Certified Financial Management Specialist Practice Exam

What is characteristic of an inverted yield curve?

1. Higher yields for shorter maturities

2. Lower yields for longer maturities

3. Continuous increases in yield as maturity lengthens

4. Uniform yields regardless of maturity

The correct answer is: Lower yields for longer maturities

An inverted yield curve is distinctly characterized by lower yields for longer maturities compared to shorter maturities. In normal market conditions, longer-term bonds typically offer higher yields as compensation for the increased risk of holding bonds for a longer duration, including inflation and interest rate risk. However, when the yield curve is inverted, this relationship flips: investors demand higher returns for short-term loans due to expected economic downturns or uncertainties, while the yields on longer-term bonds decrease as investors seek safety in those assets, potentially fearing that the economy will weaken. This phenomenon often signals an upcoming recession, as it reflects investor sentiment that suggests economic growth is slowing down or that interest rates may decline in the future. Therefore, the observation that longer maturities yield lower returns while shorter maturities yield higher returns aligns perfectly with what characterizes an inverted yield curve.