Yield curve

Indian Economy glossary

Also called: Term structure of interest rates · Topic: Financial Markets, Instruments, Insurance and Pensions · NCERT: Beyond NCERT

Meaning

A yield curve is a graph of the yields of bonds with the same credit quality (usually government securities, or G-secs) across different maturities (the time left until the bond is repaid). It shows how much return lenders ask for when they lock money away for 3 months, 5 years or 40 years.

It matters because its shape tells us what markets expect about future interest rates, inflation and growth. Its long end sets the base price for loans across the economy.

Slope of the curve = long-term yield − short-term yield (for example, 10-year yield minus 2-year yield).
Each point on the curve is a yield to maturity (YTM). YTM is the single discount rate that makes the present value of all the bond's future payments equal to its price today [1].

Explanation

How the curve is built

X-axis: maturity (91 days, 1 year, 5 years, 10 years, 40 years…).
Y-axis: the yield (YTM) on a bond of that maturity.
Keep credit quality the same. Only the maturity changes along the curve. That is why G-secs are used, since all of them carry the same sovereign (government) risk.
If you compared a G-sec with a corporate bond, the gap in yield would come from default risk, not maturity. That gap is a credit spread, not a yield curve.
Bond price and yield move in opposite directions. Each point on the curve comes from market prices:
Bond price rises → yield falls.
Bond price falls → yield rises.

Three shapes and what they mean

Normal (upward-sloping): long bonds yield more than short bonds. Investors want two kinds of extra pay:
Term premium: extra pay for locking money away for longer.
Liquidity premium: extra pay because a long bond is harder to sell quickly.
Flat: short and long yields are about equal. This often happens when the economy is moving from one phase to another.
Inverted: short-term yields are above long-term yields. It is read as a recession warning:
Markets expect growth to slow.
So they expect the central bank to cut rates later.
Buyers rush to lock in today's long yields, so long yields fall below short yields.
Example: the US 10-year minus 2-year yield stayed inverted through 2022-24.

Why long yields usually sit higher: interest-rate risk (worked example)

Longer bonds lose much more value when rates rise. Take two zero-coupon bonds, each with face value Rs 100, and let the market rate move from 5% to 6% (illustration):

Bond	Price at 5%	Price at 6%	Fall
1-year	100/1.05 = Rs 95.24	100/1.06 = Rs 94.34	about 0.9%
10-year	100/1.05¹⁰ = Rs 61.39	100/1.06¹⁰ = Rs 55.84	about 9%

The same rate rise causes about 10 times the capital loss on the 10-year bond. Holders ask for a higher yield to carry this risk. This is the term premium, and it is why the normal curve slopes upward.
Reading the slope (illustration): suppose a 91-day T-bill yields about 7.35% a year and a 10-year G-sec yields 6.5%.
Slope = 6.5 − 7.35 = −0.85 percentage points.
A negative slope means the curve is inverted at that stretch.

What moves the curve

Short end: follows the central bank's policy rate and the money available in the banking system (liquidity).
RBI raises rates → short yields rise quickly.
Long end: follows expected inflation, expected growth, government borrowing and the term premium.
Heavy government borrowing → more bonds supplied → bond prices fall → long yields rise.
Steepening: long yields rise faster than short yields, for example when people expect more inflation or more government borrowing.
Flattening or inversion: short yields rise faster, or long yields fall, for example when rates are raised to fight inflation and growth is expected to slow.

In India

Instruments along the curve:
Short end: Treasury Bills (T-bills), which are zero-coupon, issued at a discount and come in 91-day, 182-day and 364-day tenors [1].
Long end: dated securities, which usually mature in 5 to 40 years and pay interest every half-year [1].
Length of the curve: the government issues G-secs in many maturity buckets. This builds a yield curve that runs up to 40 years [1].
Zero-coupon yield curve: STRIPS (Separate Trading of Registered Interest and Principal of Securities) split existing G-secs into separate coupon and principal pieces. Each piece trades on its own as a zero-coupon bond. This helps build a market-based zero-coupon yield curve [1].
Benchmark: the 10-year G-sec yield is India's main benchmark. Corporate bonds and long-term loans are priced off it.
Short end used as a reference: the coupon on the Government of India's Floating Rate Bond (FRB) can be set as the average of the implied yields from the last three 182-day T-bill auctions, plus a fixed spread [1].
Banks and the curve: when yields rise, banks make mark-to-market (MTM) losses on the bonds they hold. MTM means valuing an asset at today's market price, not the price paid for it.
Under RBI's investment norms, in force from 1 April 2024, bonds held to maturity (HTM) are not marked to market [2].
For bonds that are available for sale (AFS), net gains or losses go to an AFS-Reserve, not the profit and loss account [2].

Don't confuse with

Credit spread: the yield curve compares different maturities at the same credit quality. A credit spread compares different borrowers at the same maturity. For example, a 10-year AAA corporate bond at 7.2% against a 10-year G-sec at 6.5% gives a spread of 70 basis points (illustration).
Coupon rate: this is the fixed payment printed on the bond as a % of face value. The yield curve plots market yields (YTM), which change with the bond's price.
Current yield: this is annual coupon ÷ market price × 100. It ignores the capital gain or loss at maturity [1]. Yield curves are drawn using YTM, not current yield.
Term premium: this is only one reason the curve slopes upward. The curve itself is the whole graph. Its shape also depends on expected future rates.

Prelims Hooks

The yield curve plots bonds of the same credit quality across different maturities. If the credit quality differs, you are looking at a credit spread, not a yield curve.
Normal curve = upward-sloping because of the term premium and the liquidity premium. Inverted curve (short yields above long yields) is read as a recession signal.
India's G-sec yield curve runs up to 40 years. T-bills (91/182/364-day) form the short end [1].
STRIPS help build a zero-coupon yield curve. They are made by splitting existing G-secs, not issued fresh [1].
India's benchmark long-term rate is the 10-year G-sec yield.
Trap: a rise in yields means a fall in bond prices. Long bonds fall the most, which is interest-rate risk.

Mains Points

The yield curve as a policy signal: its slope shows what markets expect for growth and inflation. An inverted curve (as in the US through 2022-24) warns of a slowdown. The RBI can read the curve to judge how well its rate changes are passing through to market rates.
Government borrowing and crowding out: heavy borrowing pushes up the 10-year G-sec yield.
Corporate bonds and long-term loans are priced off this benchmark, so they get costlier.
Companies then borrow and invest less.
So fiscal consolidation (the government cutting its deficit step by step) helps keep the long end of the curve low. This is a GS-III link between fiscal policy and financial markets.
Bank stability in rate cycles: when the curve shifts up, banks face MTM losses on the bonds they hold. The 2023 RBI framework softens the hit to reported profits through HTM and the AFS-Reserve [2]. But Silicon Valley Bank (US, March 2023) shows the danger: large unrealised losses on long bonds can still trigger a deposit run. Supervisors must track interest-rate risk, not just credit risk.

Related concepts

Bond basics: present value, coupon, yield and the yield curve

Sources

1Government Securities Market in India – A Primer (RBI FAQ)rbi.org.in · tier 1
2RBI (Classification, Valuation and Operation of Investment Portfolio of Commercial Banks) Directions, 2023rbi.org.in · tier 1