Introduction to Corporate Finance

4: Valuing Bonds

4-5 THe TerM STrUCTUre OF INTereST

r ATeS

We now turn to an important insight about how interest rates relate to each other over differing maturities.

We find that we can systematically explain the relationship between short-term and long-term interest

rates (yields) for bonds not only with historical data, but with a useful model of how investors behave

over time with respect to risk. We start with the empirical observation of the yield curve, then consider

why it has its typical shape.

4-5a THe YIeLD CUrVe

A quick glance at Table 4.4 reveals an important fact: bond yields vary with maturity. The difference in

the yield spread between a one-year and a 30-year bond varies from 68 (78–10) basis points for Aaa/AAA

bonds to 100 basis points, or more, for junk bonds. Although Table 4.4 reports yield spreads rather than

yields, the data suggest that a positive relationship usually exists between time to maturity and yield to

maturity for bonds in any risk category.

Financial experts refer to the relationship between time to maturity and yield to maturity for bonds of

equal risk as the term structure of interest rates. The term structure of interest rates indicates whether yields

rise, fall or remain constant across bonds with different maturities. The simplest way to communicate

information about the term structure is to draw a graph that plots yield to maturity on the y-axis and

time to maturity on the x-axis. You can find a graph like this in many financial publications and on many

websites. A graph showing the term structure of interest rates is called the yield curve.

Figure 4.5 shows the yield curve for Australian government bonds from June 2014.

LO4.4

FIGUre 4.5 YIELD CURVES FOR AUSTRALIAN GOVERNMENT BONDS

The figure shows the yield curve for Australian government bonds at 30 June 2014. The shape is positively sloped, which is

a characteristic shape for a yield curve.

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0

Yield (%)

Years

0 2 4 6 8 10 12 14 16

Source: Bloomberg, AUD Australia Sovereign Curve 30 June 2014. Used with permission. ‘Investment basics: Yield curve.’ http://www.eqt.com.au/media/199451/investment_

basics-yieldcurve.pdf

term structure of interest

rates

The relationship between

time to maturity and yield to

maturity for bonds of equal

risk

yield curve

A graph that plots the

relationship between time to

maturity and yield to maturity

for a group of equal-risk bonds