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Chap5Notes - Deconstructing bond yields What are the...

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1 Deconstructing bond yields What are the factors that cause yields to vary from one bond to another? Two dimensions to consider Holding time to maturity constant, bond yields vary as the credit quality changes. In other words, everything else equal, risky bond yields will exceed Treasury yields. Holding credit quality constant, bond yields vary as the time to maturity changes. In other words, everything else equal, bond yields will contain a premium for expected inflation. The Benchmark (Base) Interest Rate The benchmark interest rate: The minimum interest rate that investors will demand for investing in a non-Treasury security. Equal to the yield on relevant on-the-run Treasury security. On-the-run Treasury securities are available for maturities of three months, six months, two years, three years, five years, ten years and thirty years. Defined for a particular time-to-maturity.
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2 The yield on Non-Treasury Securities The interest rate or the yield on a non-Treasury security is determined at a spread to a particular on-the-run Treasury security Corporate yield = Benchmark interest rate (for same maturity) + default risk premium Measuring the yield Spread The yield spread is the difference between the yield on two bonds, measured in basis points. Yield Spread = Yield on a Corp. Bond – Yield on T-Bond In the fixed income market, the yield spread measures the price of risk. Yield spreads can also be measured on a relative basis: Relative yield spread = (yield on bond A - yield on bond B) / yield on bond B Credit Quality and Term Structure 0 0.005 0.01 0.015 0.02 0.025 0.03 0 2 4 6 8 10 12 14 16 time to maturity yield Treasury yields AA-rated yields
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3 Factors affecting yields, holding TTM constant Types of Issuers (market sectors) Credit quality – bonds with greater default risk (low ratings) require higher yields
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