Fixed Income Concepts: Yield Curve and Duration
The Yield Curve
An ideal way to illustrate the typical risk/return relationship for bonds is to look at the yield curve, which charts the maturities of bonds of the same credit quality and their corresponding interest rates. Longer-maturity bonds tend to be more volatile than shorter-term bonds, and investors are typically compensated for that risk in the form of higher yields. Thus the "normal" yield curve slopes upward (see below). During certain periods, short-term rates can be higher than long-term rates, however, resulting in the yield curve flattening or even inverting.
Duration measures a bond's sensitivity to changes in interest rates. It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. The longer the bond has until maturity, the greater its duration. The longer a bond's duration, the more sensitive it is to changes in interest rates. Duration continually adjusts as coupon payments are made over the life of a bond.
An illustration of the relationship between interest rates, duration, and bond prices is provided below: