Expected returns – the importance of the future expectations… Flashcards
What can we look at when comparing bonds?
One way of comparing bonds is to consider the yield curve of each. A yield curve will give an indication of the way a market expects interest rates to change in the
future and the returns required from the bond as a result
What does a normal yield curve look like and demonstrate?
A normal curve, as shown in the attached picture would suggest that the longer the period to redemption, the higher the
yield required from the bond. This takes into account the market’s perceived risk of adverse changes in interest rates. If investors believe that interest rates &
inflation are going to rise in the future then the more steep the curve will be as they want to be compensated by receiving a higher yield.
What does a flat yield curve look like and demonstrate?
When the market expects a degree of stability, there is no need to demand the higher yield for longer periods
to redemption. This is because there is not expected to be the same risk, as shown in attached picture, a ‘flat yield curve’
What does a inverted yield curve look like and demonstrate?
Where the market has expectations for falling interest rates over the longer term, yields will fall. This is to reflect the fact that over the longer term, as interest rates fall, the longer dated bonds will become more attractive and therefore the price of those bonds will rise and subsequently the yield will fall. Investors may also think that short term interest rates will rise, hence a higher yield in the shorter end of the curve as shorter dated bond prices fall. This is shown in the attached picture, an ‘inverted yield curve’ or reverse yield curve.
