The yield curve is a graph that plots the interest rates of bonds having equal credit quality but different maturity dates. It shows the relationship between bond yields and bond maturities. Read on to find out more.
What does the yield curve show?
The shape of the yield curve provides important information about market expectations of economic growth, inflation, and interest rate movements. There are three main types of yield curves:
- Normal/Positive yield curve
Long-term bonds have higher yields than short-term bonds. This indicates that the central bank is expected to raise interest rates in the future. It is the typical shape during economic expansion.
- Inverted yield curve
Short-term bonds have higher yields than long-term bonds. This implies that the central bank will likely cut interest rates in the future. It often precedes an economic recession.
- Flat yield curve
Short and long-term bonds have nearly equal yields. This means the central bank is expected to keep interest rates steady. It typically occurs during periods of economic uncertainty.
Debt fund managers aim to exploit the yield curve to generate higher returns for investors. Based on their assessment of the yield curve and economic outlook, fund managers invest in debt securities of different maturities: When the yield curve is normal/positive, managers tend to invest more in long-term bonds while keeping some mix of short-term bonds. This “barbell” strategy captures higher yields at both ends. Conversely, when the yield curve is inverted, managers will shift more towards short-term bonds that offer higher yields currently. They reduce exposure to long-term bonds.
During a flat yield curve scenario, managers will maintain a balanced portfolio of short, medium and long-term debt instruments.
Depending on their investment strategy and flexibility, debt funds are categorised as:
- Dynamic bond funds
They actively manage maturity durations based on the yield curve and economic conditions. They aim to maximize returns within risk limits.
- Target maturity funds
They invest in debt securities with maturity periods matching the fund’s target tenure. For example, a 2025 target maturity fund. This strategy reduces interest rate risk for investors.
- Fixed maturity plans
They offer a fixed maturity date (3-5 years) when the entire corpus is returned to investors. They have very low volatility but offer limited flexibility.
Debt fund managers analyze the yield curve and economic factors to allocate mutual funds across different maturity periods and instruments. Taking a dynamic, target, or fixed maturity approach based on the fund’s objective and strategy. This helps them manage interest rates and reinvestment risks while generating optimal returns for investors. The yield curve remains a crucial indicator for debt fund managers to study and position their portfolios accordingly. Investors need to understand the funds’ strategies to select the ones matching their goals and risk profiles.