Fixed Income Securities: Lecture Note 3: Term Structure and Yield Curve

Fixed Income Securities
Lecture Note 3: Term Structure and Yield Curve
Apoorva Javadekar
Indian School of Business
December 11, 2019
Apoorva Javadekar (Indian School of Business) Fixed Income Securities December 11, 2019 1 / 62
Agenda
We saw the concept of yield-to-maturity (ytm)

I ytm = Market required rate on the bond = Compensation
We ask two questions in this lecture

I Term-Structure: How is ytm determined for various maturities
I Dynamics: How does term-structure move through time?
Data + Traditional Take on term Structure + Economist’s view of interest

rates!
Term Structure or Yield Curve
Term structure ⇒ ytm as a function of maturity of the bonds

Comparable bonds: To tease out the effect of only the maturity on ytm, its
essential that bonds of various maturities getting compared must be similar
I liquidity, credit risk, tax-structure, currency
I similarity of re-investment risk as well
Ideally: Compare ZCB issued by same issuer for various maturities

I Then you are canceling the re-investment risk as well and efficiently capture
the maturity structure
Spot Curve: Govt issues ZCB for maturities from 1 month to 1 year. Plotting
the ytm on these gives a spot-curve or zero-curve
Problem: But what to do for longer maturities?
I Invariably we have to mix zcb’s and coupon-bonds - a sub-optimal but only
choice in real-world
US Yield Curve
India Yield Curve
India Yield Curve - 1 Dec 2019
India Government Bonds
7.5%
7%
6.5%
6%
5.5%
5%
4.5%
2Y 4Y 6Y 8Y 10Y 12Y 14Y 16Y 18Y 20Y 22Y 24Y 26Y 28Y 30Y
Residual Maturity
India (1 Dec 2019) 1M ago 6M ago

Highcharts.com
Stylized Facts
Co-movement: yields of various maturities tend to move in the same

direction.
I level factor
Term Spread is on-average positive ⇒ ytm10 − ytm2 > 0 on average - for

most parts after 1980
I yield-curve on average has been upward sloping
Term spread is volatile ytm10 and ytm2 are not perfectly correlated ⇒ Term
Spread = ytm10 − ytm2 is time-varying with high volatility.
I This is the slope factor
I Just before recessions (in fact all 7 of them in US history), term spread has
been negative!
Yield volatility is hump-shaped in maturity ⇒ short-rates and extreme

long-rates fluctuate less than medium term rates
I most of the shocks neither impact immediately not last for long-period ⇒
short and long maturities immune to shocks
Yield Comovement
Term Spread USA
US Bonds Moments
Information Content of the Yield Curve
Maturity premium
Horizon specific risk-premium
Expectations
Segmented demand
Forward Rates
Forward rate ⇒ rate determined today for lending that will happen in future
n
Notation: ft,t+h ⇒ forward rate decided today (time t) for n-period ZCB
to be purchased at time t + h (i.e h periods from now)
Example: Assume no default risk. Let yt,1 , yt,2 be ytm on 1 and 2 year ZCB
at time t. Then two risk-free ways of investing over 2 year horizon
I Buy 2-year ZCB
1

I Buy 1-year ZCB + lock-in 1-year forward , 1 year from now ft,t+1
No Arbitrage If you invest 1$ in each strategy, you should get exactly the
same at year 2 given that both the methods are risk-free
2 1

1 × (1 + yt,2 ) = 1 × (1 + yt,1 ) × 1 + ft,t+1
2
1 (1 + yt,2 )
⇒ ft,t+1 =
(1 + yt,1 )
Forward Rates Example
Example: Suppose ytm on 1 year ZCB to be 4% and 2 year ZCB to be 5%

⇒ yt,1 = 4%, yt,2 = 5%
2
Two year ZCB: 100 × (1.05) = 110.25$
Rollover Strategy: Give 104 $ at the end of year 1. At rate should 104 be
rolled-over to get 110.25 at year 2?
110.25
100(1.04) (1 + forward) = 110.25 ⇒ forward = − 1 = 6.009%
| {z } 104
payoff at year 1
Takaway: Forward rate captures the increasing structure of spot rates in this
example. This is the arbitrage free forward rate market should offer you
Forward Curve: Like spot curve, one can plot forward curve as well. Note
that nothing in the forward curve has more information than spot curve!
Finally you derive forward rates from spots
Expectation Hypothesis
Yield curve has had many shapes

