Yield Curve-Part 1

OK, so you've come up with an asset allocation. You've determined the percentage of assets to put in bonds and the percentage to go into stocks. You've looked at bonds and seen there is a mind-boggling number of choices. There are maturities to think about; and there are types of bonds including Treasury bonds, corporate bonds and agency bonds.

A good first step in thinking about structuring the fixed income portion of the portfolio is to understand the concept of the yield curve. The yield curve is simply a snapshot, at a point in time, of the yields at different maturities on the same class of bonds. The yield curve you will see and work with most often is the Treasury yield curve.

The"Daily Treasury Yield Curve Rates" provides a good source of historical data in tabular form as shown:

CLICK TO ENLARGE As shown, this particular curve shows yields on maturities ranging from 3 months out to 30 years. Typically the yields on shorter maturities are less than on longer maturities. This is because the prices of longer maturity bonds are more volatile than shorter bonds, i.e. more risky and, as we know, investors have to be compensated for taking on additional risk. There are, however, occasions when shorter maturity bond yields are above the longer maturities. This occurs when the Federal Reserve is aggressively fighting inflation by slowing down the economy.

On the other hand, when short maturity rates are considerably below the yields on longer maturities, as it is today, the curve is said to be steep. A good way to track the steepness of the curve is to watch the spread between the 2-year Treasury note and the 10-year Treasury note. As shown in the table, it stands at 213 basis points today ( 2.50 - .37). A good exercise is to track the 2s to 10s spread for the other dates in the table. You may want to click on the "Historical Data" link, go back in time, and see how this spread has been in the more distant past. You'll find today's spread is historically steep. This partially reflects investors' fear that rates will rise. The spread is the compensation that investors get for taking on price risk for buying longer maturities. Bond investors constantly assess whether the additional yield, i.e. spread, compensates for the incremental risk.