There are many economic terms and insights that you must learn to invest in. Although often difficult to understand But understanding these economic conditions is important to help you get the maximum return on your investment you want and avoid unnecessary risks.
One of the economic conditions of investment In particular, bond investments are yield curves or yield curves. What is the yield curve and how does it affect investment decisions? And why does reversal signal a recession? Check out the following comments:
What is the yield curve?
Before understanding the yield curve It’s a good idea to first understand what a return is. In other words, the rate of return on an investment after the coupon and bond price has been adjusted. as well as coupons This variable is also expressed as a percentage.
The difference is that the coupon amount is set by the issuer of the respective bond issuer. while returns are calculated by the investors themselves or by the financial authorities. (internationally) using coupons as a single component and increasing approximately The price of an asset is another component. This variable more or less is derived from the following formula:
Nominal Yield = (Total Annual Coupon / Bond Price)so, If the bond price goes down while the coupon offered by the issuer remains. The rate of return will increase slightly. and vice versaAn investor’s preferred return will, of course, change with the duration of the bond’s maturity date. The combination of returns desired by an investor over several years is shown in a curve known as the yield curve. Here’s a picture:
The yield curve is a curve that describes the relationship between yield and bond life. The image above reads that the longer the bond’s maturity, the longer it is. The higher the total return or profit required by the investor.
This is due to many things such as:
- Investors certainly don’t want to lend money to issuers over the long term if the benefits offered are not worth it. Especially if the amount borrowed is large.
- Long-term uncertainty (5 years or more) Five years ago, Indonesians might not have expected that COVID-19 would cause the economy to stagnate. This kind of uncertainty that long-term investors avoid.
- have an increased chance risk free rate in the long term. risk-free rate is the interest rate of low-risk investments such as deposits or government bonds.
Therefore, long-term bonds generally have a large number of coupons. So the payoff is great as well.
Before discussing why this curve is important. You have to understand one thing first: the degree of slope of the curve above. (gradient coefficient) describes the difference in return over the years. Thus, a flat (flat) yield curve can be interpreted as no increase in yield, which is a relatively favorable gain between a 2- or 3-year bond and a 10-year bond.
Type of yield curve
1. Normal yield curve
as shown above A normal yield curve shows higher yields for bonds with longer maturities. This curve shows that investors expect the economies of the countries involved to develop over the next few years.
2. Flattened yield curve
A flat yield curve is a flat yield curve. This indirectly shows that in the next few years The country’s economy will not change much. Therefore, there is not much difference between short-term and long-term desired returns.
3. The yield curve is reversed.
The inverted yield curve shows that short-term returns are higher than long-term returns. This can happen as investors predict that in the next few years. The reference interest rate will increase. So the coupons will increase. More and more people will switch from stocks to bonds. This results in higher bond prices and lower yields in the long run.
Why is the Yield Curve Important?
This curve is important because it can be a good indicator to forecast economic growth for the next few years. as the author said Because this curve includes investor expectations and their response to changes in the benchmark interest rate.
to understand this You have to remember two things:
- If the bond price goes up The return will be reduced.
- The reference interest rate affects the bond coupon..
When the benchmark interest rate is low the economy is expanding Known that many economic actors dared to borrow money from banks. for investors This is the time to look for a higher yielding investment tool than bonds: stocks.
As a result, the demand for bonds decreased and the bond prices also decreased. When bond prices fall The return will be higher. If investors anticipate that will happen in the long term. The yield curve appears to be a normal curve.
However, there are times when too extensive economic activity leads to extreme inflation. to reduce inflation The central bank will increase the benchmark interest rate. An increase in the benchmark interest rate inhibits economic activity and forces newly issued bond coupons to rise.
In addition to providing high yields, bonds (especially state bonds) is a safer tool than stocks. As a result, investors switch from stocks to government bonds. The higher the demand for government bonds, the higher the price, the higher the price, the lower the yield. If investors anticipate that commodity prices will rise rapidly (inflation) and this benchmark interest rate will occur over the long term. The yield curve that appears will be The yield curve is reversed..
Therefore, it is not surprising that this inverted curve is touted as an indicator that can predict the occurrence of a recession. This is evidenced by the news. CNBC United States Last year, according to reports of the emergence of The yield curve is reversed. Over the past 50 years, Uncle Sam’s land recession has been predicted correctly many times. Although not immediately after the curve appeared. But this proves that this indicator is extremely important to pay attention to.
Although the yield curve is an important indicator for assessing the economy over the next few years. But this indicator must also be accompanied by an analysis of other economic indicators such as inflation. reference interest rate Economic growth, etc., because of the current technological developments. This curve will change dramatically with changes in investor expectations about the ongoing economy.