Yield Curve Risk

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Yield curve risk is a type of risk that affects investors who hold fixed-income securities, such as bonds. Fixed-income securities are debt obligations that pay a set rate of interest over a predetermined time period. A fixed-income security's interest rate is decided when it is issued and doesn't change until it matures.

The relationship between interest rates and the maturities of fixed-income assets of the same grade is represented graphically by the yield curve. The yield curve for U.S. Treasury bonds, for instance, displays the interest rates for bonds with maturities ranging from 3 months to 30 years. Depending on how market participants perceive the future course of interest rates and the economy, the yield curve can take on a variety of forms.

The risk associated with the yield curve occurs when it changes in shape as a result of changes in market interest rates. The cost of fixed-income securities changes along with changes in interest rates, although not in the same way or to the same extent. In general, the values of fixed-income securities fluctuate in the opposite direction of interest rates, i.e., when rates rise, values down, and vice versa.

The maturity and duration of the fixed-income security, however, affect how sensitively prices are affected by changes in interest rates. The length of time a fixed-income security takes to recoup its initial investment is measured by its duration. A fixed-income security's price is more susceptible to changes in interest rates the longer it is mature and has been in existence.

There are three main types of yield curve risk: flattening risk, steepening risk, and inversion risk.

• Flattening risk occurs when the yield curve becomes flatter, meaning that the difference between short-term and long-term interest rates decreases. This may occur when long-term interest rates decline more quickly than short-term interest rates or when long-term interest rates rise more rapidly than short-term interest rates. Investors with long-term fixed-income securities are more impacted by the flattening risk than those with short-term fixed-income assets because long-term fixed-income securities depreciate more when interest rates change.
• Steepening risk occurs when the yield curve becomes steeper, meaning that the difference between short-term and long-term interest rates increases. This can occur when long-term interest rates increase more quickly than short-term interest rates or when short-term interest rates decline more quickly than long-term interest rates. Investors who hold short-term fixed-income securities are more impacted by the growing risk than those who own long-term fixed-income securities because short-term fixed-income securities depreciate more quickly in response to changes in interest rates.
• Inversion risk occurs when the yield curve becomes inverted, meaning that short-term interest rates are higher than long-term interest rates. This can occur when market participants anticipate a recession or a slowdown in economic growth, which reduces the demand for long-term fixed-income assets and boosts the demand for short-term fixed-income securities. All investors who own fixed-income securities are subject to inversion risk since an inverted yield curve denotes a poor outlook for the economy and lowers returns on fixed-income investments.

Yield curve risk can be controlled by diversifying the portfolio across various maturities and durations, utilizing derivatives like futures and options to hedge against fluctuations in interest rates, and altering the portfolio's allocation in accordance with the state of the market and expectations.