A yield curve may be positive for a variety of reasons. First of all, the concept of risk plays an important role in the tendency of yield to be higher as a bond’s length to maturity increases. Quite simply, the more time that remains until a bond matures, the greater the risk of an unfavorable event that could lower the bond’s market value — whether an increase in interest rates on newly issued bonds or default on the part of the issuer. The extra yield that investors want to earn to tie their money up in longer-term bonds is known as the risk premium.
When investors expect higher inflation, that can also have a significant impact on creating a positive yield curve. In periods of economic growth, the market anticipates that inflation will increase, making it more likely that the Fed will tighten the money supply by raising short-term interest rates. As investors shift their money from long-term into short-term securities to take advantage of the higher rates, the market prices of long-term bonds are driven lower and their yields higher.
