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Yield curve is a graphical representation of interest rates of all bonds with same credit quality but with different maturities. Yield is presented on the vertical axis while maturity dates are presented on the horizontal axis, which gives you a term structure of interest rates.
Yield curve usually compares interest rates on 3 months, 2 years, 5 years and 30 years securities, enabling investors to compare yields offered by short-term, medium-term and long-term bonds.
Yield curve can form three different shapes, normal (or positive) yield curve, flat yield curve and negative (or inverted) yield curve.
-Normal yield curve shows that interest rates are growing in correlation with maturity dates, which is normal market behavior, because longer maturities should have higher interest rates due to risk associated with time.
-Flat yield curve shows that short-term and long-term bonds have offer similar interest rates, which is a sign of economic transition and investors’ uncertainty about interest rates direction.
-Negative or inverted yield curve shows that interest rates on short-term bonds are higher than those on long-term bonds, which can be a sign of economic recession.
In order for yield curve to be a benchmark for other interest rates on the market, it is important to represent only bonds of similar risk. Most common used yield curve is the one that represents interest rates on Treasury securities with different maturity dates because these bonds are considered low-risk and can be used to determine the yields on other securities.