstances?

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The yield curve is normally upward-sloping—that is, investors usually expect a higher return for longer maturities to compensate for the higher risk in holding bonds whose cash flow returns project for a longer period into the future. As cash flows further into the future are more uncertain than nearer-term flows, longer-term yields are usually higher than short-term yields.

The most popular example of the yield curve is the one for U.S. government Treasury securities, giving the yields on T-bills (BIL), Treasury notes (IEF) and Treasury bonds (TLT). Popular ETFs that primarily invest in Treasury securities include the iShares 20+ Year Treasury Bond ETF (TLT) and the iShares 10-20 Year Treasury Bond ETF (TLH). Other Treasury securities that don’t form part of the yield curve include those paying a floating interest rate, called floating-rate notes (or FRNs) and Treasury inflation-protected securities (or TIPS). ETFs providing exposure to FRNs include the iShares Treasury Floating Rate Bond ETF (TFLO). ETFs providing exposure to TIPS include the iShares Treasury Inflation Protected Securities Fund (TIP) and the State Street SPDR Barclays Capital TIPS ETF (IPE).

To learn about some of the risks inherent in fixed income investments, please be sure to read the follow-up Market Realist series to this one, titled “Understanding key risks in fixed income investing,” which we’ll release on April 24. For more key background on investing in fixed income securities, see Market Realist’s Fixed Income ETFs page.

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