Understanding Bond Types and Yield Curve Theories

Yield Curve Theories

What explains the different forms the yield curve can take? Two main theories attempt to explain this:

1. Theory of Expectations
2. Theory of Market Segmentation

Theory of Expectations

There are three main forms within the theory of expectations:

1. Pure Expectations Theory
2. Liquidity Premium Theory
3. Preferred Habitat Theory

a) Pure Expectations Theory: According to this theory, forward rates exclusively represent the expectation of future rates. In statistical terms, they would be an unbiased estimate of spot rates that will prevail in the future.

b) Liquidity Premium Theory: To tempt an investor to hold long-term bonds, they should be offered at least an interest rate that is higher than the average of future expected rates, plus a premium for the risk assumed, which increases the longer the term of the bond.

c) Preferred Habitat Theory: Investors will seek to liquidate their investments in the shortest possible time, while loan makers want to take on longer terms.

Theory of Market Segmentation

2) Theory of Market Segmentation: For this theory, the shape of the yield curve is determined by the supply and demand of assets within each term.

Bond Types and Characteristics

Zero Coupon Bonds

Characteristics:

• They are issued at a discount to face value.
• No interest payments are made.
• Capital is returned at its face value at maturity.

Redeemable Bonds

Characteristics:

• The capital is repaid in installments over the life of the bond.
• The interest is paid along with some or all of the repayment installments.

Bonds with Grace Period

Characteristics:

• The capital begins to be returned after m grace periods.
• Interest can be paid:
  • From the outset.
  • Capitalized until the first depreciation rate is paid and then paid together with the depreciation fund.

Fixed-Rate or Variable-Rate Bonds

Characteristics:

• Their definition depends on whether they pay a fixed or variable interest rate.
• The form of emission depends on:
  • The structure of assets and liabilities of the issuer.
  • Prospects of interest rates.
  • Market conditions (sometimes, instead of issuing at a fixed rate, a variable rate is issued and becomes a swap to set it simultaneously; this concept is extended in the derivatives section).

Bonds Including Contingencies

General Features:

• Adds to any of the preceding procedures an additional duty.

Special Features:

Convertible Bond

• Combines the features of a regular bond and a warrant.
• Receives interest and principal payments as a regular bond.
• May be redeemed by the warrants, through a new share issue.

Bonds with Options

• Combines a bond with an option.
• Callable Bonds: Bonds that are issued with a call option for the issuer, who can redeem them at a given time point in the future at a fixed price.
• Putable Bonds: Bonds that are issued with a put option for the investor, who can sell them at a future time at a fixed price.