By Niranjan Avasthi

After the pandemic, which crippled the economy, there is another concern among market experts. It is: interest rates are rising too soon. Also, globally, financial markets have turned volatile with every small change in bond yields. This development is likely to bring about a definite change in the way businesses will be done. Besides this, investors will have to change their approach in investing. Small-sized investors do not get bogged down by changes in interest rates in the economy. Rather investors use change in interest rates to their advantage. This idea is captured well in Yield Curve. Let us understand Yield Curve to gain from any change in interest rates:

When an investor lends money for a long tenure, she is willing to forego her immediate consumption needs for a long period. The risk of default (credit risk) is also higher in the long-term, compared to short-term. Also, when one locks-in his or her money for long tenure, she is exposed to the risk of changes in interest rates. All this leads to investors asking for higher rate of interest as compared to rates demanded for shorter tenure. No wonder, most of the time, yield curve is moving upwards. As you may be aware that the rate of interest offered on a ten-year bond (or a fixed deposit) is generally higher than the rate of interest offered on a bond (or a fixed deposit) maturing the next year.

But due to changes in macro-economic factors yield-curve structure keeps changing. These changes are used by wise investors to predict the future growth in the economy and the stock markets. There are four types of yield curves:

1. A normal upward sloping yield curve

2. A steep yield curve

3. An inverted yield curve

4. A flat yield curve

A normal upward sloping yield curve, which we discussed earlier, with low yields on lower maturity bonds and high yields on higher maturity bonds indicate stable economic conditions and reasonable economic growth rates.

A steep yield curve prima facie resembles a normal yield curve. But an expert can figure out the steepness. Put simply, difference between the short term yields and long term yields can be higher than the usual. For example, in a normal upward sloping yield curve such difference between one year bond yield and 10 year bond yield is one percentage point, then in case of steep yield curve, it can be 2 percentage point or more.

Steep yield curve implies a growing economy moving towards a positive upturn and high growth rates. Such periods may also be accompanied by higher inflation, which often results in higher interest rates. In some cases the expectation of central bank, Reserve Bank of India, hiking the policy rates to contain inflation in the economy.

A flat yield curve has almost same yields for bonds maturing at various points in time. Some intermittent maturities may have higher or lower yields. A flat yield curve implies an uncertain economic situation. If things are uncertain then investors demand similar yields across any maturity, as they sense high risk involved. Such a situation may be an outcome of a prolonged period of high economic growth and high inflation and investors may be anticipating a slowdown in the economy.  Inverted yield curve is a rare situation. It occurs when the economy is staring at recession. Inverted yield curve has high rate of interest on shorter-maturity bonds compared to longer maturity bonds. As the name suggests, it is exactly opposite of the normal upward sloping yield curve.

Yield curve and asset allocation

While your risk profile and your financial goals should dictate your asset allocation, some tactical allocation can help either reduce risk or to enhance returns. Such tactical calls can be based on the type of a yield curve. If you see an inverted or a flat yield curve, then it is a good time to allocate more to debt and as the yield curve reverts to ‘normalcy’, then you can consider gradual movement to equities.

Yield curves and stocks

If you see a normal yield curve, then you are anticipating a growing economy, and you should make the most of it by investing in an aggressive portfolio. However, if you come across a flat or an inverted yield curve, then it is time to build a defensive equity portfolio.

Yield curves and bonds

In case of an inverted yield curve, investors are better off investing in short term bonds. In case of normal yield curve, the investors are better off investing in long term bonds to pocket higher yields. However, while investing in long tenured bonds, the investors have to keep in mind their cash-flow needs and financial goals. Ideally, investors should match their investment time frame with the maturity of the bonds. For example, if an investor wants money three years from now to pay for a down payment of his car purchase, then he should ideally invest in a bond maturing three years from now.

Holding a bond till maturity also nullifies the mark-to-market impact on the bond price in an interim period. Instead of investing all your money in one bond, it makes sense to invest in a portfolio of high-quality bonds. Target maturity funds invest in high-quality bonds maturing at various dates in future. Hence, it is important that you select a bond which suits your needs. This will help you take advantage of favourable movements shown in reflected in a Yield Curve.

(Niranjan Avasthi is the Head- Product, Marketing & Deigital Business at Edelweiss MF. Views expressed are the author’s own. Please consult your financial advisor before investing) 

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