Effect of Bonds' Riskiness on the Interest Rate - Essay Sample

Introduction

In general terms, a bond is a fixed income instrument representing a form of a loan investment made by an investor to a borrower, typically corporate or governmental that includes the details of the investment and such as terms of payments and the maturity period. Usually, in the maturity period, the principal amount paid back with a fixed interest rate (Chen, 2019). When the price of a bond lower at higher interest rates, ceteris paribus, the quantity demanded of bonds is higher revealing an inverse relationship, whereas, at lower prices at higher interest rates, ceteris paribus, the amount supplied of the bond is lower showing a positive relationship.

Is your time best spent reading someone else’s essay? Get a 100% original essay FROM A CERTIFIED WRITER!

Save 25%

Effect of Riskiness of Bonds on the Interest Rate.

Bonds with the same maturity period have different interest rates due to default risk, liquidity, and tax considerations. At default risk, the probability that the issuer of the bond is unable or unwilling to make interest rate payments or pay off the face value is high. With income tax considerations, the income tax rate on taxpayers likely to increase inconsistent with supply and demand analysis, whereby an increase in income tax rates results in low-interest rates on bonds. Bonds with the same risk, liquidity, as well as tax characteristics may have different rates of interest because the time remaining to maturity is different. Rates of Interest on bonds of different maturities move together over time, and when the short-term rates of interest are lower, yield curves are more likely to have an upward slope, and when short-term rates are high, the yield curves are more likely to slope downward and be inverted.

Market Effects on the Bonds Market and the Liquidity Preference.

Bonds of different maturity are not substitutes at all. The interest rate for each the same with a different timeline generally determined by the demand for and supply of that particular bond. Investors in bond markets have preferences for bonds of one maturity over another, and generally, prefer bonds with shorter maturities that have a less interest-rate risk, and this demonstrates why yield curves usually slope upward. The rate of interest on a long-term bond will equal an average of short-term interest rates expected to occur over the maturity period of the bond of long-term maturity, and liquidity that responds to demand and supply conditions of the market for that particular bond.

Bonds of different maturities are partial, but not perfect substitutes. Investors usually have a preference for bonds of one maturity over another, and at any given period, they will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return, and for this reason, the investors are more likely to prefer short-term bonds over longer-term bonds. The Interest rates on different maturity bonds move together over time as yield curves of the bonds tend to show upward slope when short-term rates are low and to be inverted when short-term rates are high, and this explained by a more substantial liquidity premium as the term to maturity lengthens.

References

Frederic, S. (2004). Mishkin. The Economics of Money, banking and Financial Markets

Chen, J. (2019) Bond. Investopedia. Retrieved https://www.investopedia.com/terms/b/bond.asp