Components of yield

1. Components of yield

The riskier the bond the higher is its yield.

2. Baseline component of yield

So a bond that bears no default risk must earn the risk-free yield. A baseline rate for a bond's yield is the yield on a US Treasury security with a similar maturity. This is the minimum interest rate that an investor will demand. Note that the risk-free yield is different at different points in time. This is because the Treasury yields are affected by how the economy is growing, general market interest rates, and inflation. This means that the baseline rate could be higher or lower depending on the time the bond is being valued.

3. Obtaining treasury data

To load FRED data into your R workspace, use quantmod's getSymbols command with the 10-Year Treasuries symbol, or 'DGS10'. The R code used to download the 10-year US Treasury yields with ticker DGS10 is shown here. As you can see, the getSymbols command loads a time series of rates on a daily basis.

4. Spread component of yield

There is another component of bond yields called the spread. Compared to government bonds, a corporate bond is relatively riskier. As a result, its yield needs an additional level of return on top of the risk-free yield to compensate the investor for taking on the specific type of risks of holding a specific bond. This additional return is the spread. The spread is primarily comprised of credit risk. This is the risk that the issuer will default before all the promised cash flows are paid.

5. Risks of investing in bonds

In addition to credit risk, bonds can also be exposed to a number of other risks, such as "inflation risk," "call risk," and "liquidity risk." "Inflation risk" is when inflation eats up the value of the cash flows you receive from the bond. This is when the same dollar cannot buy as much in the future as it could have today. "Call risk" is when a bond issuer has the option to "call" or buyback the bond. The issuer will only do so when buying back is advantageous for it, which means that it is at a time that is disadvantageous to the bond investor. "Liquidity risk" is the risk that when you want to sell the bond, you are unable to sell it for a price that is at or near the bond's value. Because many bonds don't trade frequently, liquidity risk could be an issue for many investors. These risks require the bond issuer to pay a "risk premium." This "risk premium" is primarily quantified in the "spread," which is added on top of the baseline risk-free yield to arrive at the bond's yield.

6. Time-varying risk premiums

Just like the risk-free yield, the spread is not constant through time. Its size depends on the market's current appetite for risk. When markets are nervous, like during the 2008/2009 financial crisis, bond investors required a larger risk premium. You can see this by plotting the Investment Grade spread, which is the difference in the yield of the highest investment grade bonds and the yield of the lowest investment grade bonds. In the Moody's scale, that means the difference between the yields on Aaa and Baa bonds. We can get the yields on these indexes from the quantmod package as shown in the prior video.

7. Let's practice!

In the exercises that follow, you will obtain and plot the risk-free yield and investment grade spread. You will then be able to see first-hand the time-varying nature of these two components of a bond's yield.

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