Reading 23: Capital Market Expectations－LOS n

Interest rates will increase during a robust expansion. If a manager thought that interest rates were set to rise, (s)he would shift from say nine-month cash instruments down to three-month cash instruments. If (s)he thought that the economy was going to improve so that less creditworthy instruments would have less chance of default, (s)he would shift more assets into lower rated cash instruments. Longer maturity and less creditworthy instruments have higher expected return, but also more risk.

A change in short-term rates has unpredictable effects. Usually an increase in short-term rates increases the yields on bonds. Bond yields may actually fall though if the interest rate increase is sufficient to slow the economy.

The key difference between developed country government bonds and emerging market government bonds is that most emerging debt is denominated in a non-domestic currency (e.g., dollars, euros, etc.). The emerging government must obtain a hard currency to pay back the principal and interest. The default risk for emerging market debt is thus much higher.