I Rising yield curve: short rates are lower than long rates
I Inverted yield curve: short rates are higher than long rates
Why? Expectations hypothesis suggests that yield curve reflects market

expectation of what will happen to interest rates in future. For example,
I Inverted curve ⇒ market expects short rates to go down in future
Under expectations hypothesis, one can view long-rates as a sequence of

expected short rates. If yield curve is upward sloping, Expectation hypothesis
says that its because market expects the future short term interest rates to
rise.
Example: Only way 2 year ZCB is offering 10% ytm compared to 5% ytm on
1 year ZCB is because market must be expecting that 1 year ZCB will offer
really high rate (around 20%) in one year from now
Three ways of Expressing Expectation Hypothesis (EH)
Expectations: N-period yield ≈ average of current and future expected

one-period yields + Risk premium
N
(1 + yt,N ) = (1 + yt,1 ) Et [(1 + yt+1,1 ) (1 + yt+2,1 ) ... (1 + yt+N−1,1 )]
1
Forward Rate = expected future spot rate ⇒ ft,t+1 = Et (yt+1,1 )
I If expectations view is true, then forward rate has to reflect expectations
I Note its not necessary that this is true. For example forward rate is derived
from no-arbitrage and in principle has got nothing to do with expectations!
Three ways of Expressing Expectation Hypothesis (EH)
Pt+1
Holding period return for ZCB = Change in prices ⇒ hprt,t+1 = Pt
EH says that Expected Holding-Period Returns are same across maturities!.

This could be really tricky to understand
1 year ytm = 5% and 2 year ytm = 10% 6= two period bond is a better
investment. Why?
I EH says that rising yield curve ⇒ short rates are expected to rise in future
I hence at t + 1 when short rates rise, price on 2 year ZCB falls producing 5%
1-year hpr
I Contrawise, if you invest in sequence of 1 year zcb, you are expected to earn
large short rate during second year (else curve would not slope up) ⇒
effective hpr over 2 years is 10%
Does EH Holds?
Average hpr from 1953-2013 in the USA not much different across maturities
⇒ seems like EH is doing fine!
Maturity Mean hpr σ (hpr )
1 5.83 2.83
2 6.15 3.65
3 6.4 4.66
4 6.4 5.71
5 6.36 6.58
But what if long-investments perform better sometimes and

short-investments perform better other times? Average might mask this.
Fama-Bliss Test
Idea: yield curve upward sloping ⇒ short-term yields expected to go up

 
proxy for Et (yt+1,1 )
z }| {
yt+1,1 − yt,1 = α + β ×  ft,t+1 −yt,1  +error
 
| {z }
Actual Yield Change
| {z }
expected yield change under EH
EH Prediction: β ≈ 1
Evidence: β ≈ 0 for 1 year horizon but 0.80 for 4 year horizon
I ⇒ EH fails in short-run but holds in long-run
β = 0 at 1 year horizon ⇒ short-term yields don’t rise as much even if yield

curve is sloping up ⇒ long-term investments earn excess returns!
I R 2 ≈ 20% ⇒ strategy risky! But yet over long term it pays off
Fama-Bliss Test
Observe the left hand panel and how b builds over time. Right hand panel
regressed excess returns on long-term bonds as a function of slope of the yield
curve (forward spread / expected yield change). If actual yields don’t change
enough (left panel), long-bonds will earn higher returns if yield-curve is upward
sloping
Take-away for Active Bond Management
Exploiting Fama-Bliss evidence is sometimes called as riding the curve

orrolling down the curve
Basically manager goes long on long bonds and short on short bonds ⇒ LL
-SS strategy
I going short on short bond means borrowing short-term and
I going long on long bonds ⇒ using these borrowed money to invest in long
term bonds
As predicted, if short-term rates don’t rise as much (Fama-Bliss), then

manager would make money
After 2008 crises, globally central banks assured to keep rates low. But there
was uncertainty as to how long this will be true ⇒ yield curve sloped
upwards
I Managers had even bigger incentive to exploit LL-SS strategy
Segmentation Hypothesis
Markets for assets are segmented

I Investors have a predetermined portfolio rules and pick their assets fitting in
those rules / universe
Example: Pension funds are not allowed to invest in Non-Investment grade

bonds many a times
Other forms of segmentation: choices over maturities, corporate vs sovereign,

choices of currencies
Segmentation theory try to split the yield curve in multiple segments and
understand yield level for each segment separately
I perhaps using demand and supply for a particular segment
Segmentation in Action: Gap-Filling Theory of Maturity
Greenwood-Hanson-Stein (2010, JF)

