Understanding the Yield Curve

The recent upheavals in the Debt market have left the investors puzzled and frightened about the debt markets. Let us understand some of the basic concept of debt markets.

What is a Yield Curve?

Interest rates typically vary with maturity.

The graph or figure which depicts the yield on bonds of the same credit quality and liquidity against maturity is called a Yield Curve.

Ideally, yield curve should be plotted for bonds that are alike in all respects other than the maturity; but this is extremely difficult in practice. Bonds that have similar risks of default may be different in coupon rates, options etc.

normal yield curve1

The yield curve shown above is a normal yield curve wherein the short term papers fetch lower interest rates and the longer duration papers fetch a higher interest rate. Yield to maturity rises with the term to maturity. The excess of long term yield over short term yield is called “Term Premium”.

Yield curve is typical upward sloping, But it is not always so..

Let’s study the Current Yield Curve of Indian Bonds.

inverted yield curve

The Indian Bonds yield curve clearly shows a different picture. Here the Short term rates are high compared to the long term rates. This situation clearly reflects that there is tight liquidity in the system and also indicates that the tight liquidity has been imposed.

When the Short term rates are high they are expected to fall to normal rates in due course, which provides opportunities for investors to take exposure in the short term papers.

Inverted Yield curve also expects the economic growth to fall and the central bank to ease monetary policy as growth is hurt. Weak growth expectation also brings down or stabilizes inflation expectations.

The Reserve Bank of India has recently tightened liquidity to tame the currency weakness which has resulted into high yields and may impact growth. The Central Bank though intends to continue with liquidity squeeze temporarily, until currency stabilizes and will continue with its soft monetary policy stance to revive growth.

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