Credit Risk-Free Bonds material, interest, increase, actually, sufficient

transferpricing

Please refer to p93 of Volume 2 in the curriculum, or to p109 of Book 2 in SchweserNotes.

When describing credit risk free bonds, the material states that:

Usually an increase in short-term rates increases the yields on medium- and long-term
bonds. Medium- and long-term bond yields may actually fall, though, if the interest rate
increase is gauged sufficient to slow the economy.

Can someone please explain this

lcw77

I havent read that section and dont have access to the materials but this is my take on it: Yields can move depending on rate expectations as well as re-allocation trades. The latter is what could make yields fall even when rates are increasing. For example if one thinks the economy might slow and enter recession in the near future, equities and other risky assets would trade down in which case investors might allocate capital to bonds seeking a safe haven, thus driving yields down. This would especially be true of a credit-risk free bond since credit considerations would increase in an economic slowdown.

liangfeng

The yield curve is normally upward sloping. If the monetary authority raises short rates high enough, ie tightens, at some point the outlook will become a slowdown.

With a slowdown comes lower inflation expectations and lower real return, ie lower nominal return on bonds

dyga

raise short term rates and it results in the yields falling on bonds as investor demand for fixed income with lower rates will decrease ====================> higher bond yields

raising mid to long term rates should lower inflation below the expected inflation contained in these nominal bonds coupon payments making these securites more attractive to the market ==========> lower bond yields