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What the yield curve tells us about rate changes

There is not just one interest rate, but rather bonds of different maturities pay different rates, creating a term structure of interest rates, which is shown as a yield curve. The level and shape of this curve depend on a variety of factors, including the outlook for monetary policy, the economy, inflation, and Treasury supply and demand. This yield curve serves as an important benchmark for valuing many other types of bonds, including corporate bonds, mortgage-backed securities, high yield bonds, loans, etc. The yield curve is typically upward sloping, indicating a higher yield demanded by investors for tying up capital in longer maturity bonds.

What the curve may mean for returns
An important implication of this upward slope is that longer bonds offer a yield cushion to help protect against rising rates. The steeper the slope, the greater the protection offered against rising rates. For example, on June 8, 2015, 1-year and 5-year Treasuries had yields of 0.34% and 1.75%, respectively. The extra yield offered by the 5-year Treasury is sufficient to protect against a yield rise of 36 basis points over the next year. In particular, if the yield of the 5-year Treasury rises less than 36 basis points, then that security will generate a higher one-year return; if it rises more, the 1-year Treasury will generate a higher one-year return.

What the market expects for rate changes
Looking at the chart above, as of the June 8, the yield curve was steeply upward sloping out to a maturity of five years, and then has a shallower slope. One interpretation is that investors expect a rather significant increase in short-term rates without a corresponding increase in long-term rates.


Interest-rate changes and bond math

Rising rates mean falling bond prices, but that doesn't necessarily mean negative returns. The results will depend on price and income changes, and vary depending on the magnitude of rate changes and different types of bonds. The table below shows how income and price changes might hypothetically play out with three different rate changes, for a variety of different bonds.