Question

• Explain what the yield curve is, what determines its shape, and how you can use the yield curve to help forecast future interest rates.
• Explain the different types of risk that bond investors and issuers face. Might there be more than four?

Answer 1

A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit but differing maturity dates.

There are three main types of yield curve shapes:

- Normal, inverted and flat

A normal yield curve is one in which longer maturity bondes have a higher yield compared with shorter-term bondes dye to the risk associated with time.

An inverted yield curve is one in which the shorter-term yields, which can be a sign of upcoming recession.

In a flat or humped yield curve, the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic.

The shape of the curve helps investors get a sense about the future course of interest rates. A normal upward sloping curve means that long-term securities have a higher yield. Whereas an inverted curve shows short-term securities have a higher yield.

Different types of risk that bond investors and issuers face:

1) Interest rate risk and bond prices:

Interest rates and bond prices have an inverse relationship; as interest rates fall, the prices of bonds trading in the marketplace generally rises. Conversely, when interest rates rise, the price of bonds tends to fall.

2) Reinvestment risk and callable bonds:

It is the risk of having to reinvest proceeds at a lower rate than the funds were previously earning. One of the main ways this risk presents itself is when interest rates fall over time and callable bonds are exercised by the users. The callable feature allows the issuer to redeem the bond prior to maturity. As a result, the bondholder recieves the principal payment, which is often at a slight premium to the par value.

3) Inflation risk and bond duration:

When an investor buys a bond, he or she essentially commits to receiving a rate of return, either fixed or variable, for the duration of the bond or at least as long as it is held.

If the cost of living and inflation increase dramatically, and a faster rate than income investment happens, than investors will see their purchasing power erode and may actually achieve a negative rate of return.

4) Liquidity risk of bonds:

While there is almost always a ready market for government bonds, corporate bonds are sometimes entirely different animals. There is a risk that an investor might not be able to sell his or her corporate bonds quickly due to a thin market with few buyers and sellers for the bond.

Low buying interest in a particular bond issue can lead to substantial price votality and possibly have an adverse impact on a bondholder's total return. Much like stocks that trade in athon market, we may be forced to took a much lower price than expected to sell our position in the bond.