Find out more about the yield curve and what a parallel shift in the yield curve means for investors.
What Is a Parallel Shift in the Yield Curve?
The yield curve refers to the relationship between several factors: short-term interest rates, intermediate interest rates, and long-term interest rates. When plotted on a graph, these points form a curve. The shape depends on the rates and maturities of the debt securities being measured.
A so-called parallel shift in the yield curve happens when the interest rates on all fixed-income maturities increase or decrease by the same number of basis points. Such a change would shift the yield curve parallel to its present place on the graph without affecting its slope.
Let's say one-year, five-year, eight-year, ten-year, 15-year, 20-year, and 30-year bonds all increased by 1.5% or 150 basis points over their previous levels. This would be a parallel shift in the yield curve because the curve itself didn't change. Rather, all data points on it moved in the same direction. The curve itself kept its prior slope and shape.
How Does Parallel Shift in the Yield Curve Work?
When the yield curve is sloping up, which is most of the time, long-term rates are higher than short-term rates. This is due to the higher inflation risk of longer maturities. Parallel shifts are the most common during these normal yield curves.
Inflation risk is the risk that inflation will rise. This drops the value of the payouts of an investment.
When the yield curve is inverted, or on a downward slope, it means long-term interest rates are lower than short-term rates. This can mean a recession may be coming.
Common risks to guard against include inflation risk, repayment risk, and call risk. Call risk is the risk a callable bond will be called, or redeemed.
These investors must also deal with yield-curve risk. It's more commonly known as interest rate risk. This is the danger that shifts in the yield curve can cause bond prices to fluctuate substantially.
When investing in bonds, be sure you understand the effect of market rates on bond prices and yields. There's often an inverse relationship between prices and interest rates: When market interest rates rise, bond prices fall, and vice versa. When market interest rates fall and bond prices rise, the yields decrease. That's because it becomes more expensive to buy the bond, and the interest rates are lower.
Interest rate risk can mean huge losses, or years spent in underwater (below-value) positions. This is even more true if it is not carefully managed. It can be especially disastrous for hedge funds, ETFs, or private accounts that use leverage to boost fixed-income returns.
What Does It Mean for Individual Investors?
If you buy bonds and hold them to maturity, parallel shifts in the yield curve aren't meaningful in a practical sense. They will have no effect on the ultimate cash flow, taxes, and capital gains or losses of the held bond.
What about those who might liquidate their positions prior to maturity? One way to protect against major changes in interest rates may be to reduce the duration. Closer maturity dates often mitigate the volatility.
Another way is to use investment laddering. This is when you buy an assortment of fixed-income investments with different maturity dates, from short-term to long-term. At any given time, you have a maturity coming up. That means there's capital there if you need it. If not, you can roll it into a more distant maturity. This allows you to capture the often higher yields on longer-term holdings.
Laddering is one of three bond investing strategies that can make a big difference in your risk profile. You can build a collection of securities that can return a higher aggregate yield in a shorter duration. Ideally, it gives you the best of both worlds.
- A parallel shift in the yield curve is when interest rates across all maturities change by the same number of basis points.
- Yield-curve risk is also known as interest-rate risk. This is the risk of interest rate changes having an impact on bond prices.
- A parallel shift in the yield curve neither flattens nor steepens the yield curve. Instead, it shows a change in interest rates.
- If you buy bonds and hold them to maturity, parallel shifts in the yield curve aren't too meaningful to you.