I If supply of Govt. bonds shrinks for a particular maturity, corporates
fill-the-gap by issuing more bonds of that maturity
I They fill 30-40% of the gap
I In essence, corporates are maturity liquidity providers
Relation to segmentation? If investors are segmented by maturities (so some

investors prefer long-term bonds while other prefer short-term bonds), then
there is always a clientele to be satisfied for particular maturity.
I If government can’t provide a particular maturity, corporates steps in
I It’s not as if everyone is moving away from bonds of particular maturity
Time variation of maturity profile: They show that a lot of variation in

maturity profile of corporate bonds can be explained by this gap-filling effect
Implications for Term Structure of Gap-Filling Theory
Slope of term-structure is a function of relative supply of long-term and

short-term bonds by governments
I If supply of long bonds ↑, (say exceeding the segmented demand for long
bonds), then excess supply can be sold at higher yields as investors in
short-term segment will demand premium to move out of their preferred
habitat
I ⇒ Yield curve will slope upward in this case
Corporate issues short-term bonds then. But from Fama-Bliss tells us that
when yield curve is upward sloping, borrowing costs with rollover strategy are
much lower than issuing a long-bond.
I In essence, managers are timing the yield curve
Another Example: Financing Frictions and Maturity Choices
A more recent contribution is that by Chakraborty - Mackinlay (2019).
Idea Firms adjust the maturities of bonds to match to the preferences of

underwriters
How do they measure preferences?
I Average maturity choices of insurance companies who are underwriter’s clients
/ investors
Result: Firm’s maturity choice more sensitive to underwriter’s changing

preferences rather than firm’s current maturity structure
Does Segmented market hurt companies? Yes!
I Firm’s with large maturity mismatch with underwriter’s maturity choice raise
lower amount through debt issuance
Example from Quantitative Easing: Wen Fed bough huge amount of

mortgage backed securities, it reduced the market supply of MBS. Given that
MBS oriented investors / funds had a preferred habitat for these assets, the
only way they could buy limited assets was to bid up the prices ⇒ yields on
MBS dropped from 6% in 2006 to 2% in 2012.
Corporate Debt Maturity Dynamics
Average maturity drops during US recessions!
Corporate Debt Maturity Dynamics By Size
Smaller firms can’t borrow long-term in recessions, but that’s exactly when larger
firms issue long-bonds!
Level, Slope and Curvature Factors
Factor Model for Yield - Curve
Yield curve is dynamic ⇒ it changes from time to time
We want to know how it changes. There are multiple possibilities

I Level Shifts: It can be that curve shifts up or down in a parallel fashion. That
is yields on all maturities move up or down in tandem?
I Slope: When yield curve changes, it could also change it’s slope ⇒ term
spread changes.
I Curvature: specific maturities, (say medium term yields) could move
differently but long and short end move in tandem
Empirically, what do we observe? What type of change is most common?

Note each type of change exposes you to different portfolio risk depending
upon what is your portfolio. So important to note the way yield curve shifts
Quick Answer: 70 % of the yield curve dynamics is level factor. 25 % is slope

and remaining is curvature
How can we find this? Can we use it to hedge better or trade?
A simple factor model
Level factor: average yields across all maturities

1
Levelt = (yt,1 + yt,2 + ... + yt,n )
n
Slope: term spread, long minus short
yt,5 + yt,4 yt,2 + yt,1
Slopet = −
2 2
Run a factor model one for each maturity
yt,n = α + β level × Levelt + β slope × Slopet + errort
Factor Model Results
level and slope explains 97% variation in yields!
ytn = an + bn × levelt + sn × slopet + εnt

|{z}
n-year yield
Maturity an bn sn R2
y1 0.09 0.9998 -0.77 0.97
y2 -0.08 1 -0.28 0.97
y3 -0.04 0.9999 0.1 0.97
y4 -0.02 1.0008 0.38 0.98
y5 0.04 0.9993 0.56 0.98
⇒ 97% of the dynamics of yield-curve can be captured either as level-shift (up

or down) or changing slope.
Litterman-Scheinkman Approach (optional)
Factor model approach is little adhoc

I where did level or slope factors came from? We would like data to tell us the
factors that explains variation in yields
I Contribution of each of the factor is difficult to identify
Instead one can perform a Principal Component Analysis (PCA)

