Fixed Income 101: Understanding yield curves

Yield curves are an important concept for any fixed income portfolio manager.

In the simplest terms, a yield curve is a line graph plotting the market-implied yield a bond issuer is expected to pay for borrowing at different maturities, for debt of the same type and credit quality.

However, because the shape of the curve provides insight into market expectations regarding the economy, monetary policy, and broader financial conditions, they can be a valuable input for asset allocation decisions.

What is a yield curve?

A yield curve can be plotted for any bond issuer with the same type of debt outstanding at different maturities.

However, because the yields on credit assets such as corporate bonds are effectively determined by adding a credit spread on top of a benchmark government bond, it is the shape of government bond yield curves that generate the most discussion in fixed income markets. If you hear a fund manager refer to the yield curve, they will most likely be talking about major government bond markets such as US Treasuries (USTs), German Bunds or UK Gilts.

Exhibit 1 shows the UST curve as of April 2026. On the y-axis is yield-to-maturity (YTM), which from an investor standpoint is the annual return they can expect to receive by buying a bond at its current yield and holding it to maturity, regardless of any fluctuations in the bond’s price in between (YTM also assumes coupons are re-invested at the same yield).

The shape of the yield curve is determined by the difference between shorter term and longer term yields, as this determines the steepness of the curve. Short end yields (roughly 0-5 years) are heavily influenced by market expectations for near-term changes in the policy rate, while at the long end (roughly 10+ years), inflation and growth projections, and how these will impact the policy rate in the future, take over as the dominant factors.

But higher long-dated yields are not just a function of expected future policy rates, which is where term premium comes in.

Term premium drives long end yields

Term premium can be tricky to define and quantify, but it is essentially the extra yield required to compensate investors for buying a 10-year bond, for example, as opposed to buying a one-year bond and rolling that investment into a new one-year bond for 10 consecutive years.

Put another way, term premium is the extra yield investors demand for holding longer dated bonds over and above what can be explained by rate expectations. 

Several factors can influence the level of term premium observed in the market:

Inflation – It is difficult to predict both the level and volatility of inflation in the future, so investors require compensation for the risk that inflation will lower bond prices (and thus increase yields) down the line.

Hedging value – Term premium tends to be higher when stocks are more correlated with bonds, because the ability of government bonds to hedge against risk asset downturns is reduced.

Supply-demand dynamics – Heavy government bond issuance can push term premium higher, a factor that has become increasingly relevant in the post-quantitative easing era now government demand has become more price sensitive. 

Opportunity cost and liquidity – Investors can require some level of compensation for the opportunity cost of investing elsewhere, or for the lower liquidity offered in longer dated bonds versus shorter dated bonds.

Yield curve shapes

Normal

A “normal” yield curve is upward sloping (as in the UST curve in Exhibit 1) because investors demand a higher return for lending money over longer periods. This is typically seen during periods of healthy economic expansion, when solid GDP growth and rising inflation lead market participants to expect higher policy rates in the future.

Inverted 

An inverted curve occurs when short end yields are higher than long end yields. This typically happens when central banks raise policy rates aggressively to combat inflation, pushing up short end yields, while markets expect growth and inflation to slow in the future, putting downward pressure on long end yields as investors price in future rate cuts. In addition, investors may want to hold longer dated government bonds as a potential hedge against an economic downturn, with this demand further compressing long end yields. Curve inversions, especially between two-year and 10-year USTs, are closely watched given they have often preceded a recession in relatively short order. 

Flat  

A flat curve is when yields across maturities are similar and generally depicts an economy in transition with market uncertainty about the outlook. This often appears late in a policy rate hiking cycle when a central bank has started to raise rates, but similar long end yields reflect the expectation that tighter monetary policy will eventually slow the economy and bring inflation down.

Humped

Humped yield curves are rare and occur when medium term yields are greater than both short and long end yields. The bell-like shape usually implies an economic shift is happening or that market uncertainty is high. Technical factors such as heavy issuance or hedging activity in certain maturities can also play a role.

Shifts in the yield curve

Yield curves change shape as market sentiment and expectations evolve.

These moves are described as a “flattening” when the spread between long end yields and short end yields narrows, and a “steepening” when it widens. However, they are described as “bull” or “bear” moves depending on whether yields are falling or rising overall.

In a bull flattening long end yields fall more than short end yields, often signifying falling inflation expectations or a weaker growth outlook that prompts investors to seek the safety of government bonds. A bear flattening occurs when short end yields rise more than long end yields, which often occurs when investors price in or bring forward expected rate hikes. 

A bull steepening on the other hand occurs when short end yields fall more than long end yields, typically when markets price in rate cuts. A bear steepening occurs when long end yields rise more than short end yields, which could point to higher inflation expectations, fiscal concerns or rising term premium.

Why yield curves matter

From a portfolio management perspective, the shape of the yield curve, or any changes in its shape, can be a crucial forward-looking indicator of the state of the economy and the market’s assumptions about the future.

Importantly, because underlying government bond yields are such a key component of the yields in credit markets, the shape of yield curves can also influence where on the curve (i.e. at what sort of maturity) a portfolio manager might want to concentrate their credit exposure.

When curves are steeper, for example, investors are better compensated for moving out along the curve and taking on more credit duration. When curves are flatter, the extra yield gained by taking on that duration might be less compelling.

Ultimately, yield curve shape is one indicator in a sea of data points investors might use for evaluating market conditions, but it is a window into broader market sentiment and the expectations that are priced into bond markets. Whether a portfolio manager’s view aligns with these or not can be a valuable input for asset allocation decisions.