Experienced investors may try to predict how interest rate changes will affect bond returns. They use tools like yield curves and duration to help make these predictions and to decide when to hold bonds and when to sell.
Yield curves are graphs that show the yields for different maturities of a particular bond, for example, Government of Canada bonds. A yield curve’s shape, steepness and interest rate levels can indicate what direction the economy and interest rates are heading in.
3 main yield curves
Normal (or positive) yield curve
Under normal conditions, the yield curve slopes upward to the right. This is because long-term bonds pay higher yields than short-term bonds. When the yield curve is positive, the economy is considered to be healthy.
Flat yield curve
There is little difference between short-term and long-term yields. This can happen when short-terms rates are rising as long-term rates are falling. For example, a government’s central bank may increase short-term rates to slow inflation. At the same time, yields on long-term bonds may fall because of lower expectations for inflation and economic growth. A flat yield curve can indicate that the economy is in transition and is weakening.
Inverted (or negative) yield curve
The yield curve slopes downward to the right. This happens when short-term yields rise above long-term yields, for example, after a series of hikes in short-term interest rates to curb inflation. Investors receive a greater reward for investing in short-term bonds, and lenders are less willing to make long-term loans. This can lead to an economic slowdown or recession.
Duration is a way to compare bonds with different interest rates and terms. It measures how sensitive a bond’s price is to interest rate changes. It is stated in years.
With long-term bonds, duration gives an indication of what will happen to bond prices over the years, in case an investor wants to sell early.
Example – A bond with a 5-year duration will decrease 5% in price with each 1% increase in interest rates. The same bond will increase 5% in price with each 1% decrease in interest rates.