Investing in Bonds, Slope and Shape of the Yield Curve - Example

Investing in Bonds Client Insert Name Client Insert Institution Investing in Bonds Introduction There are many concepts that define the various approaches involved in the investment of bonds in the business world. According to Quint (2010), investment in bonds is one of the most lucrative investment initiatives particularly for significant investment businesses working with large agencies and corporations such as governments (Quint, 2010). By definition, a bond is basically a debt investment where a given investor gives money in the form of a loan to a given entity say government or corporate which borrows the money for a given length of time at an agreed interest rate (Sullivan & Sheffrin, 2003; Friedman, 2010). This interest rate may either be fixed or variable as stipulated in the bond terms of reference. The reason that this business arrangement occurs is to enable governments, corporate, municipalities, and states to raise the required money to finance and run different projects that such entities may be interested in. This paper, discuses the different theories and concepts involved in the bonds investment business and will in the process seek to explain how the various features of this business relate to each other. Theories that explain the Slope and Shape of the Yield Curve In order to understand and explain the shape and slope of the yield curve, it is important first of all to understand what a yield curve is. According to Sullivan & Sheffrin (2003); “A yield curve is a graph plotting the yields of similar quality bonds against their maturities from shortest to longest” (Sullivan & Sheffrin, 2003, p. 34). In a typical sense, the yield curve shows the different yields that are given on different bonds at different maturity levels making it easier for investors to compare the yields that can be accrued by short-term, medium-term and long-term bonds in order to make wise investment decisions (Batten & Szilagyi, 2006). In its traditional form, there are three different shapes of the yield curve which means different things when plotted on a graph. In the first instance, the graph would slope upwards when the short-term yields are less than the long-term yields in which case the yield curve is referred to as, a positive/normal yield curve (Sullivan & Sheffrin, 2003). Blaug (2007) further alludes that in the event that the short-term yields are more or higher than the long-term yields, the graph would slope downwards and this yield curve is referred to as, an inverted/negative yield curve. Lastly, there are instances where the yield curve is flat and this occurs when there is really no outright difference between short-term and long-term yields in bonds investment. These three different variations of yield curve are shown in figure 1 below: Fig. 1: Different Shapes of Yield Curves Source: (Batten & Szilagyi, 2006, p. 121 – 122) Why is the slope and shape of the yield curve important? Batten & Szilagyi (2006) observe that the shape and slope of the yield curve is very important as it gives investors an idea about what kind of prudence exists in which kind of investment. For this to be achieved, the curve has to plot only bonds of similar risks and in this case, a good example of such curves in real life is usually the Treasury securities which are usually risk-free and therefore can provide a good benchmark for yields when considering other forms of debt (Batten & Szilagyi, 2006). The foregoing three shapes of yield curves mean different things to investors in the market. For instance, in general terms, the normal yield curve shows that investors will need higher rates of return when they take the risk of lending money for longer periods of time. When the curve is steep and sloping positively, many economists anticipate stronger economic growth in future with higher inflation which means that there is an anticipation of higher interest rates. The converse is true; that is, when the yield curve is sharply inverted this generally means that investors should expect a slowing economic growth with lower inflation rates and hence interest rates in future (Baptiste, 2010). A flat yield curve usually means that the market is unsure of the future economic dynamics and inflation rates hence not predictable. Sullivan & Sheffrin (2003), shares that there are three main theories that attempt to explain the shape and slope of yield curves. These theories are the following: 1. The Segmented Market Theory – this is the other hypothetical theory that surmises that investors segment themselves into different maturity segments. This means that with this preferences, the yield curve is nothing but a reflection of the market investment policies that demarcate it to different preferences and hence segmentations (Sullivan & Sheffrin, 2003). 2. The Expectations Theory – in its basic form, this theory seeks to suggest that the forward rates involved in current long-term bonds is closely related to what the bond market expects the future short-term interest rates in the market to be (Sullivan & Sheffrin, 2003). In other words, “the expectations of rising short-term interest rates are what create a positive yield curve; and the converse is true” (Sullivan & Sheffrin, 2003, p. 45). 