FLATTENING OF BOND YIELD CURVES

Putting no restrictions on forward interest rates, earlier research has shown that yield curves for coupon-bearing bonds will become flat for long maturities. This paper shows that weak restrictions on forward rates imply flattening of bond yield curves for maturities of 10 to 15 years.     

THE SLOPE OF THE TERM STRUCTURE OF CREDIT SPREADS: AN EMPIRICAL INVESTIGATION

In this article we analyze the slope of the term structure of credit spreads. We investigate the explanatory role of interest rate, market, and idiosyncratic equity variables that the recent empirical literature highlights as important determinants of credit spread levels. This study extends the analysis and assesses its effect on credit slopes for a sample of corporate bonds. We find that these factors affect credit spreads at short and long maturities in a significantly different way. A closer inspection of the credit spread slope also reveals that it is a useful indicator of the direction of changes in future short‐term credit spreads. This evidence has important implications for the trading and risk management of portfolios of bonds with different maturities.     

On the Relative Performance of Investment‐Grade Corporate Bonds with Differing Maturities

We find that short‐maturity investment‐grade corporate bonds perform better, controlling for risk differences, than similar bonds with longer maturities. Our results are at least partially attributable to insurance companies’ trading behavior and align with the preferred‐habitat theory of the term structure. We find that insurance‐company purchases create a strong demand for long‐term bonds and that their rebalancing activity results in sales of short‐term bonds. As documented by extant literature, such demand‐supply imbalance is not easily resolved by arbitrageurs or firms seeking to time the market with bond issuance.     

Consumption risk and the cross-section of government bond returns

In this paper we provide a consumption-based explanation of risk in nominal US Treasury bond portfolios. We use a consumption-CAPM with Epstein–Zin–Weil recursive preferences. Our model introduces two sources of risk: uncertainty about current consumption (reflected in contemporaneous consumption growth) and uncertainty about prospects of consumption in a long run (reflected in innovations to expectations about future consumption growth). We use a novel approach to estimate pricing factors in our model: we employ a factor-augmented VAR model with common factors, extracted from a large panel of macroeconomic and financial data, as state variables. We find that the important source of risk in US bonds is related to uncertainty in prospects in future consumption and it induces a positive and significant risk premium. We find as well that covariance risk related to innovations in expectations about future consumption growth is greater for long term bond portfolios than for short term bond portfolios, which is consistent with a duration measure of risk and justifies why long term bonds require greater premium than short term bonds. Our model explains well the cross-sectional variation in average excess returns of bonds with different maturities over the period 1975–2011 and compares favorably with competing models.     

The fluctuating maturities of convertible bonds

The maturities of newly issued convertible bonds vary substantially over time. Firm-specific determinants of maturity from the straight debt literature are relevant for convertible bonds. However, the growth of the convertible arbitrage industry and the role of convertible arbitrage hedge funds have changed the importance of firm characteristics in the convertible bond market. Recently issued convertible bonds come with particularly short maturities that serve as substitutes for call provisions. This substitution implies that backdoor-equity and sequential-financing rationales for issuing callable convertible bonds are also applicable for non-callable convertibles with shorter maturities.     

Term Structure Models: A Perspective from the Long Rate

Term structure models based on dynamic asset-pricing theory are discussed by taking a perspective from the long rate. This paper partially answers two questions about the asymptotic behavior of yields on default-free zero-coupon bonds: in frictionless markets having no arbitrage, what should the behavior be; and, in known term structure models, what can the behavior be.

In frictionless markets having no arbitrage, yields of all maturities should be positive and uniformly bounded from above. The yield curve should level out as term to maturity increases. Slopes with large absolute values occur only in the early maturities. In a continuous-time framework, the longer the maturity of the yield is, the less volatile it will be. The long rate should be a nondecreasing process. Furthermore, the long rate in continuous-time factor models with nonsingular volatility matrices should be a nondecreasing deterministic function.

In the Black, Derman, and Toy model and factor models with the short rate having the mean reversion property, yields of all maturities are uniformly bounded from above. The long rate in the Duffie and Kan model with the mean reversion property is a constant. The long rate in the Heath, Jarrow, and Morton model can be infinite or a nondecreasing process. Examples with the long rate increasing are given in this paper. A model with the long rate and short rate as two state variables is then obtained.     

Does the Failure of the Expectations Hypothesis Matter for Long‐Term Investors?

