Yield to Maturity %

PRUDENTIAL INVESTMENTS MUTUAL FUNDS

FIXED INCOME PRIMER An educational

series for todays investor.
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UNDERSTANDING
YIELD CURVES
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A yield curve is a line graph that illustrates the relationship between the yields
Term to Maturity
and maturities of fixed income securities.

The chart6 below shows aAA

normal yield curve. As you can see, it is upward sloping.
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The longest-maturity
securities offer the highest returns while the shortest maturities
offer the 4lowest returns. This scenario is considered normal because longer-term
securities3 generally bear the greatest investment risks and, as a result, should offer
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higher interest rates. Of course this is not always the case. In addition to a normal,
Term to Maturity: Years
upward sloping curve, a yield curve may also be inverted, or downward sloping, or it
may be humped, as we will discuss later in this paper.

Yield to Maturity %

Yiled

Yield to Maturity %

Yield curve graphs provide a quick way to review and compare the yields that
different types of fixed income securities offer, and to determine investor
expectations for market conditions in the future. They are created by plotting the
yields of different maturities for the same type of bond. The spreads between
the yields9 of different maturities
are what create the slope, or shape, of the yield
Government
curve for8a given type ofAAA
security.

Normal Yield Curve

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Term to Maturity: Years

For illustrative purposes only.

Inverted Yield Curve

TYPES OF YIELD CURVES

prudentialfunds.com

Yield to Maturity %

Ask your financial professional.

a similar maturity, non-US Treasury security should offer adequate compensation for
any additional risks incurred by the investor.

Humped Yield Curve

ld to Maturity %

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FIXED INCOME INVESTING?

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Yield curves
may be created for any type of fixed income security, including
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US Treasury
securities, investment grade and high yield corporate securities,
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global bonds,
and municipal bonds. The yield curve for US Treasury securities is
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considered
a market benchmark, as it is often used as a basic reference point by
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fixed income
investors to evaluate market conditions. It is also used as a benchmark
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to evaluate
the relative attractiveness of investing in non-US Treasury securities. This
1 Treasuries,
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3 in4 theory,
5 have
6 no
7 credit
8 risk,
9 so10the extra
30 yield offered by
is because US
Term to Maturity: Years

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FIXED INCOME PRIMER

The yield curves for corporate securities are more typically

known as credit curves because, unlike yield curves that
plot the yield and maturity of a specific security, credit curves
plot the yields available on a universe of corporate bonds
of a specific credit quality, such as AAA-rated (the highest
investment-grade credit quality) through BBB-rated (the lowest
investment-grade credit quality), as well as for lower quality,
high yield bonds.

Investors can also evaluate spreads from a current vs.

historical standpoint. In other words, lets say the spread
today between a 10-year US Treasury bond vs. a 10-year
AAA-rated corporate bond is +50 basis points. Is that typical?
Perhaps not. Perhaps the spread was only +35 basis points a
year ago. If thats the case, the AAA-rated corporate bond, with
the +50 basis points yield advantage today, looks particularly
attractive.

COMPARING YIELD CURVES

Finally, investors also use yield curves to compare the

relationship between maturities within the same type of
security, such as between two-year and 10-year US Treasury
securities (often called 2s/10s for short). In the above
example, that spread is +175 basis points. (4.25% vs. 6.00%)
Another maturity relationship that is frequently evaluated is
the spread between the ultra-short 3-month US Treasury bill
versus the ultra-long 30-year US Treasury bond. This spread
tells investors whether they are being paid enough in extra
6 to compensate them for the additional interest rate
yield
risks
5 associated with extending maturities within the same
type of security.
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One way to do this is to review the spread, or the difference

in yields between different types of securities. The spread
columns in the chart below show the difference between the
yields on the benchmark US Treasury yield curve and the
AAA- and AA-rated corporate bond curves, respectively.
Investors can use this data to determine if the amount of
spread available today on a AAA- or AA-rated bond offers
enough additional yield over US Treasuries to make the
security an attractive investment.

