Financial analysts who closely watch interest rates will frequently develop a chart comparing the rate of return for various instruments on one axis and the time to maturity on another axis. The rate of return, or yield, of the investment will vary inversely with the price of the security. When bond prices go up, the yield goes down, and vice versa. By graphing yield rates for various times to maturity, analysts can compare the relative value that investors are placing on short term versus long term investments in those bonds.
Under normal conditions, the yield curve for treasury bonds is upward-sloping from short term to long term maturity, with the slope of the curve flattening out in the long term. There are various academic theories for why the yield curve normally slopes upward. Under one theory, the yields of long term bonds are higher because those investors demand a premium to compensate for the potential that rates will increase over the term of the security. So if an investor is willing to accept a 1% (annualized) yield on a 3-month maturity, that same investor will demand a higher yield, such as 4% or more, on a maturity that will occur five or ten years down the road. Under this theory the higher rates for longer terms reflect the fact that those investors believe that if they are willing to lock away money for a longer period they can expect a higher return.
A second theory for why rates are higher for long term investments focuses on the risk of default. If an investor buys a bond today and plans to hold it only for three months, there tends to be a very slight chance that the backer (the government, in the case of treasury bonds) will default in that time. But the same might not be true for a bond that will not mature for many years. An investor buying a bond that will not mature until ten or more years down the road will normally factor in a risk of default between the purchase date and the maturity date, and will expect to be compensated for that risk.
Under unusual financial conditions, the normal yield curve can change shape to being flat or even inverted. An inverted curve shows lower yields on longer term maturity. Analysts have noted a correlation between periods of inverted yield curves and economic slowdowns or recessions. The exact link is unclear, but the inverted yield curve might reflect great uncertainty on the part of investors: as they collectively sense economic turmoil ahead, they flock to longer term debt instruments for longer stability to ride out the storm. This increased demand for long term instruments raises their market price, driving down their yields. Or at least, that’s the theory.
The next time you hear that they treasury yield curve is flattening or inverted, know that this means that the normal ordering of the financial markets that keeps longer term maturities worth slightly less than shorter term maturities is breaking down. While that need not be a signal to abandon any particular investment, it is a signal that normal rules of finance and investment might not apply for the immediate future, and investors should tread cautiously.