Experienced investors may try to predict how interest rateInterest rate A fee you pay to borrow money. Or, a fee you get to lend it. Often shown as an annual percentage rate, like 5%. Examples: If you get a loan, you pay interest. If you buy a GIC, the bank pays you interest. It uses your money until you need it back.+ read full definition changes will affect bondBond A kind of loan you make to the government or a company. They use the money to run their operations. In turn, you get back a set amount of interest once or twice a year. If you hold bonds until the maturity date, you will get all your money back as well. If you sell…+ read full definition returns. They use tools like yieldYield Your yearly return on an investment. Its often stated as a percentage, such as 5%. With stocks, yield can be your yearly income from dividends. With bonds, its the interest you get.+ read full definition curves and durationDuration Duration is a way to compare bonds with different interest rates and terms. It measures how sensitive a bonds price is to interest rate changes. It is stated in years.+ read full definition 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 curveYield curve A graph that shows how bonds of similar quality pay out different yields over the years.+ read full definition’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-termTerm The period of time that a contract covers. Also, the period of time that an investment pays a set rate of interest.+ read full definition 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 inflationInflation A rise in the cost of goods and services over a set period of time. This means a dollar can buy fewer goods over time. In most cases, inflation is measured by the Consumer Price Index.+ read full definition. 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.
Yield curves can be a useful forecasting tool, but there’s no guarantee that a yield curve – and therefore bond prices – will move the way you expect.