A 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 changing its slope. Suppose that one-year, five-year, eight-year, ten-year, 15-year, 20-year, and 30-year bonds all were to increase by 1.5% or 150 basis points over their previous levels. That would be a parallel shift in the yield curve. The curve wouldn’t change. All data points on it would move in the same direction. The curve itself would keep its prior slope and shape.
How Does a Parallel Shift in the Yield Curve Work?
Long-term rates are higher than short-term rates when the yield curve is sloping upward, which is most of the time. It’s due to the higher inflation risk of longer maturities. Parallel shifts are the most common during these normal yield curves. When the yield curve is inverted, or on a downward slope, it means that long-term interest rates are lower than short-term rates. It may signal that a recession is coming.
What Is Yield Curve Risk?
Marketable fixed-income securities include treasury bonds, corporate bonds, or tax-free municipal bonds. Those who invest in these must deal with many types of risk, including yield-curve risk, more commonly known as “interest rate risk.” This is the danger that shifts in the yield curve can cause bond prices to fluctuate substantially. Make sure you’re aware of the effect of market rates on bond prices and yields when you’re investing in bonds. There’s often an inverse relationship between prices and interest rates. When market interest rates rise, bond prices fall, and vice versa. The yields decrease when market interest rates fall and bond prices rise. It becomes more costly to buy the bond. The interest rates are lower. Interest rate risk can mean huge losses or years spent in “underwater” or below-value positions, especially if it’s not carefully managed. It can be especially adverse for hedge funds, ETFs, or private accounts that use leverage to boost fixed-income returns.
What It Means for Individual Investors
Parallel shifts in the yield curve aren’t meaningful in a practical sense if you buy bonds and hold them to maturity. They’ll have no effect on the ultimate cash flow, taxes, and capital gains or losses of the held bonds. But 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, whereby you buy a mix of fixed-income investments with different maturity dates, from short-term to long-term. You’ll have a maturity coming up at any given time, which means that there’ will be capital available if you need it. You can roll it into a more distant maturity if you don’t need it, allowing 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 group of securities that can return a higher aggregate yield in a shorter duration. It can give you the best of both worlds.
