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Bond Basics: How to Read the Yield Curve

This lesson was written by Stockpickr member Ira Krakow.

If you did the homework assignment in "The Basics of Bond-Picking: Pricing and Quotes," you would have discovered that, in general, the yield to maturity of a bond increases as the maturity date goes farther into the future.

In a normal situation, you should be paid more interest when you hold a bond for a longer a period of time. Why? You're taking the risk that bond prices could fall (which means interest rates could rise), over a longer period of time.

So what is the often discussed "yield curve" all about?

The yield curve is simply a graph of the relationship between interest rates and maturity dates. Here's the current Treasury yield curve, from Bloomberg:

Click here for larger image.

When bond yields are increasing over time, the yield curve is said to be "normal." Even though there are a lot of things that aren't normal in the financial markets these days, one thing that is normal right now is the Treasury yield curve, because yields steadily increase as the maturity date lengthens.

According to the Daily Treasury Yield Curve Table, as of June 11, 2008, the yield to maturity on 2-year Treasuries was 2.83%, increasing to 3.49%, 4.10%, 4.76%, and 4.72% for 5, 10, 20 and 30-year Treasuries, respectively.

As an investor in the stock market, why should you care about the yield curve?

The reason is that the yield curve theoretically tells us whether the market is expecting economic growth, stagnation or a slowdown.

A normal yield curve should be good for the stock market. If the economy is growing, bond investors expect accompanying inflation, which increases the risk of higher interest rates. Bond investors expect to be rewarded more, in the form of higher yield, for taking on this risk. They're betting that the Federal Reserve will raise interest rates to control inflation.

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