I PCA is a statistical tool to identify common factors driving many economic
variables. This way we can pin down and study only handful of factors and we
can predict movement of many variables at a time
Interpreting backed-out factors: These factors are just time series variables -
we don’t know what they mean. We need to see how these recovered factors
correlate with some postulated aggregate factors
Example: Postulate that cash flow growth for a firm are given as
yit = αi + βi × GDPt
Then after running PCA, we would see if first factor looks like GDP or not
Litterman-Scheinkman Approach (Optional)
Step 1: Collect the data on yields of various maturities over time and
compute var-covariance matrix Σ
Step 2: Decomposition: Find Q and Λ such that
Σ = QΛQ 0
where Λ is diagonal matrix
Step 3: Get the Factors as

xt = Q 0 yt
Matlab Code: It’s two lines
Sigma = [21; 12];
[Q, Lambda] = eig (Sigma);

apply this Q to time series of y to get x
Equilibrium Level of Interest Rates
What Determines he Interest Rate Level?
Impatience Rate: If savers in the economy are impatient, then interest rates
are higher as investors need more compensation to over-come their
impatience of consumption
Expected Growth: Higher expected growth ⇒ higher expected income

growth. Consumers like to maintain stable profile of consumption ⇒ they
start borrowing today in anticipation of better income tomorrow ⇒ demand
for loans ↑ ⇒ interest rates ↑
Variance of growth of risk: If risk ↑ ⇒ precautionary savings ↑ ⇒ demand

for loans ↓ ⇒ interest rates ↓
Credit and Transition Risk
Credit Risk
Credit risk ⇒ Bond issuer fails to repay coupons / face value as promised
Components of Credit risk
I default risk ⇒ probability that issuer fails to repay
I recovery risk ⇒ conditional on default, recovery could be very low
Credit loss
Credit Loss = P (default) × (1 − recovery )
I If high yield bonds default 5% of times on average and recovery in case of

default is 30% ⇒
Credit Loss = 0.05 × 0.70 = 3.5%
Credit losses for Investment-grade ≈ 0.50%, junk-bonds ≈ 2.50% in last 50

years in the USA
Default Rates
Default Rates By Industry
Default Rates: Financial vs Non-Financial
Default Rates Hazard Rates
Recovery Rates
Recovery Rates
Type of Bond Matters
Type of Bond Average Recovery Rates (1980-2018)
Loans 80.40%
Senior Secured 62.30%
Senior Unsecured 47.90%
Subordinate 29%
Credit Risk Summary
Average global default rate ≈ 1% between 1980-2020

I default rates ≈ 3 to 4% for speculative grade bonds
Leisure / media and Energy / natural gas sector with highest defaults (> 3
%) in last 40 years
Utility and ironically Real estate, Insurance are least defaulted sectors in last
40 years
Non-financials default way more financial firms
I but maybe because financial firms are bailed out?
Risk of default for speculative bonds is very early in life and recedes later
Recovery rates: 40% for bonds, 75% for bank loans. Lastd ecade saw much
better recovery even for bonds
Credit Migration and Transition Risk
Risk that initial rating of a bond changes

Typically this risk can be analysed using transition matrix
I Probability that a bond rated in one-category moves to other rating category
over n-year period
Observations:
I Ratings Inflation: Downgrades more frequent than upgrades!
I Horizon is important: AAA stay AAA with 87% chance over 1-year, but just
with 22% chance over 10-years
I Clustering: Downgrades clustered in recession. but so are upgrades!!
1 Year Global Transition: 1980-2018
10 Year Global Transition: 1980-2018
Asymmetric Nature of Transition
Asymmetric Nature of Transition
Credit Spreads ⇒ Price of Risk!
Various Spreads
G-Spread: Spread of a risky-bond over matched maturity government bond

I makes sense only if government bond for that maturity is considered risk-free
I if matched-maturity bond is not-available, average of yield on bonds with
maturity around matched-maturity is used
Moody’s Baa-AAA Spread: classical gauge of junk vs highly-rated firms

Swap-Spread: Under the swap, one party pays fixed-rate and other pays
floating-rate (linked to some benchmark rate)
I swap-spread = fixed rate under swap - govt yield
I swap spread ⇒ counter-party risk
Moody’s Corporate Bond G-Spread
Moody’s Corporate Bond Credit Spread
Moody's Seasoned Baa Corporate Bond Yield-Moody's Seasoned Aaa Corporate Bond Yield
3.5
3.0
2.5
%-%
2.0
1.5
1.0
0.5
1975 1980 1985 1990 1995 2000 2005 2010 2015
Shaded areas indicate U.S. recessions Source: Moody’s fred.stlouisfed.org
Observations on Spreads
Quantum: Baa-AAA ≈ 1%
Baa-AAA is Counter-cyclical ⇒ shoots up in recession

