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Consider an investor who purchases a 5-year note today and plans to reinvest in another 5-year note in the future. Over the 10-year investment horizon,

Consider an investor who purchases a 5-year note today and plans to reinvest in another 5-year note in the future. Over the 10-year investment horizon, this investor expects to earn about 27.5%, ignoring compounding (thats 3% per year for the first 5 years and 2.5% per year for the next 5 years). To compete with that return, a 10-year bond today could offer 2.75% per year. That is, a bond that pays 2.75% for each of the next 10 years produces the same 27.5% total return that the series of two, 5-year notes is expected to produce. Therefore, the 5-year rate today is 3% and the 10-year rate today is 2.75%, and the yield curve is downward sloping.

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