YIELD CURVE (also known as term structure of

interest rates)
◼ Existing bond value- present value of the future income
stream discounted at the required rate of return(interest yield).
◼ Cost of existing bond is the yield to maturity.
◼ Cost of fixed rate debt is also referred to as interest yield.
◼ Interest yield depends on period to maturity.
◼ As a general rule, the interest yield on debt increases with the
remaining term to maturity.
◼ Interest yield might vary inversely with the remaining period of
maturity (i.e. when interest rates are expected to fall)
◼ When interest rates expected to rise in the future, interest
yield on longer period bonds might be much higher than a
shorter dated bonds. (WHY?) as compensation for tying up
funds for a longer period of time

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Value and cost of new bond estimated using yield curve
A yield curve – a graph showing term to maturity on X-axis
and interest yield on Y-axis (usually determined by central
banks)
Upwards
sloping
(positive)

This yield curve is used as a benchmark for other debt in

the market, such as corporate debts, mortgage rates or
bank lending rates. The curve is also used to predict
changes in economic output and growth. Usually when the
Feds hikes the interest rates, it will impact worldwide.

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 it helps to give an idea of future interest rate
◼ change and economic activity. There are three
main types of yield curve shapes: normal, inverted
and flat (or humped).

Normal yield curve slopes upward. The longer the

maturity, the higher the yield, with diminishing
marginal increases (that is, as one moves to the
right, the curve flattens out).

Two common explanations for upward sloping yield

curves.

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1. The market is anticipating a rise in the risk-free
rate. If investors hold off investing now, they may
receive a better rate in the future. Therefore,
under the arbitrage pricing theory, investors who
are willing to lock their money in now need to be
compensated for the anticipated rise in rates—
thus the higher interest rate on long-term
investments.

2. Longer maturities entail greater risks for the

investor. A risk premium is needed by the market,
since at longer durations there is more uncertainty
and a greater chance of catastrophic events that
impact the investment.

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◼ This effect is referred to as the liquidity spread. If the
market expects more volatility in the future, even if
interest rates are anticipated to decline, the increase
in the risk premium can influence the spread and
cause an increasing yield.

◼ The opposite position (short-term interest rates

higher than long-term) can also occur. The market's
anticipation of falling interest rates causes such
incidents. Negative liquidity premiums can also exist
if long-term investors dominate the market, but the
prevailing view is that a positive liquidity premium
dominates, so only the anticipation of falling interest
rates will cause an inverted yield curve.

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• Strongly inverted yield curves have historically preceded
economic depressions. When the yield curve is inversed, this
is usually an indication that the markets expect the short term
interest rates to fall sometime in the future. (note : The Great
Depression was the worst economic downturn in US history. It began in 1929 and did not
abate until the end of the 1930s. The stock market crash of October 1929 signalled the
beginning of the Great Depression. By 1933, unemployment was at 25 percent and more than
5,000 banks had gone out of business.

• The yield curve may also be flat or hump-shaped, due to

anticipated interest rates being steady, or short-term volatility
outweighing long-term volatility.

• Yield curves continually move all the time that the markets
are open, reflecting the market's reaction to news.

• Yield curves tend to move in parallel (i.e., the yield curve

shifts up and down as interest rate levels rise and fall).
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◼ • Expectation
Downwards
sloping or • Government
inverted Policies
(negative) • Market
Segmentations

2 points to note on yield curve.

1. Interest yields are gross yields i.e pre tax yields
2. Yield curve meant for risk free debt securities – risk
free yields (i.e government bonds)
Interest yield on corporate bonds and loans –higher with
same maturity- because of risks.
For corporate bonds – add spreads. YC = rf + risk pm
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Spread –difference between risk free rate on yield
curve and cost of corporate debt for the same maturity
period.

100 basis point =1% interest rate

Eg. If risk free rate =3.2% and spread for a company’s
debt is 60 basis points. Yield on company’s debt =
3.2% + 0.60 =3.8%

High spread –high risk

Low spread – low risk

Spread depends on rating given by rating agency.

Spread will be lowest for best rating.
Spread will be highest for worst rating.
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No Criteria(s) Explanation
No issuer’s debt will be rated higher than the country of the origin of the
1 Country risk
issuer (Sovereign Debt)
The company’s standing relative to the other companies in the country of
2 Country importance domicile and globally (measured in terms of sales, profits, relationships
with government, importance of the industry to the country)

The strength of the industry within the country, measured by the impact of
3 Industry risk
economic forces, cyclical nature of the industry, demand factors
Issuer’s position in the relevant industry compared with the competitors in
4 Industry position
terms of operating efficiency
The company’s planning, controls, financing policies and strategies, overall
Management
5 quality of management and succession, merger and acquisition
Evaluation
performance and record of achievement in financial results
Auditors’ qualification of the accounts, and accounting policies for
6 Accounting quality
inventory, goodwill, depreciation polices, etc
Earnings power including return on capital, pre-tax and net profit margins,
7 Earnings protection
sources of future earnings growth
Long term debt and total debt in relation to capital, gearing, nature of
8 Financial gearing
assets, off balance sheet commitments, working capital management, etc
Relationship of cash flow to gearing and ability to finance all business cash
9 Cash flow adequacy
needs
Evaluation of financing needs, plans and alternative under stress (ability to
10 Financial flexibility
attract capital), banking relationships, debt covenants

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Spread vary according to :
1. the risk characteristics of the industry
2. The time remaining to maturity for the debt
3. The current ratings

Eg of spreads

Rating 1 year 2 year 3 year

AAA 14 25 38
AA 29 41 55
A 46 60 76

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The financial press and central banks will publish
estimated spot yield curves based on government
issued bonds.

Yield curves for individual corporate bonds can be

estimated from the government yield curve by adding
the relevant spread to the bonds. For example, the
following table of government yield curve and spreads
(in basis points) is given for the Megamall Plc.
Year
1 4.29%
2 5.16%
3 5.98%
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◼ Spread
Rating 1 year 2 year 3 year
AAA 16 26 39
AA 27 38 51
A 49 63 74

Megamall Plc has a credit rating of A, then its

individual yield curve – based on the government
bond yield curve and the spread table above – may
be estimated as:
Year 1 4.29% +0.49% =4.78%
Year 2 5.16% +0.63% =5.79%
Year 3 5.98% + 0.74% =6.72%

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How to estimate the yield curve
◼ There are different methods used to estimate a spot
yield curve, and the iterative process based on
bootstrapping coupon paying bonds is perhaps the
simplest to understand.

◼ Bootstrapping- procedure used to calculate the

zero-coupon yield curve from market figures.
Because the T-bills offered by the government are
not available for every time period, the bootstrapping
method is used to fill in the missing figures in order to
derive the yield curve. The bootstrap method uses
interpolation to determine the yields for Treasury
zero-coupon securities with various maturities.
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Other methods of estimating the spot yield
curve, such as using multiple regression
techniques and observation of spot rates of
zero coupon bonds, is beyond the scope of the
Paper P4 syllabus.

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