Yield Curve Risk

What is yield curve risk?

Yield curve risk is the potential for losses on fixed-income investments when market interest rates change and the yield curve shifts. The yield curve plots interest rates (y-axis) against bond maturities (x-axis), typically from short-term bills to long-term bonds. Because bond prices move inversely to yields, changes in the curve alter bond values and can affect portfolio returns.

How it affects investors

• Bond prices fall when yields rise and rise when yields fall. A shift in yields for some maturities but not others changes relative prices across the curve.
• Investment strategies that depend on particular maturities—duration targeting, roll-down returns, or cash-flow matching—are sensitive to curve movements.
• Traders and portfolio managers watch yield-curve shifts to infer economic trends and to position portfolios (e.g., favoring short or long maturities).

Types of yield-curve movements

• Flattening: Short- and long-term yields converge, narrowing the spread. This can indicate slowing growth or lower future inflation expectations. Example: 2-year yield 1.1% and 30-year yield 3.6% (spread 250 bps) move to 0.9% and 3.2% (spread 230 bps).
• Steepening: The spread between long- and short-term yields widens. This often signals stronger growth and rising inflation expectations; long-term yields rise faster than short-term yields. This can hurt long-term bond holders.
• Inversion: Short-term yields exceed long-term yields. An inverted curve often reflects expectations of falling future rates and has historically preceded recessions.

Managing yield curve risk

• Duration management: Shorten duration to reduce sensitivity to rising yields; lengthen if you expect rates to fall.
• Curve positioning: Adjust exposure across maturities (barbell, ladder, bullet) to reflect expected curve shape.
• Hedging: Use interest-rate derivatives (futures, swaps, options) or exchange-traded products that target flattening/steepening to offset adverse moves.
• Diversification and cash management: Combine bonds with other asset classes or maintain liquidity to meet obligations without forced selling.
• Active monitoring: Track spreads and macro indicators that drive curve shifts (inflation, growth, central bank policy).

Key takeaways

• Yield curve risk arises when changes in interest rates across maturities affect bond prices.
• Flattening, steepening, and inversion each convey different economic signals and have distinct implications for bond returns.
• Investors can manage this risk through duration control, curve positioning, hedging, and diversified portfolio construction. Understanding likely curve movements helps in both risk mitigation and potential opportunity capture.