economic downturns, because weaker economic conditions tend to be correlated with
declining inflation, which in turn leads to lower long-term rates.
Now let’s consider the yield curve for corporate bonds. Recall that corporate
bonds include a default-risk premium (DRP) and a liquidity premium (LP).
Therefore, the yield on a corporate bond that matures in t years can be expressed
as follows:
rCtr* IPtMRPtDRPtLPt.
A corporate bond’s default and liquidity risks are affected by its maturity. For ex-
ample, the default risk on Coca-Cola’s short-term debt is very small, since there is al-
most no chance that Coca-Cola will go bankrupt over the next few years. However,
Coke has some 100-year bonds, and while the odds of Coke defaulting on these bonds
still might not be high, the default risk on these bonds is considerably higher than that
on its short-term debt.What Determines the Shape of the Yield Curve? 39FIGURE 1-7 Illustrative Treasury Yield CurvesInterest Rate
(%)
8 7 6 5 4 3 2 1 010 20 30
Years to MaturityMaturity
Risk
PremiumInflation
PremiumReal Risk-
Free Ratea. When Inflation Is Expected to Increase
Interest Rate
(%)8 7 6 5 4 3 2 1 010 20 30
Years to MaturityMaturity
Risk
PremiumInflation
PremiumReal Risk-
Free Rateb. When Inflation Is Expected to DecreaseWith Increasing With Decreasing
Expected Inflation Expected Inflation
Maturity r* IP MRP Yield Maturity r* IP MRP Yield
1 year 2.50% 3.00% 0.00% 5.50% 1 year 2.50% 5.00% 0.00% 7.50%
5 years 2.50 3.40 0.18 6.08 5 years 2.50 4.60 0.18 7.28
10 years 2.50 4.00 0.28 6.78 10 years 2.50 4.00 0.28 6.78
20 years 2.50 4.50 0.42 7.42 20 years 2.50 3.50 0.42 6.42
30 years 2.50 4.67 0.53 7.70 30 years 2.50 3.33 0.53 6.36