Bond Yield and Yield Spread Decomposition

There are a lot of reasons why investors demand a certain yield on a bond. These individual reasons can be listed alongside each other as components of the yield, and summed to the yield actually observed for a bond. This listing is a __bond yield decomposition__.

Start with a real risk-free interest rate. There is just the pure opportunity cost of money, and for that, investors need to be compensated. Then there's the loss in value of money due to inflation, so that is a second component. Locking up money for a longer time period is riskier than shorter periods, so there is a maturity premium.

What sort of bonds do you think would have these components in their yield?

Exactly! All of these things are considerations for all bonds; even for the safest, risk-free bond. So a risk-free bond can be thought of as having its yield decomposed into: Yield = real risk-free rate + expected inflation rate + maturity premium.

No, it's true that risky bonds have these components, but think about whether this list so far should be different for riskless bonds.

No, it's true safe bonds will contain these items, but that's not all.

What sort of yield component do you think would need to be added to a risky bond?

No, the tenor of a bond can be matched with that of a risk-free bond with the same tenor. This is already captured in the maturity premium.

That's right! Not only that, but bonds can also have differing levels of liquidity, depending on the issuer. This is often correlated with credit risk, but is an independent component. So the final yield decomposition is: Yield = real risk-free rate + expected inflation rate + maturity premium + liquidity premium + credit spread.

No, the inflation risk would be captured in the expected rate which is present for the risk-free bond. That doesn't change with the risk of a bond.

Now consider the __yield spread__ for a risky bond. If a small issuer sells a BBB+ rated bond, that bond will have a yield that is different from the yield of a risk-free bond with similar features, and that difference is the yield spread.

What components of the yield do you think would be in the yield spread?

No, these are the components of the risk-free bond yield. But think about what components would make up the difference between the yield of a risk-free bond and that of a risky bond.

No, the maturity premium is present in all bonds, including a risk-free bond of the same tenor as the bond being evaluated.

To summarize this discussion: [[summary]]

Yes! The yield of all bonds, including risk-free bonds, contains the components of the risk-free real interest rate, expected inflation rate, and a maturity premium. Therefore, the yield spread over and above that of a risk-free bond can be stated as: Yield spread = liquidity premium + credit spread Yield spreads can be affected by many things. Any sort of crisis, credit crunch, market turmoil, or lack of confidence will widen spreads, while periods of stability will generally see tighter spreads.

Only safe bonds

Only risky bonds

All types of bonds

A tenor premium

A credit premium

Another inflation premium

Liquidity premium + credit spread

Maturity premium + liquidity premium + credit spread

Real risk-free rate + expected inflation rate + maturity premium

Continue

Continue

Continue