Yield to Maturity %

Comparing the yield curves of different types of securities can

help investors determine the relative value of a bond and
can also help to create strategies to increase a portfolios total
return. Investors may wish to compare the US Treasury yield
curve against AAA-rated and AA-rated corporate bonds, for
example, to see how much additional yield they could capture
by assuming some credit risk. (See charts below.)

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Term to Maturity

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SPREADS
Govt

AAA

AA

AAA

AA

1 Year

4.00%

4.15%

4.45%

0.15%

0.45%

2 Year

4.25

4.45

4.90

0.20

0.65

3 Year

4.50

4.75

5.20

0.25

5 Year

5.00

5.30

5.90

0.30

10 Year

6.00

6.50

7.25

0.50

1.25

30 Year

7.00

7.70

8.50

0.70

1.50

0.70

Yiled

Yield to Maturity %

US Government vs. AAA-/AA-Rated Credit Curves

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Government
AAA
AA

0.90

Yield to Maturity %

rity %

Term to Maturity: Years

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Normal Yield Curve

For illustrative purposes only.

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Term to Maturity: Years

Inverted Yield Curve

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FIXED INCOME PRIMER
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Finally,
a humped yield curve indicates an expectation of
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higher
rates in the middle of the maturity periods covered,
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perhaps1 reflecting
investor
uncertainty
about
specific
Term to Maturity: Years
Yield to Maturity %

Yield to Maturity %

Inverted Yield Curve

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3 TELLS
4 A STORY
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EVERY1YIELD2 CURVE
Term to
Maturity
The shape of a yield curve provides
valuable
information to

Yield to Maturity %

Yield to Maturity %

economic policies or conditions, or it may reflect a transition

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Each yield curve shape tells a different story. A normal,
of the yield curve from a normal to inverted, or vice versa.
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upward-sloping
yield curve implies that investors expect the
economy
Humped Yield Curve
4 9 to grow in the future, and for this stronger growth to
Government
lead to
and higher interest rates. They will not
8 higher inflation
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3 7 to purchasingAAA
commit
longer-term securities without getting
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6 interest rateAA
a2 higher
than those offered by shorter-term
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6 occurs
7 when
8 central
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securities.
A2normal3 yield4curve 5typically
banks4 (such as the Federal Reserve
the United States) are
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Term toinMaturity
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easing monetary policy, increasing the supply of money and
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the availability of credit in the economy.
0
Term to Maturity: Years

Yield to Maturity %
Yield to Maturity %

A normal yield curve signals that investors expect the economy

to expand. An illustration of this is shown below.
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Normal
Government
AAA

Yield Curve

AA

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Term
to

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An inverted yield curve, on the other hand, occurs when longterm yields fall belowNormal
short-term
yields.
An inverted yield curve
Inverted
Yield
Curve
Yield
Curve
indicates
that investors expect the economy to slow or decline
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6 future, and this slower growth may lead to lower inflation
in 76the
5 5lower interest rates for all maturities. An inverted yield
and
4 4 typically indicates that central banks are tightening
curve
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monetary
policy, limiting the money supply and making credit
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less
available.
An inverted yield curve has often historically been
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a harbinger
of
to
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2 an 3economic
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5recession.
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7Investors
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9are willing
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accept a lower interestTerm
rate now
in return for being locked in for
TermtotoMaturity:
Maturity:Years
Years
years to come. An illustration of this is shown below.

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Inverted Yield Curve

Humped Yield Curve

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Years
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Term to Maturity: Years

Humped Yield Curve

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Term to Maturity: Years

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CONCLUSION

Term to Maturity: Years

Yield
to Maturity
Yield
to Maturity
% %

Yield to Maturity %

investors as to what other investors believe will take place in

the fixed income market in the future.

y%

Yield to Maturity %
Yield to Maturity %

ed

Term to Maturity: Years

Yield curves are created by illustrating the yields for a

particular type of security at different maturities. The US
Treasury yield curve is used as a benchmark to which yield
curves for other types of bonds can be compared. The shape
of the yield curve for a fixed income security reflects market
factors including the direction of interest rates, risk, and
investor demand. Yield curves are widely used by investors
and portfolio managers as a snapshot of market conditions
and to compare different investment options.

FIXED INCOME PRIMER

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