Interest rates affect the cost of your mortgage and credit cards, how much your savings grow, and the value of any bonds you hold. They also can influence growth in the overall economy. Interest rates are important in setting bond prices because changes in interest rates strongly influence changes in bond prices.
Generally, there is an inverse relationship between interest rate changes and bond prices. In other words, if interest rates rise, bond prices usually fall — and vice versa. But interest rates don’t have a uniform effect on all bonds. The relationship between interest rates and bonds often varies by a bond’s maturity, or holding, period.
So, you might wonder whether there is any indicator that can shed some light on this interest-rate-to-maturity relationship? Yes, there is.
Turn on any financial or business news channel, and you’ll likely see economists and market analysts talk about the Treasury Yield Curve when discussing bonds and interest rates. This tool can be found on the Treasury’s website, and is very handy for following interest rates in one simple graph.
The Treasury Yield Curve shows the key Treasury bond data points for a trading day, with interest rates running up the vertical axis and bond maturity running along the horizontal axis.
A typical yield curve is upward sloping, meaning that bonds with longer holding periods carry higher yields. That’s because under ordinary market conditions, bonds with longer maturities pay investors more for taking on the greater risk that interest rates may change.
In the hypothetical yield curve above, interest rates, and also the yield, increase as the maturity or holding period increases — the yield on the 30-day T-bill is 2.55 percent, compared to 4.80 percent for a 20-year Treasury bond — but not by much. When an upward-sloping yield curve is relatively flat, it means the difference between an investor’s return from a short-term bond and the return from a long-term bond is minimal.
In this scenario, investors would want to weigh the risk of holding a long-term bond that pays only a moderately higher interest rate than a shorter-term bond. Remember, the rule of thumb with bonds is that when interest rates increase bond prices fall — and conversely, when rates fall, bond prices rise.
As in the example above, interest rate risk comes into play. It’s the risk that changes in interest rates in the U.S. and the world might reduce (or increase) the market value of a bond you hold. Interest rate risk increases the longer you hold a bond.
The monetary policy of the Federal Reserve, or what investors expect the Fed to do, as well as economic conditions, can determine the shape of the yield curve, whether it’s flatter or steeper. A flat positive yield curve means there is little difference between short-term and long-term interest rates. This is usually a sign that investors expect the economy to grow without inflationary pressures.
Sometimes economic conditions and expectations create a yield curve with different features. For instance, an inverted yield curve slopes downward instead of up. When this happens, short-term bonds pay more than long-term bonds. Yield curve watchers generally read this as a sign that interest rates may decline. Long-term bond investors want to lock in the lower rates before they drop even further.
Inverted yield curves, though rare, are usually a sign that the economy is slowing down and perhaps could fall into recession.
The Treasury Department provides daily Treasury Yield Curve rates, which you can use to plot the yield curve for that day. For more information on interest rates and bond investing, visit the Investor section of FINRA.org.
FINRA is the largest independent regulator for all securities firms doing business in the United States. Its chief role is to protect investors by maintaining the fairness of the U.S. capital markets.