A yield curve is a graphical representation of where interest rates are today for bonds of different maturities. As economies experience expansion and contraction, interests rates will rise and fall accordingly. These overall movements are captured by a yield curve which gives us a view of general yield trends. Yield curves are constructed using bonds that have a wide range of maturities and similar credit risks, and which are from a single government or corporation. It is then constructed by plotting the yield to maturity against the respective time to maturity figures.

Bond investors normally use yield curves to forecast the future trends in bond yields. Yield curve provide investors with a graphical view of the bonds yields with respect to the maturities date. Usually, long-term bonds have higher yields than that of short-term bonds. This is because they are exposed to more market volatility and price fluctuations prior to maturity as a result of changes in interest rates. Long-term bond investors are therefore compensated with higher yields in return for the greater risk exposure and uncertainties.

Yield curves can exist in 4 different shapes. Each shape reveals the current expectation of the future economic outlook. From time to time, when the economy is going through periods of growth or recession, the yield curve responds to economic cycles by taking on different shapes to take account of changes in interest rates. Let's take a look now at the different types of yield curves and what it means to us.

Normal Yield Curve

A normal yield curve exists in an economic environment where the economy is expected to post normal rates of growth without significant changes in inflation rates. The main characteristic will be that the yield curve tends to slope gently upwards. During this period of time, investors can expect a higher rate of return if they are willing to invest their money for longer periods. As maturities lengthen, interest rates will get progressively higher and the curve goes up. Looking at the normal yield curve below as an example, you could lock in an investment for the next 5 years for an annual return of 4%. For a 10-year bond, you will be looking at a yield of 5.5%.

Inverted Yield Curve

The inverted yield curve may seem a little unbelievable when you first look at it. From investors' point of view, it seems that short-term bonds offer yields that are higher than long-term bonds. If that is the case, there will be a high demand for short-term bonds as they are more attractive. Such a situation does happen, but is pretty rare. Usually, such a curve is formed at the peak of an economic cycle where interest rates are at its highest level. While long-term rates stay low, short-term rates are expected to decline to the same level as the long-term rates or go lower. This could be an indication of an economic slow down or approaching recession.

Humped or Flat Yield Curve

In order for a normal yield curve to become inverted, it must pass through a transitional phase where the long-term yields are the same as short-term yields, before it drops and forms an inverted curve. When that happens, the yield curve might appear a little humped in the middle and eventually flatten out as short-term interest rates fall. This transformation does not occur overnight, but over a couple of months as the normal yield curve slowly converts itself into an inverted curve and back again. As a result, the yields for long-term bonds will be approximately the same as the yields for short-term bonds. However, such a scenario is unlikely to hold for long, because it is meaningless to invest in long-term bonds that yield the same return as short-term bonds. Chances are that the humped yield curve will then straighten out as a flat yield curve before correcting itself into a normal yield curve.

In essence, yield curves give us a quick overall picture of the expected future trends in bond returns. As they are plotted based on the different yield returns and maturities, you could, by looking at one, examine what are the yields you ought to be getting with regards to the various holding periods.