We solve the portfolio problem of a long‐run investor when the term structure is Gaussian and when the investor has access to nominal bonds and stock. We apply our method to a three‐factor model that captures the failure of the expectations hypothesis. We extend this model to account for time‐varying expected inflation, and estimate the model with both inflation and term structure data. The estimates imply that the bond portfolio of a long‐run investor looks very different from the portfolio of a mean‐variance optimizer. In particular, time‐varying term premia generate large hedging demands for long‐term bonds.     

Riding the yield curve: a spanning analysis

The average return on long-term bonds exceeds the return on short-term bills by a large amount over short investment horizons. A riding-the-yield-curve investment strategy takes advantage of the higher returns on longer term bonds. This strategy involves the purchase of bonds with maturities longer than the investment horizon and the sale of these bonds, before they mature, at the end of the investment horizon. Most of the literature that evaluates this strategy compares only ex post average returns or Sharpe ratios. In this paper, we use spanning tests to provide formal statistical evidence on the benefits of investing in long bonds when the investment horizon is short. The results for both the United States and Canada indicate that an investor with a short horizon is better off investing in short-term debt instruments than long-term bonds.     

New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates

Survey data on interest rate expectations permit separate testing of the two alternative hypotheses in traditional term structure tests: that the expectations hypothesis fails, and that expected future interest rates are ex post inefficient forecasts. We find that the source of the spread's poor predictions of future interest rates varies with maturity. At short maturities the expectations hypothesis fails. At long maturities, however, changes in the yield curve reflect changes in expected future rates one-for-one, an implication of the expectations hypothesis. This result confirms earlier findings that long rates underreact to short rates, but now it cannot be attributed to term premia.     

Return generating process and the determinants of term premiums

This paper examines asset pricing theories for treasury bonds using longer maturities than previous studies and employing a simple multi-factor model. We allow bond factor loadings to vary over time according to term structure variables. The model examines not only the time variation in the expected returns of bonds but also their unexpected returns. This allows us to explicitly test some asset pricing restrictions which are difficult to study under existing frameworks. We confirm that the pure expectation theory of the term structure of interest rates is rejected by the data. Our empirical study of a two-factor model finds substantial evidence of time-varying term-premiums and factor loadings. The fact that factor loadings vary with long-term interest rates and yield spreads suggest that bond return volatilities are sensitive to interest rate levels.     

The Behavior of Eurocurrency Returns Across Different Holding Periods and Monetary Regimes

Recent empirical studies of the risk premium across foreign exchange and other asset markets such as equity and longer term bonds have found conflicting evidence about the latent variable model restrictions of the consumption-based intertemporal capital asset pricing model. While studies using data for holding periods of one month or less generally reject the model, evidence using three-month holding periods indicates that the model cannot be rejected when including the returns on long relative to short deposit rates. This paper investigates the sources of differences in results using returns on foreign exchange and Eurocurrency deposits at three different maturities.     

Market Interest Rates and Commercial Bank Profitability: An Empirical Investigation

The widespread notion that commercial banks “borrow short and lend long” implies that sharp market interest rate increases may induce a significant number of banking failures. This paper develops a method for estimating average asset and liability maturities for a sample of large money center banks. Regression models are tested to determine if market rate fluctuations have a significant impact on bank profitability. The conclusion is negative: large banks have effectively hedged themselves against market rate risk by assembling asset and liability portfolios with similar average maturities.     

Stochastic cash flow constraints and the term structure of interest

This paper attempts to provide a theoretical foundation for liquidity premia to be found in the term structure of interest rates. These premia arise from the borrowers' future availability of cash and from the lenders' future need for cash. In addition a third category of investors are active on the market: speculators who have no cash constraint and take positions on the basis of their expectations of future spot rates only. The interaction between these three groups yields an equilibrium term structure which is tested empirically; the test produces estimates of the relative weights of the groups in the determination of liquidity premia. Analysis of these weights indicates that there exists some market segmentation between bonds of different maturities.     

