Analysis of Yield Curves, Risk Premiums and Cooperate Bonds

Analysis of Yield Curves, Risk Premiums and Cooperate Bonds

Question 1

Yield Curve

The yield curve displays the level of debt interest for different maturities. It shows the return that an investor is aiming to make on loans for a specific time (Bauer & Mertens, 2018). Correlation on the vertical axis and time of maturity on the horizontal axis is shown in the graph.  At different points in the economic cycle, the curve can take various forms, but typically it slopes upwards.

Throughout the broader scheme of things, finance, economists, investors, market observers, and others are involved in deciding whether interest rates for bonds will adjust depending on various maturities (Bauer & Mertens, 2018). While no one can predict the future, the yield curves help to understand the trends.

Normal yield curve

Normal yield curves indicate that bonds with longer maturity have higher interest rates than short-term ones because the long-range risk of keeping bonds, such as inflation, requires higher income (Bauer & Mertens, 2018).

Inverted yield curve

Inverted yield curves are indicators of higher returns for short-term bonds as investors worry about the near-term future and therefore need higher earnings to retain the short-term investment (Bauer & Mertens, 2018). Lower rates appear to mean less economic growth, and an inverted return curve may suggest that there’s a recession.

Steep yield curve

A steep performance curve is the one in which the short-term outcomes are common but with higher long-term outcomes (Bauer & Mertens, 2018). The curve suggests that future interest rates will increase.

Flat yield curve

Flat curve shows that both short-and long-term returns are on similar rates, which means that the economy is going from growth to recession or recession to growth during a transitional era. Question 2

Corporate Bonds and Risk Premium

In the market cycle boom, fewer companies go into bankruptcy, and lower corporate bond default risk reduces the risk premium (Choy, & Wei, 2020). Similarly, corporate bonds ‘ default rates increase, and threats are compounded during a recession. The corporate risk premium thus increases anticyclical during a recession and falls at boom.

Question 3

Liquidity Premium and Expectation Theory

If yield curves were flat on average, it would be preferable to embrace the theory of expectations because it implies that the longer-term risk compared to the short-term is null. Additionally, the liquidity premium will show that the market expects an early fall in short-rates and a sustained moderate fall in the future (Choudhry, 2019).

References

Choudhry, M. (2019). Analysing and interpreting the yield curve. John Wiley & Sons.

Bauer, M. D., & Mertens, T. M. (2018). Economic forecasts with the yield curve. FRBSF Economic Letter, 7.

Choy, S. K., & Wei, J. (2020). Liquidity risk and expected option returns. Journal of Banking & Finance, 111, 105700.