The yield curve represents a snapshot in time of the yields offered by bonds of the same type - and, in particular, of the same credit quality - but of different maturities. Here is a snapshot of the US Treasury yield curve taken in 1997.

Two bonds with the same credit rating but different maturities will have different yields. Why?

Well, unsurprisingly, we are back to the basic risk/return relationship again i.e. the greater the risk, the higher the return needed to compensate for that risk.

We have already said that our two bonds have the same credit risk but, as we have seen, credit risk is not the only risk faced by a bondholder, and our other risks – interest rate risk, reinvestment risk, event risk and so on – are higher for long-tem bonds than short-term bonds, because they have more time to actually occur.

This basic principle of risk and return gives a distribution of return (yield) against maturity called the yield curve (or the term structure of interest rates), which, under normal circumstances, is shaped like this.

Remembering that government bonds have the lowest credit risk – the lowest risk of default – government yield curves in the relevant market are seen as a benchmark against which other bond classes can be priced; i.e. they exhibit various spreads over governments.

So, corporate bonds – otherwise known as investment grade bonds – will show a spread over governments; and high yield bonds – non-investment grade bonds – will show a spread over corporates.

So that is what a yield curve is. The question now is, what use can you make of it?