In search of a theory of debt management

The complete market approach to government debt management argues that a portfolio of non-contingent bonds at different maturities should be chosen so that fluctuations in market value offset changes in expected future deficits. However, this approach recommends huge fluctuations in positions, enormous changes in portfolios for minor changes in maturities and no presumption it is always optimal to issue long and invest short term in a wide array of model specifications. These extreme, volatile and unstable features are undesirable for two reasons. Firstly fragility of portfolios to small changes in assumptions means that it is often better to follow a balanced budget rather than issue the optimal debt portfolio under some possibly misspecified model. Secondly for even miniscule transaction costs, governments prefer a balanced budget rather than the large positions complete markets recommends. The complete market recommendations conflict with a number of features we believe are integral to bond market incompleteness, e.g. transaction costs, liquidity effects, robustness, etc. and which need to be explicitly incorporated into the portfolio problem.     

Tax and Liquidity Effects in Pricing Government Bonds

Daily data from interdealer government bond brokers are examined for tax and liquidity effects. We use two approaches to create cash flow matching portfolios of similar securities and look for pricing discrepancies associated with liquidity or tax effects. We also look for the presence of tax and liquidity effects by including a liquidity term when fitting a cubic spline to the after-tax yield curve. We find evidence of tax timing options and liquidity effects. However, the effects are much smaller than previously reported and the effects of liquidity are primarily due to high volume bonds with long maturities.     

Permanent trading impacts and bond yields

We analyse four years of transaction data for euro-area sovereign bonds traded on the MTS electronic platforms. In order to measure the informational content of trading activity, we estimate the permanent price response to trades. We not only find strong evidence of information asymmetry in sovereign bond markets, but also show the relevance of information asymmetry in explaining the cross-sectional variations of bond yields across a wide range of bond maturities and countries. Our results confirm that trades of more recently issued bonds and longer maturity bonds have a greater permanent effect on prices. We compare the price impact of trades for bonds across different maturity categories and find that trades of French and German bonds have the highest long-term price impact in the short maturity class, whereas trades of German bonds have the highest permanent price impact in the long maturity class. More importantly, we study the cross-section of bond yields and find that after controlling for conventional factors, investors demand higher yields for bonds with larger permanent trading impact. Interestingly, when investors face increased market uncertainty, they require even higher compensation for information asymmetry.     

Fitting the term structure of interest rates for Taiwanese government bonds

The term structure of interest rates provides a basis for pricing fixed-income securities and interest rate derivative securities as well as other capital assets. Unfortunately, the term structure is not always directly observable because most of the substitutes for default-free bonds are not pure discount bonds. We use curve fitting techniques with the observed government coupon bond prices to estimate the term structure. In this paper, the B-spline approximation is used to estimate the Taiwanese Government Bond (TGB) term structure. We apply the B-spline functions to approximate the discount function, spot yield curve, and forward yield curve respectively. Among the three approaches, the discount fitting approach and the spot fitting approach are reasonable and reliable, but the spot fitting approach achieves the most suitable fit. Using this methodology, we can investigate term structure fitting problems, identify coupon effects, and analyze factors which drive term structure fluctuations in the TGB market.     

Subjective evaluation of delayed risky outcomes for buying and selling positions: the behavioral approach

This paper analyzes time discounting as a function of risk, using reservation prices. Based on experimental data, we compare bidder reservation prices for riskless assets with those for risky assets. The experiments rely on a second price auction with real monetary incentives and real delay in payoffs. We estimate the pure time discount rate for different maturities, considering riskless assets (bonds) and risky assets (delayed lotteries). An innovation in the experimental design allows disentangling pure time from pure risk discounting effects. If subjects bid for assets, we find implied discount rates for risky assets to be uniformly lower than those for riskless assets, across all maturities (the risk moderation effect). However, there is no risk moderation effect if subjects quote ask prices. We argue that delaying a payoff has a stronger effect on the price of bonds than on the price of risky assets since, in the case of bonds, the investor moves from a position of certainty to a position of risk, or uncertainty. Our findings on the risk moderation effect may be used to explain the attractiveness of compensation contracts with options, as commonly used in the financial industry.     

Bond yields compared to amortizing yields

A large amount of theoretical research has been conducted concerning the impact of debt instrument features such as callability, tax treatment, and default risk upon valuation and yield. Almost all this research has been performed on bond-like instruments; this is unfortunate since a large proportion of debt instruments is amortizing. This research develops a model for the spread between bonds and amortizing instruments with otherwise identical features. The shape of the term structure is crucial. Furthermore, the behavior of the spread is systematically related to the level of interest rates, tax rates, degree of default risk, and maturity where the maturity relation changes sign at intermediate maturities.