Bond Investing 101: Yield Curves

The yield curve is one of the most fundamental concepts of fixed-income investing. In short, it’s a graphical depiction of the yields for bonds (or other fixed-income investments, such as CDs) of varying maturities.

For example, the following is the yield curve for nominal Treasury bonds as of 7/9/12. (Data from Treasury.gov.)

Higher Yields for Longer Duration and Maturity

You’ll notice that the yield curve is sloped upward. That’s typical. In normal (though not all) circumstances, longer-term bonds have higher yields than shorter-term bonds.

And that makes sense. Longer-term bonds tend to carry higher yields because investors demand higher expected return to compensate for the higher risk that comes with longer-term bonds. Specifically, longer-term bonds have:

1. Greater inflation risk (because dramatic inflation is more likely over longer periods than over shorter periods), and
2. Greater interest rate risk (because, as we’ve discussed before, the longer a bond’s duration, the more its price changes as a result of changes in market interest rates).

There’s More Than One Yield Curve

It’s important to understand that there’s a separate yield curve for each type of bond. For example, the following chart includes the yield curve for AA-rated corporate bonds as well as the yield curve for nominal Treasury bonds. (Data for corporate bonds is from Yahoo Finance as of 7/9/12.)

As you can see, the yield curve for AA-rated corporate bonds is also upward-sloping (again, because longer-term bonds have higher risk than shorter-term bonds). You’ll also notice that the yield for AA-rated corporate bonds of each maturity is greater than the yield for Treasury bonds of that maturity. That’s because corporate bonds have greater credit risk, so investors demand a higher yield.

And as you would expect, corporate bonds of other credit ratings have their own yield curves, as do TIPS and tax-exempt muni bonds.

Yield Curve for TIPS

Personally, I find the yield curve for TIPS (and Larry Swedroe’s related monthly articles) to be of particular interest. Unlike with other bonds, going farther out on the yield curve with TIPS (that is, buying longer-term TIPS) doesn’t mean taking on a great deal of inflation risk. And if you expect to hold the TIPS until maturity, the interest rate risk isn’t a particularly large problem either.

As a result, when yields on long-term TIPS are high, it can make sense for certain investors to shift their allocations toward them. For example, if, based on the TIPS yield curve at a given time, an investor can meet all of her retirement goals with very little risk by moving most of her portfolio to long-term TIPS, I think it can be entirely reasonable to do so.

In my opinion, this is meaningfully different from other strategies that often get lumped into the category of “market timing” because it doesn’t rely on any predictions at all. It’s simply an understanding that, as William Bernstein puts it, “If you’ve already won the game, there’s no need to continue playing.”