Chapter 6: Interest-Rate Spreads and Yield Curves
The chapter opens with a consideration of variations in interest rates in the United States and what is generally found is that in periods of prosperity (the 1920s, the 1950s, and the 1980s) the abundance of wealth in society pushes interest rates downward, whereas in periods of deprivation (the 1930s and 1970s) the lack of wealth in society causes interest rates to rise.
There is an self-feeding cycle. In a good cycle, people have wealth to invest because they have been productive and invest that wealth in increasing productivity. In a bad cycle there is little productivity, which generates little profit, which leads to less wealth to invest in productivity.
(EN: The author doesn't step into the reasons why, and gives the perception this "just happens" naturally, which leads many to believe regulatory intervention is necessary to keep the market healthy - but it is regulatory intervention itself that causes major boom-bust patterns. Regulations and actions that attempt to pump up the economy often create artificial highs that cause balloons to inflate and then burst - the government's support of cheap real estate loans to unqualified buyers in the 1990s led to many defaults and the resulting crash about fifteen years later. The same pattern was suggested in the 1920s/1930s and 1950s/1960s where regulators interfered in the market to pump up the economy and there was a later crash. This doesn't "just happen" on its own.)
The Risk Premium
A bond is essentially a loan that is repaid over a long period of time (typically ten years), with the risk that the issuer of the bond will repay as agreed or at all. In general, the greater that risk, the higher interest must be offered to investors to entice them to extend credit to the issuer.
Federal government bonds are considered the lowest risk because the US government has never defaulted on bonds, and its ability to repay is based on the economy of the entire nation. The government does not need to make a profit, merely to extort additional money from its citizens, to pay its debts.
Municipalities (cities and states) are also low risk, but because they do not have the same power as the federal government to tax and create money, there are instances in which municipalities have declared bankruptcy and suspended bond interest payment.
Corporation are more likely to default on bonds because they are reliant on the performance of their operations to generate a profit. Businesses fail, and smaller and newer firms tend to fail quite often, so there are multiple grades of corporate bonds (from AAA to C) that reflect the creditworthiness of a firm. The return on bonds varies accordingly.
In general, the amount of interest paid for a bond above the rate being paid for federal securities is called the "risk premium" because it is entirely based on the amount of risk.
There is also the mention that municipal or "muni" bonds have advantage of being tax-exempt, so an investor who pays taxes of 25% would make the exact same after-tax return on a 3% muni as on a 4% corporate bond, at a lower level of risk.
The Term Structure
Generally, bonds that have longer terms and are further from their maturity are considered more risky and must provide a higher return, in the same way that a customer loan for five years has a higher interest rate than a loan to be repaid in one year. So even bonds from the same issuer have different yields according to the length of time before the principal is repaid.
In unusual instances, a short-term bond may offer more interest than a long-term one. This happens only when the buyers expect that interest rates will rise and are reluctant to commit their capital to an investment that pays less interest than they expect to be able to earn in the near future. This is most commonly seen with short-term treasury investments. But outside of these unusual situations, the general rule that long-term credit costs more than short-term holds.
The author mentions the "yield curve," which is a diagram that charts the interest rates of bonds of various maturities and the same level of risk. In general, the curve slopes up and to the right because short-term rates are lower than long-term rates - but at times part of the curve may be flat or inverted. This curve is used as a prediction tool because the amount customers are willing to pay for credit reflects their own expectations about future interest rates. Statistical analysis has shown that the predictions of the yield curve are "good" in the very short term (the next few months) and the long term, but there is a lot of variance in-between.