# Understanding Yield Curve Risk: Impacts on Bond Prices and Investments

## What Is the Yield Curve Risk?

Yield curve risk refers to the potential losses investors face when changes in market interest rates adversely affect the value of [fixed-income](https://www.investopedia.com/terms/f/fixedincome.asp) investments. The yield curve, which reflects the relationship between interest rates and bond maturities, is a key indicator of economic trends and interest rate expectations.

Because bond prices move inversely to interest rates, rising yields lower bond prices and vice versa. Investors often monitor yield curve shifts, such as flattening, steepening, or inversion, to anticipate economic changes and use strategies like duration management or hedging to mitigate this risk.

### Key Takeaways

*   The yield curve risk arises from potential changes in interest rates, which can significantly affect the prices of fixed-income investments.
*   A flattening yield curve, where short- and long-term rates converge, may signal economic weakness with low inflation and interest rates expected in the future.
*   A steepening yield curve suggests stronger economic activity and rising inflation expectations, with long-term bond yields increasing faster than short-term ones.
*   An inverted yield curve, a rare occurrence where short-term rates exceed long-term rates, can indicate that investors expect future interest rates to decline.
*   Investors can use strategies like exchange-traded products (ETPs) to hedge against yield curve risk and potentially profit from shifts in the yield curve.  
    

## How Yield Curve Risk Impacts Investors

Investors pay close attention to the [yield curve](https://www.investopedia.com/terms/y/yieldcurve.asp) as it provides an indication of where short term interest rates and economic growth are headed in the future. The yield curve is a graphical illustration of the relationship between interest rates and bond yields of various maturities, ranging from 3-month [Treasury bills](https://www.investopedia.com/terms/t/treasurybill.asp) to 30-year [Treasury bonds](https://www.investopedia.com/terms/t/treasurybond.asp). The graph is plotted with the y-axis depicting interest rates, and the x-axis showing the increasing time durations. 

Short-term bonds usually have lower yields than long-term bonds, so the curve slopes upward from left to right, forming a normal yield curve. Interest rates and bond prices have an inverse relationship in which [prices decrease when interest rates increase](https://www.investopedia.com/articles/bonds/11/5-reasons-to-trade-bonds.asp), and vice versa. When interest rates change, the yield curve shifts, posing what's known as yield curve risk to bond investors.

Yield curve risk occurs when the curve either flattens or steepens due to changing yields in bonds of different maturities. When the yield curve shifts, the price of the bond, which was initially priced based on the initial yield curve, will change in price.

## Managing Yield Curve Risk in Your Portfolio

Investors with interest-rate securities face yield curve risk. Investors can hedge this risk by creating portfolios that are expected to react predictably to interest rate changes. Since changes in the yield curve are based on bond [risk premiums](https://www.investopedia.com/terms/r/riskpremium.asp) and expectations of future interest rates, an investor that is able to predict shifts in the yield curve will be able to benefit from corresponding changes in bond prices.

In addition, short-term investors can take advantage of yield curve shifts by purchasing either of two [exchange-traded products](https://www.investopedia.com/terms/e/exchange-traded-products-etp.asp) (ETPs)—the iPath US Treasury Flattener ETN (FLAT) and the iPath US Treasury Steepener ETN (STPP).

## Different Types of Yield Curve Risks Explained

### Understanding the Flattening Yield Curve

When interest rates converge, the [yield curve flattens](https://www.investopedia.com/terms/f/flatyieldcurve.asp), narrowing the [yield spread](https://www.investopedia.com/terms/y/yieldspread.asp) between long- and short-term rates. This affects bond prices. If the bond is a short-term bond maturing in three years, and the three-year yield decreases, the price of this bond will increase.

Let’s look at an example of a flattener. Let’s say the Treasury yields on a 2-year [note](https://www.investopedia.com/terms/t/treasurynote.asp) and a 30-year bond are 1.1% and 3.6%, respectively. If the yield on the note falls to 0.9%, and the yield on the bond decreases to 3.2%, the yield on the longer-term asset has a much bigger drop than the yield on the shorter-term Treasury. This would narrow the yield spread from 250 [basis points](https://www.investopedia.com/terms/b/basispoint.asp) to 230 basis points. You can chart these and other yields to [create a yield curve in Excel](https://www.investopedia.com/ask/answers/052215/how-can-i-create-yield-curve-excel.asp) and other software.

A flattening yield curve may suggest economic weakness, with low expected [inflation](https://www.investopedia.com/terms/i/inflation.asp) and interest rates, little growth, and weak bank lending.

### What a Steepening Yield Curve Means for Investors

If the yield curve steepens, this means that the spread between long- and short-term interest rates widens. In other words, the yields on long-term bonds are rising faster than yields on short-term bonds, or short-term bond yields are falling as long-term bond yields are rising. Therefore, long-term bond prices will decrease relative to short-term bonds. Steepening yields pose a risk for bond traders using a [roll-down return](https://www.investopedia.com/terms/r/rolldownreturn.asp) strategy with long-term bonds.

A [steepening curve](https://www.investopedia.com/terms/c/curve-steepener-trade.asp) usually signals stronger economic activity and higher inflation expectations, leading to higher interest rates. When the yield curve is steep, banks are able to borrow money at lower interest rates and lend at higher interest rates. An example of a steepening yield curve can be seen in a 2-year note with a 1.5% yield and a 20-year bond with a 3.5% yield. If after a month, both Treasury yields increase to 1.55% and 3.65%, respectively, the spread increases to 210 basis points, from 200 basis points.

### Decoding the Inverted Yield Curve: Risks and Indicators

On rare occasions, the yield on short-term bonds is higher than the yield on long-term bonds. When this happens, the curve becomes inverted. An [inverted yield curve](https://www.investopedia.com/terms/i/invertedyieldcurve.asp) indicates that investors will tolerate low rates now if they believe rates are going to fall even lower later on. So, investors expect lower inflation rates, and interest rates, in the future.

## The Bottom Line

Yield curve risk reflects the impact of changing interest rates on fixed-income securities, where rising rates typically lower bond prices and falling rates increase them. The yield curve itself is closely watched as a predictor of economic conditions, signaling shifts in future interest rates and growth trends.

Different curve movements, such as flattening, steepening, or inversion, can indicate changing market expectations and economic health. For investors, understanding these dynamics is essential for managing portfolio risk, and strategies like adjusting duration hedging can help mitigate potential losses from adverse yield curve shifts.