Yield curve analysis involves the measurement of differences in interest rates between notes that have a different term to maturity. To evaluate the term to maturity effect, one examines the same issuer (for example, U.S. Treasury bills) with various debt notes and maturity. The typical yield curve is upward sloping, meaning short term to maturity notes have low interest rates and longer term to maturity notes have higher interest rates. Of course, one strategy to maximize investment return would be to invest in the longer term, higher yielding notes. This strategy presumes there are no immediate liquidity needs and that the shape and level of the yield curve will not change. In fact, the shape and level of the yield curve itself can be used to develop an interest rate forecast using an expectations theory model. This theory as it applies to yield curve analysis states that the interest rate for a longer time period is a product of the interest rates for the total of the shorter time intervals that comprise the longer time period. The increase in investment yield with the longer term notes is not present if the yield curve shape is flat (same rate for all maturities), downward sloping (short-term notes have high interest rates whereas long term notes have low rates) and humped (a combination upward sloping and flat) yield curve.
Another aspect of yield curve analysis is the comparison of yields between issuers of a different quality (determined by bond ratings) or sector (for example, corporates versus federal government). The spread (difference) between the two issuers may vary by term to maturity. Opportunities to earn higher returns may occur when the spread between the notes is not the normal amount. For example, the spread between the 91-day U.S. Treasury bill and 3-month bank certificates of deposit (CD) usually is about 40 basis points (0.40 percent). If the present spread is 70 basis points that would favor investment in CDs, whereas a spread of 15 basis points would tilt the advantage towards U.S. Treasury bills. The spread between the two issuers will vary with other term to maturity comparisons causing a more complicated investment strategy to be employed.
Another yield curve strategy is "riding the yield curve." This technique is the most profitable with upward sloping yield curves. The investors acquire a longer term to maturity debt note than their planned holding period, and sell the debt note at the date when they had initially desired to cash out. The reason for doing so is to earn a higher interest rate on the longer term note at purchase plus a capital gain on the sale of the higher return note. The end result is a higher total investment return.
[ Raymond A. K. Cox ]
Cox, Raymond A. K., and Daniel E. Vetter. "Money Market Returns and Risk, 1938-1989." Journal of Midwest Finance 22 (1993): 50-54.
——, and James M. Felton. "Performance from Riding the Yield Curve, 1980-1992." Journal of Business and Economic Perspectives 20 (1994): 128-32.