Link between upward sloping yield curve, interest rates, and bond risk premiums

CFA Level II Portfolio Management
#1

Hello,

If we observe an upward-sloping, default-free government bond nominal yield curve, why is it that both interest rates and bond risk premiums might be expected to rise in future?

Why is “bond risk premium” included in a default-free government bond? Isn’t a default-free government bond without credit risk nor liquidity risk?

If a government bond includes a “bond risk premium”, what do we obtain when we subtract the “bond risk premium” from the default-free government bond nominal yield?

Thanks in advance.

#2

This is a consequence of the Pure Expectations Theory for the shape of the yield curve.

Pure Expectations holds that today’s forward rates are tomorrow’s spot rates.

I’m not sure that there’s a lot of empirical evidence to support the theory.

#3

Thanks @S2000magician , but I don’t follow. For an upward-sloping, default-free government bond nominal yield curve, I understand why interest rates themselves are expected to rise in future.

But why are bond risk premiums also expected to rise in future?

#4

If the spread curve slopes upward, Pure Expectations would anticipate higher future spreads; same reasoning.

#5

But why is “bond risk premium” included in a default-free government bond? Isn’t a default-free government bond without credit risk nor liquidity risk?

#6

The government yield curve includes a term premium; they’re likely talking abut that.

The default premium should be zero across all maturities, as you say.

#7

Thanks @S2000magician but I still don’t really have a crystal clear understanding.

If they are talking about a term premium, isn’t that already captured in the expectation that interest rates are expected to rise in future, to compensate for the increased uncertainty in actual inflation?

Why do we need a “bond risk premium”?

#8

Where in the curriculum are you seeing this?

#9

It’s in the practice questions in LES

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#10

They’re not clear about what they mean by bond risk premia. Even for default-free government bonds, there could be premia for:

  • Interest rate risk
  • Yield curve risk
  • Call/prepayment risk
  • Reinvestment risk
  • Liquidity risk
  • Currency exchange rate risk
  • Inflation risk
  • Volatility risk
  • Other risks
#11

OK I see. So basically (if we take a step back and disregard the question for a moment), we know that for an upward-sloping default-free government bond nominal yield curve, all of the risks you mentioned are expected to increase? We just don’t know the exact combination?

#12

We expect the total to increase.

You’re correct: we don’t know the exact combination.

#13

Thanks @S2000magician , you’ve been really helpful

#14

My pleasure.

#15

Hi, Thanks for share it