The yield curve

The interest rate that lenders require of any borrower will depend on the term of the borrowing. The yield curve depicts the various rates at which the same borrower is able to borrow for different periods of time. The most closely watched yield curve in any country is that of the national government, which is the closest approximation to a risk-free yield. Other yield curves, such as the one for corporate borrowers, are best understood in comparison with the risk-free yield. The yield curve is drawn against two axes, the vertical showing yield (expressed in percentage points) and the horizontal giving the term in years. Most of the time the yield curve is positively sloped, going from the lower left corner of the chart to the upper right. In this case, very short-term borrowings would have the lowest yield, with the yield increasing as the term lengthens. The reasons for this shape are readily understandable, as lenders and investors wish to be compensated for the greater risk that i…

The changing nature of the market

Until the 1970s the bond market was principally a primary market. This meant that investors would purchase bonds at the time of issuance and hold the bonds until the principal was repaid. Their highly predictable cash flow made bonds attractive assets to investors such as life insurance companies and pension funds, the obligations of which could be predicted far in advance. The basic investment strategy  was to match assets and liabilities. An investor would estimate its financial requirements in a certain future year, often 10 or 20 years hence, and would then search for bonds of acceptable quality that would be repaid at that time. Successful bond investors were those who managed to buy bonds offering slightly higher yields than other bonds of similar quality.

Since the late 1970s, the reasons for investing in bonds have changed. Many investors now actively trade bonds to take advantage of price differences, rather than holding them over the long term. Two developments have brought about this change. First, computers have made it possible for traders to spot price differences quickly. Second, whereas investors previously valued all their bonds at the original purchase price until they were sold, accounting rules now require that under certain conditions bonds be valued at their current market value, or “marked to market”. As this requires the owner to record any loss or gain during each reporting period regardless of whether a bond is sold, there may be no advantage in holding rather than selling it.

Secondary dealing

Some corporate bonds trade on stock exchanges, where brokers for buyers and sellers meet face-to face. The vast majority of bond trading, though, occurs in the over-the-counter market, directly  between an investor and a bond dealer. Most trades are made over a telephone linking investor and dealer. Whatever the system, an institutional investor wishing to purchase or sell a bond makes its desire known, usually by calling several dealers. Dealers which hold or are willing to hold inventories of that bond respond with a bid price if they are offering to buy, or an asking price if they are offering to sell. Government bonds are traded by many dealers, and the spread between bid and ask prices is often razor-thin. Popular corporate issues will be actively traded by a dozen or more dealers and usually have wider bid-ask spreads than government bonds. Smaller issues by corporations or sub sovereigns can be difficult to trade, as there may be only one or two dealers interested in buying or selling the bonds. In some cases, it may not be possible to acquire a particular bond as none is being offered in the market.

Strips (an acronym for Separately Registered Interest and Principal of Securities) are an innovation related to zero-coupon bonds. strips turn the payments associated with a bond into separate securities, one foreach payment involved. Thus a ten-year bond with semi-annual interest payments could be restructured as up to 21 different securities, with 20 representing the right to each of the interest payments to be made overthe bond’s term and one the right to receive the principal when it is repaid. Each of these securities is effectively a zero-coupon bond, which is sold for less than the related payment and is redeemed at face value.Federal Reserve Banks will strip US Treasury bonds at the request of securities dealers, and the British government’s debt-management office does the same with certain gilts. The Deutsche Bundesbank, the German central bank, also offers stripped securities. Investment banks may construct similar securities from any bond to meet the needs of particular investors.


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