Question

Discuss the yield curve and explain how it applies to the yield to maturity (YTM) of short and long-term bonds. Explain what causes an inverted yield curve and the impact that it has on bonds prices. Explain how investors can lose money investing in U.S. Treasury Bonds.

Please be detailed, Thank you

Answer 1

Yield curve and the yield to maturity (YTM)

In a yield curve, the yield that is the interest rates of bonds with equal credit quality but with different maturity dates are plotted. The time to maturity is plotted on the x-axis and the yield to maturity is plotted on the y-axis of the graph.

In a normal yield curve the low yields are for shorter maturity bonds and high yields are for bonds with longer maturity. A normal yield curve slopes upwards. When the bonds reach the highest maturities, the yield curve flattens and remains consistent. Long-term bonds have a higher YTM than shorter-term bonds.

Inverted yield curve

Other than normal yield curve, there can be an inverted yield curve. It is a curve in which the shorter-term yields will be higher than the longer-term yields. This is considered as a sign of recession in future.

The investors by expecting lower yields for long term bonds in future, will purchase long-term bonds to lock in yields. The increasing demand for long-term bonds and the less demand for short-term bonds will lead to higher prices for long-term bonds, and lower prices for short-term bonds. This will lead to an inverted yield curve.

Loss of money by investing in U.S. Treasury Bonds

The United States government has made any default on a debt. But the following may cause loss of money in T-bonds.

• The changes in the inflation can reduce the return on bonds. When interest rates rise, the market price of bonds will fall. This will force the bond investor to sell a T-bond.
• Another risk is the default risk. Default in making the interest payments.
• Another risk in investing T-bonds is opportunity risk which means that an investor might have received a better return elsewhere.