Concept of Yield Curve

A yield curve is a graphical representation that plots the interest rates (or yields) of securities having equal credit quality against their time to maturity. In the Indian context, the most commonly used curve is the government‑bond yield curve, which shows yields on Treasury bills, dated securities and bonds issued by the Government of India.

The vertical axis shows the annualised yield (expressed in percent), while the horizontal axis shows maturity ranging from a few days to 30 years. Each point on the curve is derived from the market‑observed price of a benchmark security and reflects the cost of borrowing for that specific horizon.

For the NISM exam, you must be able to read a yield‑curve diagram, recognise the maturity associated with each point, and understand that the curve summarises market expectations about future short‑term rates.

The curve can take three primary shapes:

Normal (upward sloping) – longer‑term yields are higher than short‑term yields, indicating expectations of rising rates or a premium for bearing duration risk.

Inverted (downward sloping) – short‑term yields exceed long‑term yields. Historically, an inverted curve has preceded economic slowdowns or recessions in India, making it a crucial warning signal for advisers.

Flat – yields across maturities are roughly the same, suggesting market uncertainty about the direction of future rates.

Three broad forces drive the term structure of interest rates:

1. Expectations about future short‑term rates – If market participants anticipate rate hikes, the curve tilts upward; expectations of cuts cause a downward tilt.

2. Liquidity and risk premiums – Investors demand extra compensation for holding longer‑dated securities because of greater price volatility and lower liquidity.

3. Supply‑demand dynamics in specific maturity segments – Large issuance of long‑dated government bonds can push long‑term yields up, independent of expectations.

Advisers use the yield curve to align client portfolios with macro‑economic expectations. For a client seeking capital preservation, a flat or inverted curve may signal a shift to shorter‑duration instruments to avoid falling bond prices.

Conversely, when the curve is steeply upward, longer‑duration bonds offer higher yields, and advisers might recommend a duration‑tilt toward 10‑year or 30‑year securities to capture the term premium.

Exam questions often ask you to choose the most appropriate advisory action given a particular curve shape, so memorise the risk‑return implications of each shape.

Forward rates are derived from the current spot yield curve and represent the market’s implied future short‑term rates. The relationship is expressed as: (1+f_{n,m})^{m-n} = (1+z_m)^m / (1+z_n)^n, where f_{n,m} is the forward rate from year n to m, and z_k is the spot rate for k years.

In practice, advisers use forward rates to gauge whether the yield curve is reflecting pure expectations or whether a liquidity premium is embedded. If forward rates are higher than current short‑term rates, the market expects rate hikes.

For the exam, you may be asked to identify which theory best explains a given forward‑rate pattern or to choose the correct advisory action based on forward‑rate expectations.

Advisers construct bond ladders, duration‑matched portfolios, and barbell strategies by analysing the yield curve. A steep curve supports a barbell (short‑ and long‑duration bonds) to capture the term premium, while a flat curve favours a laddered approach for liquidity.

When interest rates are expected to rise, shortening portfolio duration reduces price volatility. Conversely, a falling rate environment encourages extending duration to lock in higher yields.

Exam scenarios frequently present a client’s investment horizon and ask you to recommend the optimal fixed‑income structure based on the current shape of the yield curve.