debt, bonds, yield-curveThis question is about “normal” situations, not any recessions etc.
Why would yield curves slope consistently upwards? The risk situation is symmetrical - long term bonds expose borrower to interest rate decrease, but protect lender, and expose lender to interest rate increase, but not borrower (and vice versa for short term bonds). Unless there’s any long term trend in interest rates, they should be pretty much flat, or at least not consistently sloping either way. (and if anything interest rates tend to decrease not increase, as does inflation)
If it’s inflation risk, or otherwise inflation-related, wouldn’t that mean that inflation-protected bonds should have flat yield curve?
I’ve read a few proposed explanations, but none of them seems to make much sense.
Longer term bonds have higher yields due to the uncertainty of the future. It’s difficult enough to predict market conditions for the next 3 months let alone the next 30 years. There is also the opportunity cost of being without your money for a longer period of time.
Another thing to think about: imagine all bonds having the same yield. What would be the incentive to purchase a longer term bond? There would be none. In this scenario investors would purchase the shortest term bond to reduce their risk and would roll over the bond when it expires into another bond if they wanted to stay invested in bonds. Thus, longer term bonds must offer higher yields to attract investors when the longer term bond is competing with shorter term bonds.
As you say, yield curves tend to be upward-sloping: that is to say, that long-maturity bonds tend to require higher returns than shorter-maturity bonds. Here are a couple of reasons why:
From a demand-supply analysis, it’s simply that the demand for longer-term bonds is lower, so the price is lower, hence the yield is higher.
The dominant theories for the term structure of interest rates are the rational expectations, liquidity preference, and market segmentation.
Generally, we expect longer-term maturities to have correspondingly higher yields because the investor must bear more risk (inflation risk, bond price risk, interest rate risk, liquidity risk, credit risk).
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