Yield Curve Risk
Candlefocus EditorWhen the yields of bonds rise, their prices tend to fall as fewer investors are willing to purchase them. On the other hand, when the yields of bonds fall, their prices tend to increase as more investors are willing to purchase them. This inverse relationship between bond prices and yields is a very important concept to understand when considering yield curve risk, as any changes in interest rates will have an effect on these prices.
Yield curve risk arises from the fact that changes in the yield curve can lead to substantial losses for fixed income portfolios, as the relationship between bond yields and prices changes, along with the direction of interest rates. Changes in the level of interest rates usually lead to a steepening of the yield curve, which might cause securities with higher yields to become more expensive to purchase, while securities with lower yields become less attractive. On the other hand, when the level of interest rates decrease, the yield curve usually flattens, which enables increased demand at the short end of the yield curve and causes prices of longer term securities to start falling.
Yield curve risk can be managed by various tools and techniques. For instance, derivatives can be used to hedge against yield curve risk, while portfolio diversification and dynamic hedging strategies have also been used to mitigate the risks associated with yield curve movements. Bonds with shorter maturities generally have an inverse relation with interest rates, so bonds consisting of shorter maturities can be used to lower yield curve risk. Similarly, bonds with longer maturities tend to have an inverse relation with interest rates, so longer maturities can be used to increase sensitivity to yield curve risk.
In conclusion, yield curve risk is the risk associated with changes in interest rates impacting the fixed income securities, and can result in heavy losses for fixed income portfolios if not managed properly. Various tools and techniques—such as derivatives, portfolio diversification, dynamic hedging strategies and adjusting maturities—can be used to reduce the risk associated with yield curve movements.