In bonds, a simple visual is helpful. Below is an illustration of what the slope of a normal U.S. Treasury Bond Yield Curve would look like.
- Bonds are debt securities. It means when you “buy” a bond, you are really loaning money to the issuer (in this case, the U.S. Treasury) with the promise of payment in return. When you buy a house, the bank issues you a mortgage with a term of 15 or 30 years. During that term, you pay interest to the bank. In the case of bonds, you are the bank receiving interest until the bond “matures.” Unlike a home mortgage where principal is paid throughout the loan term, you won’t get your principal back until the date of maturity (unless you sell it sooner).
- The time frames referenced in the above graph (3 months, 1 year, etc) are the maturity dates of the various bonds issued by the U.S. Treasury. If on 12/31/19 you buy a 2-year bond for $10,000, you will receive interest in June and December for the next two years and then your $10,000 back on 12/31/21.
- The yield curve refers to the blue line that connects the yields (or interest rates) as plotted on the graph. It makes sense for long bonds (those maturing sometime in the distant future) to yield a higher rate of interest than short bonds (those maturing in the near future). Why? Because if you tie up your money in a bond for 30 years, you expect to be compensated for it. You’ve taken on more risk, since any number of things could occur in your personal life or the economy in 30 years’ time.
It is important to realize that the bond market is rarely a perfect slope like our illustration above, and the points on the yield curve change every single day for a variety of reasons. There are even periods of time, such as in 2019, where the yield curve is inverted. An inverted yield curve refers to longer yields falling below shorter yields. For more about why yields are inverted in 2019, see our article titled, “Backwards Bonds: What’s Happening in the U.S. Bond Market?”