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bombardoj02Slide1
First, they provide income. Many bonds pay regular interest payments, called coupon
payments. For example, if you buy a corporate bond or a Treasury bond, you may receive
interest every six months.
Second, bonds are often considered safer than stocks.
Third, investors buy bonds for diversification. If a portfolio only has stocks, it may be too
risky. Adding bonds can help reduce total portfolio risk.
Fourth, investors buy Treasury bills, or T-bills, because they are very short-term and
highly liquid. T-bills usually mature in one year or less. They do not pay coupons. Instead,
investors buy them at a discount and receive the face value at maturity.
Takeway:
Investors buy bonds for income, safety, and diversification.
Investors buy T-bills for short-term safety, liquidity, and a relatively low-risk return.
Slide 3
The yield to maturity (YTM) is defined as the
discount rate that makes the present value of a bond’s payments equal to its price
First, what is the yield curve?
The yield curve is simply a graph that shows the relationship between a
bond’s yield to maturity, or YTM, and its time to maturity. On the
horizontal axis, we put the maturity—like 3 months, 2 years, 10 years, 30
years. On the vertical axis, we put the yield. When we connect these yields,
we get the curve.
Why does the yield curve matter?
Because it summarizes the entire term structure of interest rates. For
example, if long-term yields are much higher than short-term yields, the
curve slopes upward. If long-term yields are lower than short-term yields, the
curve slopes downward, which we call an inverted yield curve.
Information on expected future short-term rates can be implied from the
yield curve.
This idea comes from the Expectations Theory, which says that long-term
interest rates reflect what investors expect future short-term interest rates to
be. If the yield curve is steep and rising, the market is expecting short-term
rates to increase in the future. If the curve is flat or inverted, the market may
expect short-term rates to fall.
Of course, the textbook also introduces other explanations—like the
Liquidity Preference Theory, which suggests investors demand a
premium for holding long-term bonds—but overall, the curve contains
valuable information about how the market views future economic
conditions.
So to summarize:
The yield curve shows the connection between YTM and maturity
across bonds of different lengths.
And by studying the shape of the curve, we can infer what investors
believe will happen to future interest rates and even the overall
economy.
Question 1
What does the yield curve show?
A. The relationship between a bond’s coupon rate and its market price
B. The relationship between a bond’s yield to maturity and its time to
maturity
C. The relationship between stock prices and bond prices
D. The relationship between inflation and unemployment
Correct Answer: B
Explanation:
The yield curve shows how YTM changes across different maturities,
such as 3 months, 2 years, 10 years, and 30 years.
Question 2
If the yield curve is inverted, what does this usually mean?
A. Long-term yields are higher than short-term yields
B. Short-term yields are higher than long-term yields
C. All bonds have the same yield
D. Bond prices are equal to face value
Correct Answer: B
Explanation:
An inverted yield curve means short-term interest rates are higher than
long-term interest rates. This may suggest that investors expect future
short-term rates to fall, and it can also signal concerns about future
economic conditions.
Slide 4
So what does a flat yield curve tell us?
A flat yield curve may suggest that the market does not expect short-term
interest rates to rise much in the future. It may also indicate uncertainty
about the future economy. Investors may believe that economic growth will
slow down, or that the Federal Reserve may stop raising interest rates.
Slide 5
The first key idea is that yields on bonds with different maturities are not the same.
This is exactly what the yield curve shows. A one-year bond may have one yield, while a ten-
year bond may have a very different yield. Because each cash flow of a coupon bond occurs at a
different maturity, each cash flow should be discounted at its own maturity-specific rate.
This leads to the second point:
We can think of each cash flow of a coupon bond as if it were a separate zero-coupon bond.
For example, if a 5-year bond pays coupons every year, then each coupon payment can be
viewed as a stand-alone payment with its own maturity. The yield curve tells us what discount
rate applies to each of those future payments. So instead of using a single YTM for everything,
we discount each cash flow at the zero-coupon rate that corresponds to its maturity.
So the last point on the slide is the most important takeaway:
The value of a coupon bond should be equal to the sum of the values of its individual cash-
flow components.
If the coupon cash flows and principal cash flow were priced separately using the correct
discount rates from the yield curve, and then summed up, we should get the exact fair value of
the whole bond. If we don’t, arbitrage will push prices back into alignment.
Question 1
Why should each cash flow of a coupon bond be discounted using a maturity-specific rate?
A. Because all coupon payments have the same maturity
B. Because the yield curve shows that bonds with different maturities may have different yields
C. Because coupon bonds do not have principal payments
D. Because zero-coupon bonds always have higher prices than coupon bonds
Correct Answer: B
Explanation:
Each coupon payment occurs at a different point in time, so each cash flow should be discounted
using the rate that matches its maturity.
Sometimes the yield curve slopes downward. This happens when short-term yields are higher
than long-term yields. One reason is that the Federal Reserve may have raised short-term interest
rates to fight inflation. At the same time, investors may expect the economy to slow down and
future interest rates to decline. As a result, long-term yields fall relative to short-term yields,
creating an inverted yield curve.
GDP=C+I+G+NEXP
Slide8
It’s important to understand that these two curves don’t always match.
The pure yield curve is theoretically cleaner for valuing cash flows, because
it uses zero-coupon rates. The on-the-run curve, on the other hand, reflects
real market trading but mixes different cash-flow maturities into a single YTM
number.
So when we price bonds—especially more complex bonds—it is often better
to rely on the pure yield curve, because it allows us to discount each cash
flow individually at its correct maturity-specific rate. But in everyday market
discussions, the on-the-run yield curve is more widely referenced.