Killik Explains: Fixed Income Basics - the yield curve

in this short video I want to take on a very important aspect of the fixed income security market the yield curve just going to cover the basics so what is the yield curve what can you interpret from its shape and one or two of the sort of pros and cons of relying on yield curve to tell you about what might happen next some investors do so the basics first of all a yield curve links the total return usually the gross Redemption yield or yield to maturity as it's known on bonds of a similar type that's important but with different maturities and the curve can reveal how thick stuck income investors as a group basically see future interest rates are the expected to rise the expected fall and they can also reveal one or two other things as well and in certain situations the yield curve when it inverts is quite a useful early warning indicator of potential trouble ahead as seen by the so called bond vigilantes the bond market investors out there trading fixed income securities on a daily basis so let's take a look at that basically it's do some basics first of all if you had a choice of four bonds from the same issuer and with similar risk characteristics that's quite important so we're comparing apples with apples but differing maturities I've just picked four how would you expect the returns to look and the answer basically is this over time you should be expecting to get a higher return for taking more investment risk in other words if I ask you to lock your money away for 30 years you will expect normally on an annual basis to demand a higher return than you would if I ask you to lock your money away for two years or for five years so broadly speaking the normal situation is you would expect to see yields for bonds don't forget now the same issuer could be UK or the US government similar risk characteristics in terms of likelihood of default and so on but basically you'd expect to see a rising relationship and that's what you normally do see as they call it the normal yield curve shape therefore is something like this if you were to take let's say UK government I use called guilts and look at the total return the yield available on a three month as opposed to a one year as opposed to a five year as opposed to a thirty year you generally expect you connect those dots if you like the shape to be something like that in other words investors are demanding a higher return annually for investing with something like a government over 30 years than they are for investing over say five three months or one year that's the kind of relationship you'd normally expect to see and that would reflect an environment where investors for example thing interest rates in the future are likely to rise or more likely to rise than fall because if you think about it if general rates of interest are going to start rising and you're gonna lock in to something that's got a 30-year maturity with a fixed income this is a fixed income IOU market you're going to want to be rewarded for doing that all right because the income return on that fixed income investment isn't going to change whereas interest rates so rates available on say deposit accounts anything with the variable rate of interest are going to change so in a nutshell you'd expect the price at those longer-dated securities to be a bit lower than shorter dated and that's going to tend to push up the yield hence the shape of the graph now we do see that at the end of at the end of 2014 for example in the US Treasury market the shape isn't quite the same as the one I just sketched but broadly it's you know upward sloping as they call it reflecting the fact that at that point a snapshot point most investors expect an increase in interest rates the timing of which is uncertain rather than a fall and that'll be the normal kind of market expectation so why is it that when you look at a yield curve it's not always that shape and what do the other shapes actually tell you well on the way to what's called an inverted yield curve which as the name suggests is the exact reverse what we've just seen you get sometimes what's called a flat shape so again plotting time and yield if you take just four bonds the shape when you join the lines together comes out more like that maybe not an exactly flat line in other words you've seen at the short end as they call it yield starting to rise and at the long end yields starting to fall that can be an early warning indicator the markets about to invert and as the name suggests there that simply may not be a straight line that's simply where when you join up the dots if you like across different maturities you get that shape that might be more like that shape I have a few kinks in it but the principle is you're seeing lower overall yields on long-dated stuff compared to short-dated all right so what's happening there how could that be well there are several reasons why that can happen but a key one is an expectation of lower interest rates and we have seen this in the relatively recent past why does the yield curve invert well basically if investors in the fixed income bond market expect central banks to cut interest rates suddenly looking at something like a 30-year government-backed fixed income security so you got something there with a 4% fixed coupon that suddenly looks pretty attractive in an environment where other rates of interest of being slashed or cut so investors thinking hey if I lock in to that long maturity fixed income returns where it's backed by a UK US government great I want some of that it's an anticipation for falling interest rates from say central banks investors pile in to the long ended long end of the curve that long dated stuff okay thank you very much I'll take down that course that's the effect of driving up the price and driving down the yield now is it all about interest rate expectations well is heavily driven by industry expectations the shape of the curve tends to be driven by that but there are one or two other factors in play as our highlight in just a moment the curve tends to invert when interest rates are expected to fall tends to be normal when interest rates are expected at some point in the future to rise because no one knows the certain it's bond market investors giving you their view in a snapshot why your codes are useful what other factors could play well there are quite a few actually pension funds and other institutions are hold a lot of say government IO use might decide to have pile into supply and demands important if there's suddenly a rush on pension funds and other institutions to grab longer-dated government backed fixed income securities in order to be able to pay out you know retirement fund pensions and so on that in itself would for example drive up prices at the long end as it's called and drive down yields so that in itself can contribute to it towards what's got an inversion and government intervention you do the same thing depending on how and where governments intervene so QE is a program where central bank's you know by essentially government IO use from their own governments that's going to depending on which ones they go for push up prices drive down yields the Federal Reserve tried to think of Operation Twist where it basically sold short-dated at io u--'s and bought longer-dated in an attempt to move the shape of the curve so government influence is always worth bearing in mind and we've seen increasing amounts of that in the last few years now just final word really on another aspect of yield curves if you can put one yield curve onto a graph why not plot to so you could start with a government yield curve UK us and plot you know three month one year five year in thirty-year and see a nice normal upward slope and then you could put another type of bond on against that over the same timeframe and compare the two what you get is a spread and just a reminder I deal with this in more detail in the video the bigger the gap there the riskier whatever this is the second one is perceived to be against the so-called benchmark bond at the bottom and government IOUs are often used as a benchmark for riskier securities whether that's you know other governments or corporate issuers and so on so that is also worth watching the spread between two yields at different points in time and there's another type of spread that matters too yeah how steep a yield curve is upward sloping is is driven to an extent by how much extra reward investors did for taking the risk of locking into longer-dated securities so essentially the pace of future interest rate rises the expected pace would some extent influence the steepness of the curve and therefore the shape of it and that can be sort of captured in another sort of spread you know comparing the yield gap between say five-year in one year or thirty year and five year so just a bit of jargon there to keep an eye on in two useful ways of interpreting what's going on between different yield curves or different maturities on the same curve usefulness it's all quite useful from an investor's point of view investors use the yield curve first of all as a signal as to our interest rates what might go next and as an indicator the pace of future rises all cuts depending on which one we look you're looking at and that's important for both retail and corporate borrowers because of course what the bond market thinks will happen to interest rates in the future directly affects what could happen to your mortgage rate in the future if you're an individual what can happen to your borrowing rate if you're a company so your curves are pretty key you'll see them quoted fairly often in future videos we can deal with them in more detail but they're all your basics you

Channel: Killik & Co

Views: 51,217

Rating: 4.9208632 out of 5

Keywords: Fixed Income Securities, Bond Markets, Yield Curves, Interest Rates, Inverted Yield Curve, Red Flags

Id: d6_7AhyhjGI

Length: 10min 47sec (647 seconds)

Published: Wed Jan 14 2015