A yield curve refers to a line graph that plots the connection between the yields to maturity and the time to maturity of bonds of the same asset class and quality. From left to right, the yield curve represents the rates for bonds with the shortest maturity to the longest maturity, usually up to a maturity of 30 years. A flat yield curve means there is little difference between the rates of short-term and long-term bonds.
A yield curve graph has a vertical axis that represents the yield to maturity in percentage and a horizontal axis that represents time to maturity in years. Time to maturity refers to the length of time that remains until a bond expires and its holder receives back the bond principal, which is the amount of money he or she initially invested on the bond. Yield to maturity refers to the rate of return the bond generates if held until the maturity date.
A yield curve shows the differences between various yields, also known as yield spreads, which are caused by differences in time to maturity. A normal yield curve has an upward slope, which means the yields increase as maturities extend. An inverted yield curve has a downward slope, which means the yields of long-term bonds are lower than those of short-term bonds. A flat yield curve often manifests when the yield curve transitions between a normal shape and an inverted shape.
The yield curve can often indicate economic expectations. An upward slope indicates expectations of higher interest rates in the future, and a sharp upward slope often comes just before economic improvement. A downward slope indicates expectations of lower interest rates in the future and often shows up just before a recession. A flat yield curve usually appears during economic transitions and lasts only for a short time. Inflation and the central bank's decisions affect future interest rates and the shape of the yield curve, so a flat yield curve could also mean that the market believes inflation is under control and will not change much in the future.
When an investor sees a flat yield curve, he or she usually chooses to hold short-term bonds rather than long-term bonds. This is because holding long-term bonds carries higher risks stemming from greater possible fluctuations. Higher yields usually compensate for the greater risks. When the yields are the same, the investor would gain no benefit from holding the riskier long-term bonds.