Baa-10yr Govt is not necessarily counter-cyclical
I late 1970 and early 1980 recessions ⇒ 10 year yield went up more than Baa
as it was primarily fiscal crises (oil shocks, inflation)
Post GFC, Baa-AAA spread has been around 1% after peaking to 3% during
2008
What Determines Credit Spread? We don’t know!
Influential paper by Collin-Dufresne, Goldstein, Martin (2001) in Journal of

Finance
Idea: Spread is a function of firm-specific and aggregate characteristics. For

better identification, regress changes in spreads on changes in characteristics
∆CSit = αi + β1 ∆levit + β2 ∆rt10 + β3 ∆slopet

+ β4 ∆VIXt + β5 ∆S&Pt + β6 ∆retit + errorit
Expected Signs: β1 > 0, β2 < 0, β3 < 0 , β4 > 0, β5 < 0
Higher leverage makes firm more risky ⇒ CS should go up. Higher

aggregate uncertainty (VIX) should make agents more risk averse and push
up the credit spreads. If firm’s equity is returning good, then there must be
positive news about the firm ⇒ CS should move down and so on
Results: Not default risk, but risk-premium
r: Rising r pushes down CS. This sensitivity is higher for low credit bonds
VIX: most sensitive factor, but affects short-term bonds more
∆ ret vs ∆ S&P: CS ↓ with both, but CS far more sensitive to ∆ S&P ⇒

First sign that firm-specific factors may not be as important
R 2 ≈ 25%: ⇒ host of factor explain only 25% of the variation in the credit
spreads
Correlated Residuals: Unexplained CS changes are correlated across bonds

and one-single factor explains 55% of variance of residuals on average
Unknown factor This factor is not correlated to firm-specific factors ⇒

credit spread is not reflective of default risk. Recall this factor is common!
Risk Premium: It reflects risk-premium ⇒ the price of risk demanded by

investors.
Take-Away: Changes in credit spread reflect changing risk-premium (price of

risk), not the change in default risk (quantity of risk)
Risk-Neutral Implied Probabilities of Default
Example: 1-year economy, two possible states at t = 1: default (D) or

no-default (ND). Risk-free ZCB yield is 5%. Risky ZCB is priced at 90 $ and
recovery rate in case of default is 40%.
Under risk-neutral environment, P = E (PresentValue) ⇒ no risk-premium
π × 40 + (1 − π) 100
= 90 ⇒ π = 9.16%
1.05
Risk-Neutral default-probability (implied by prices) is 9.16%
Why we call it risk-neutral? If default probability is 9.16%, only a risk-neutral

investor is ready to pay 90$. A risk-averse investor would invest only if
P < E (presentvalue) as he requires risk-premium
Quantifying Risk-Premia
Fons (1987): Risk-neutral (price-implied) default rates 5% point larger than

actual default rates
I gap between the two is indicative of risk-premium charged by investors.
Risk-averse investor price assets lower as if actual default probability was 5%
point larger
Altman (2001): Creates a portfolio of BBB-rated bonds and also of treasury

bonds. When bond defaults, the portfolio loses value. Still Risky portfolio
outperform treasuries.
I ⇒ credit spread more than adequate to cover default losses
I ⇒ risk-premia is present
Chen, Lesmond, Wei (2007): Liquidity explains 50% of credit spreads ⇒

credit spread less affected by credit ratings but more by liquidity
I sort on liquidity within each rating group matters. But once you sort the bonds
on liquidity dimension, further sorting on rating has not effect on spreads
GZ Spreads
Bond by Bond Credit spread measure: For each bond, create a hypothetical
matched treasury security with exact cash flow structure
I discount the cash-flow using zero-curve
I compute ytmrf of this matched security
Sit [k] = yit [k] − yt,rf [k]

