Below are three different pairs of bonds and their recent yields. Pick one pair (pairs are labebed 1, 2 and 3 below) and 1) explain the primary factors that contribute to making the yields of the two bonds in your pair differ. While there may be a single factor, there will be multiple underlying causes for that factor. 2) State which of the two bonds in your pair you would buy if you had to buy one of them and why.
Bond pairs:
1. Germany 10 year bond yielding 1.57% Vs. Germany 30 year bond yielding 2.4%
2. US 10 year treasury bond yielding 1.96% Vs. US 10 year inflation indexed treasury bond yielding -0.578
3. France 10 year bond yielding 2.23% Vs. Greece 10 year bond yielding 11.07%
Let's analyze each pair of bonds and discuss the factors that contribute to the difference in their yields.
1. Germany 10-year bond yielding 1.57% vs. Germany 30-year bond yielding 2.4%:
The primary factor that contributes to the difference in yields between these two bonds is the term length. The 30-year bond has a longer maturity period compared to the 10-year bond. Several underlying causes affect the yields:
a) Interest rate risk: Longer-term bonds are more exposed to interest rate fluctuations. Bond investors demand a higher yield for longer-term bonds to compensate for this risk. If interest rates rise in the future, the value of the longer-term bond may decline.
b) Inflation expectations: Bonds with longer maturities are more susceptible to inflation. Investors require a higher yield on longer-term bonds to offset the potential erosion of purchasing power caused by inflation over an extended period.
c) Market liquidity: Longer-term bonds may have lower liquidity than shorter-term bonds, making them less attractive to some investors. Consequently, higher yields are needed to entice investors to hold longer-term bonds.
Considering the factors mentioned above, if I had to choose one of the pair, I would buy the Germany 10-year bond with a yield of 1.57%. This is because the 10-year bond carries less interest rate risk than the 30-year bond. Additionally, it provides a relatively stable yield while maintaining a reasonable maturity period.
2. US 10-year treasury bond yielding 1.96% vs. US 10-year inflation-indexed treasury bond yielding -0.578:
The difference in yields between these two bonds is primarily driven by inflation expectations and the presence of an inflation adjustment in the second bond:
a) Inflation expectations: The US 10-year inflation-indexed treasury bond provides protection against inflation by adjusting its principal value based on changes in the Consumer Price Index (CPI). If investors anticipate higher inflation, the yield on this bond will be lower as the inflation adjustment provides a hedge against rising prices.
b) Deflation concerns: A negative yield on the inflation-indexed bond suggests that investors are currently concerned about deflationary pressures. Investors are willing to accept a negative yield to safeguard their investments from the possibility of falling prices.
Given these factors, if I had to choose one bond from this pair, I would buy the US 10-year treasury bond with a yield of 1.96%. This bond offers a positive yield, and even though it lacks inflation protection, it provides a higher return compared to the negative yield on the inflation-indexed bond.
3. France 10-year bond yielding 2.23% vs. Greece 10-year bond yielding 11.07%:
The difference in yields between these two bonds is primarily influenced by credit risk and market perception of the economic conditions in each country:
a) Credit risk: Greece, having experienced financial difficulties in the past, carries a higher credit risk compared to France. The higher yield on the Greek bond compensates investors for this added risk.
b) Economic conditions: Market perception of the economic stability and growth prospects of each country also impact the bond yields. France, being a more stable and developed economy, may be viewed as a safer investment, resulting in a lower yield. Greece, on the other hand, may be seen as a riskier investment due to its previous financial issues, leading to a higher yield to attract investors.
Considering these factors, if I had to choose one bond from this pair, I would buy the France 10-year bond with a yield of 2.23%. This bond offers a higher credit quality and is associated with a more stable economy, reducing the risk for investors compared to the Greek bond.