Case 8.1: Frank and Lucille Develop A Bond Investment
The bond investment program that should be sought by the Leadbetters is one that will provide an optimal long-term yield within the context of risk. The yield curve is the popular name for the term structure of interest rates. It is a static function that relates (1) term to maturity to (2) yield to maturity at (3) any given time point. The yield curve represents a cross section of yields for a category of bonds that are comparable in all respects but maturity.
Yield curves for different securities have different shapes. While yield curves per se are static in nature, their behavior over time is quite fluid! As a result, the shape of the yield curve can undergo dramatic alterations. There are four basic patterns, or shapes, of the yield curve·ascending, declining, humped, and flat.
An ascending, sometimes called rising, yield curve is the most common. This pattern occurs when the yields on short-term securities are lower than those for long-term securities, are projected to rise consistently with longer maturities, and flatten out at the extremities. The implication of this scenario is that forward rates are higher, the farther in the future the period of maturity lies. The rising yield curve tends to prevail when interest rates generally are at low or modest levels.
A declining yield curve occurs relatively frequently. This pattern occurs when the yields on short-term securities are higher than those for long-term securities, are projected to decline consistently with longer maturities. The implication of this scenario is that forward rates are lower, the farther in the future the period of maturity lies. The declining yield curve tends to prevail when interest rates generally are at relatively high levels.
A humped yield curve occurs less frequently that does either an ascending yield curve or a declining yield curve. This pattern occurs when (1)
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