3. The Liquidity Preference Theory – this theory surmises that investors in general prefer higher liquidity of short-term debts. This according to this theory then means that all other forms of deviation from a positive yield curve is only a temporary phenomenon foreseeable for some time (Sullivan & Sheffrin, 2003; Hodgson, 2007). From the foregoing discussion, it is clear that the yield curve provides very critical information about an investment opportunity particularly as regards future market growth and expansion of contraction. This underlies the importance that yield curves have in the modern understanding of economic concepts of investment particularly in bonds and hence providing a clearer understanding of the prudence of investment in future opportunities. In addition to this, the way the yield curve changes also has an influence on the portfolio returns since it makes some bonds sort of more valuable than others and this largely influences investors’ decisions to invest in given bonds at given times under given circumstances (Batten & Szilagyi, 2006; McColluog, 2007). The Relationship between Interest Rates and Maturity of Bonds When there are changes in the interest rates, not all bonds are affected in an equal way. In other words, when bonds take longer periods to mature, there are increased risks that prices of the bonds are likely to change over time due to fluctuation and inflation of the same and therefore investors usually expected to be compensated better for taking the extra risk with their investment (Batten & Szilagyi, 2006; Bell, 2009). This then means that there is a direct relational link between maturity and yield, which is seen in the plotting of a yield curve. The following excerpt from Sullivan & Sheffrin (2003), provide a clearer understanding of this relationship: A steep yield curve means that yields on short-term bonds are slightly lower compared to those on the long-term bonds. This means that one can obtain actually increased bond income (yield) by buying a longer maturity than with a short one. Conversely, a flat yield curve means that the difference between short-term bonds and long-term bonds is actually very slim, or non-existent. This means that the reward for extending maturities is relatively small, and many investors will choose to stay in the short end of the maturity range (Sullivan & Sheffrin, 2003, p. 65). Interpretation of Statistical data from Reserve Bank of Australia (RBA) The Reserve Bank of Australia (RBA) provides different statistics on investment developments within the country and how the interest rates vary with time of investment. The foregoing sections of this paper have explained already that there is a direct relationship between interest rates of a bond and the time to maturity where the longer the time of maturity of a bond, the greater the risks associated with it and hence the higher the interest rates (Batten & Szilagyi, 2006). From one particular chart, (shown in figure 2 below), RBA makes an estimate of the average interest rates on lending in Australia among small businesses and large businesses for a period of the years between 1999 and 2015. Fig. 2: Australian Business Lending Rates: Average interest Rate on Outstanding Lending Source: (Reserve Bank of Australia, 2015, p. 1) From this graph, the reality in both small businesses and large businesses is similar by and large based on the slope of the respective graphs. With the help of the Expectations Theory, this graph is understood to indicate that the earlier on in the decade the yield curve of investment for small businesses as well as large businesses was inverted meaning that the short-term yields from investment were higher than the long-term yields hence investment in short-term yields. The periods between 2002 and 2009, the market was a relatively uncertain of future economic projections as the yield curve is relatively flat. This means that investors remained uncertain of what to expect within the market and did not take many risks hence reduced levels of investment within the economy. The graph further shows that in more recent times during the 2015 Fiscal Year, investment in short-term bonds is more preferred than in long-term bonds for both small and large businesses as the yield curve is inverted in a steep slope. References Baptiste, J. (2010). A Treatise on Political Economy: Or The Production, Distribution, and Consumption of Wealth. New York: Wells and Lilly. Batten, J. & Szilagyi, P. (2006). Developing Foreign Bond Markets: The Arirang Bond Experience in Australia. Sydney: Sage Publishers. Bell, C. (2009). Development Economics: The New Palgrave: A Dictionary of Economics. New York: Sage Publishers. Blaug, M. (2007). “The Social Sciences: Economics – Growth and development”. The New Encyclopedia Britannica, 27(2): 351 – 357. Friedman, M. (2010). "The Methodology of Positive Economics". Essays in Positive Economics, 14(15), 22 – 31. Hodgson, M. (2007). "Evolutionary and Institutional Economics as the New Mainstream". Evolutionary and Institutional Economics Review, 4 (1): 7–25. McColluog, B. (2007). “Got Replicability? The Journal of Money, Banking and Credit Archive”. Econ Journal Watch, 4 (3): 326 - 337. Quint, M. (2010). "Elements in Bearer Bond Issue". New York Times. 12 October 20110. Reserve Bank of Australia. (2015). Chart Pack: Interest Rates. Retrieved from http://www.rba.gov.au/chart-pack/interest-rates.html#19. Sullivan, A. & Sheffrin, M. (2003). Economics: Principles in Action. Upper Saddle River, New Jersey: Pearson Prentice Hall. Read More