1 XX
StGZ = ksSit [k]
Nt
i
Advantage: Duration of underlying treasury bond is matched. Typically,

Baa-AAA spreads are plagued with duration mismatch
GZ Spread
GZ Spread and Economic Activity
Excess Bond Premia
Excess bond premia ⇒ Credit spread in excess of that due to firm level
factors
I Step 1: Estimate S[
it [k] = f (firm factors)
I Step2: Compute average of S[

it [k] and call it St
b
I firm factors are leverage, distance to default, age governance etc
I Step 3: Bond-Premiat = S GZ − Sbt
Substantial variation in GS spreads is due to bond-premia ⇒ factors

common to all the firms
You can think of bond-premia as price of risk (default). GZ find that

bond-premia is not correlated with default risk ⇒ credit spreads move up
due to changing price of default rather than change in probability of default
Predictability: Most of the predictability of economic activity through credit

spreads is actually due to bond premia
Excess Bond Premia and Economic Activity

Fixed Income Securities: Lecture Note 3: Term Structure and Yield Curve

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Fixed Income Securities: Lecture Note 3: Term Structure and Yield Curve

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Fixed Income Securities

Lecture Note 3: Term Structure and Yield Curve

Indian School of Business

December 11, 2019

We saw the concept of yield-to-maturity (ytm)

We ask two questions in this lecture

I Dynamics: How does term-structure move through time?

Data + Traditional Take on term Structure + Economist’s view of interest

Term structure ⇒ ytm as a function of maturity of the bonds

Ideally: Compare ZCB issued by same issuer for various maturities

India (1 Dec 2019) 1M ago 6M ago

Co-movement: yields of various maturities tend to move in the same

Term Spread is on-average positive ⇒ ytm10 − ytm2 > 0 on average - for

Yield volatility is hump-shaped in maturity ⇒ short-rates and extreme

Example: Suppose ytm on 1 year ZCB to be 4% and 2 year ZCB to be 5%

Yield curve has had many shapes

Why? Expectations hypothesis suggests that yield curve reflects market

Under expectations hypothesis, one can view long-rates as a sequence of

Expectations: N-period yield ≈ average of current and future expected

EH says that Expected Holding-Period Returns are same across maturities!.

Maturity Mean hpr σ (hpr )

But what if long-investments perform better sometimes and

Idea: yield curve upward sloping ⇒ short-term yields expected to go up

β = 0 at 1 year horizon ⇒ short-term yields don’t rise as much even if yield

Exploiting Fama-Bliss evidence is sometimes called as riding the curve

As predicted, if short-term rates don’t rise as much (Fama-Bliss), then

Markets for assets are segmented

Example: Pension funds are not allowed to invest in Non-Investment grade

Other forms of segmentation: choices over maturities, corporate vs sovereign,

Greenwood-Hanson-Stein (2010, JF)

Relation to segmentation? If investors are segmented by maturities (so some

Time variation of maturity profile: They show that a lot of variation in

Slope of term-structure is a function of relative supply of long-term and

Idea Firms adjust the maturities of bonds to match to the preferences of

Result: Firm’s maturity choice more sensitive to underwriter’s changing

Example from Quantitative Easing: Wen Fed bough huge amount of

Yield curve is dynamic ⇒ it changes from time to time

We want to know how it changes. There are multiple possibilities

Empirically, what do we observe? What type of change is most common?

Quick Answer: 70 % of the yield curve dynamics is level factor. 25 % is slope

How can we find this? Can we use it to hedge better or trade?

Level factor: average yields across all maturities

yt,n = α + β level × Levelt + β slope × Slopet + errort

level and slope explains 97% variation in yields!

ytn = an + bn × levelt + sn × slopet + εnt

⇒ 97% of the dynamics of yield-curve can be captured either as level-shift (up

Factor model approach is little adhoc

Instead one can perform a Principal Component Analysis (PCA)

Step 2: Decomposition: Find Q and Λ such that

where Λ is diagonal matrix

Step 3: Get the Factors as

Matlab Code: It’s two lines

Sigma = [21; 12];

[Q, Lambda] = eig (Sigma);

Expected Growth: Higher expected growth ⇒ higher expected income

Variance of growth of risk: If risk ↑ ⇒ precautionary savings ↑ ⇒ demand

I If high yield bonds default 5% of times on average and recovery in case of

Credit Loss = 0.05 × 0.70 = 3.5%

Credit losses for Investment-grade ≈ 0.50%, junk-bonds ≈ 2.50% in last 50

Type of Bond Average Recovery Rates (1980-2018)

Average global default rate ≈ 1% between 1980-2020

Risk that initial rating of a bond changes

G-Spread: Spread of a risky-bond over matched maturity government bond