Chapter 6 Interest Rates and Bond Valuation

Lecture objective: after finishing this lecture, you should be able to:

1. Understand the main elements of corporate bonds: face value (par value), coupon rate,
maturity, yield to maturity.
2. Understand the bond valuation formula and apply it for different calculations.
3. Understand the main factors that affect bond pricing and interest rate risk of bonds.
4. Understand different kinds of bonds and the associated terminologies.
5. Understand the bond markets, bond quotes and bond trading.
6. Understand the determinants of bond yields.

1. Main elements of bonds: an example

When a corporation or government wishes to borrow money from the public on a long-term basis, it
usually does so by issuing or selling debt securities that are generically called bonds.

A bond is nothing but a certificate showing that a borrower owes a specified sum. To repay the money,
the borrower/issuer has agreed to make interest and principal payments on designated dates. The
following figure shows an advertisement that appeared in the WSJ of July 23, 1997. Dynex Capital
Inc. issued bonds with a total face value of $100 million in July 1997. The bonds carried a coupon of 7
7/8%. This means that each bond pays $78.75 in interest each year. Half of this interest is paid every
six months. The bonds will mature after 5 years. They are senior notes in the sense that interest on
these bonds will be paid before some other junior notes. This makes the bonds relatively safer.
$100,000,000
DYNEX
Dynex Capital Inc.
7 7/8% Senior Notes Due July 15, 2002
Interest Payable January 15 and July 15

Price 99.9000%
Plus, accrued interest from July 15, 1997

This simple example introduces the main elements when defining a bond:

1) Face Value: the principal amount of a bond that is repaid when the bond matures. Face value is
also referred to as par value. Most corporate bonds in the US have a face value of $1,000. If the
bond price is greater than the face value, the bond is said to be selling at a premium; if bond price
is less than the face value, the bond is said to be selling at a discount; if bond price is equal to
face value, it is selling at par. Later we will discuss the conditions under which bonds will sell at
a premium/discount/par.

2) The bond holder will certainly receive periodic interest payments before the bond matures. These
interest payments are usually referred to as coupon payments. In the old days bond holders would
clip off the coupons and mail them to the bond issuers to collect interest payments. The rate at
which the coupons are calculated is the Coupon Rate. The above bonds have a stated annual
coupon rate of 7 7/8% = 7.875%. Annual coupon can be calculated by the following formula:

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 Based on the annual coupon rate of 7.875% and the assumed face value of $1000, one bond will pay
an annual coupon (interest) = $1000*7.875% = $78.75. Notice that the above bonds pay interest twice
a year (Jan. 15 and Jul. 15 of every year). So, we simply divide the annual coupon of $78.75 to get
each semi-annual coupon payment = $78.75/2 = $39.375. Another way of expressing this is to say the
semi-annual coupon rate = 7.875%/2 = 3.9375%.

3) Maturity: date on which the principal amount of a bond is paid. The maturity date of the above
bonds is July 15, 2002 (remember the above advertisement appeared on WSJ dated July 23, 1997).

Given the above discussion, we can now outline the cash flows from the above bonds at each
applicable date. Notice that for simplicity we assume the current date is July 15, 1997.
7/15/199 1/15/199 7/15/199 1/15/199 7/15/199 1/15/200 7/15/200 1/15/200 7/15/200 1/15/200 7/15/200
date 7 8 8 9 9 0 0 1 1 2 2
perio
d 0 1 2 3 4 5 6 7 8 9 10
CF 39.375 39.375 39.375 39.375 39.375 39.375 39.375 39.375 39.375 1039.375

4) Also notice that the above advertisement states “Price 99.9000%”. This is using the bond market
convention that bond prices are quoted as a percentage of the face value. Given the face value of
$1000, each of the above bonds sells for = 99.9%*1000 = $999.

So the real question is: do you want to invest in this bond?

This is essentially a valuation problem. We need to value this bond. And our decision rule is simple
based on our valuation.

Scenario Under/Over-valued? To Invest?

Our valuation > price bond is undervalued Yes
Our valuation = price bond is fairly valued Indifferent
Our valuation < price bond is overvalued No

Obviously, the valuation technique is the discount cash flow approach. We need to find an appropriate
discount rate to discount the cash flows generated by the Dynex bonds. Imagine many different
discount rates can be applied. Out of all these different discount rates, one discount rate is particularly
interesting to us, that is, the discount rate at which the PV of all the cash flows generated by the
bonds equal the bond market price of $999. We refer to this discount rate as the yield to maturity
(or simply, yield).

We can find out the yield to maturity implied by the market price of $999 for the above bonds by
either trial-and-error approach or Excel function approach. We will illustrate this process soon.

2. Bond Valuation

1) Bond pricing formula

To calculate the above bond price, it really boils down to value the above multiple cash flows generated
by the bonds. The bond cash flows can be classified in many ways. A simple way is to classify them
into two categories: 1) one component is the coupon payment, which turns out to be an annuity; 2)
another component is a lump-sum face value. We can thus estimate the market value of the bond by
calculating the present value of these two components separately and adding the results together. First,

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Second, the present value of the coupon annuity is:

So, the bond price can be calculated as follows:

Where: C is the coupon payment in each period; r is the yield to maturity for each period; F is the face

value; T is the maturity (in periods).

Example 1: An Example of Bond Pricing:

Brittany Co. issued a 15-year bond at a coupon rate of 8.5 percent. The bonds make semi-annual

payments. If the YTM on these bonds is 7.90 percent, what is the current bond price?

To solve the bond price, we need to sort out the main elements of this bond first.

The maturity is 15 years, and it makes semi-annual coupon payments, so number of periods in this

case is 15*2 = 30.

The coupon rate is 8.5 percent, so the annual coupon payment is $1,000 (Face Value) * 8.5% (Coupon

Rate) = $85. But this annual coupon payment will occur two times a year, so each semi-annual coupon

payment = $85/2 = $42.5.

The YTM on the bond is given by 7.9% and notice that this is the annual YTM. The semi-annual yield

is thus given by 7.9%/2 = 3.95%.

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Now we are ready to plug in the numbers into the formula:

(Excel function approach = pv (7.9%/2,15*2,1000*8.5%/2,1000) = 1052.19)

Example 2: An Example of Finding the Bond Yields:

The Timberlake-Jackson Wardrobe Co. has 8 percent coupon bonds on the market with nine years left

to maturity. The bonds make annual payments. If the bond currently sells for $1047.50, what is its

YTM?

Let’s first sort out the main elements:

Face Value = $1,000; Coupon rate = 8%. So, Annual Coupon Payments = $1000 x 8% = $80; Period =

Year; Bond Price = $1047.50. Maturity = 9 (years/periods).

To find the YTM, essentially, we still need to apply the bond pricing formula and solve the unknown

variable in the following equation.

Solving the above equation could be very tricky. You can work out the exact answer by trial and error.
Or we can use the Excel rate function = rate (9,1000*8%, -1047.50,1000) = 7.26%.

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2)
Comments on Bond Pricing Formula

Notice in the above formula, everything is expressed in terms of “periods”. You may need to

adjust three things before you can plug numbers into the formula. For example, typically, US

Treasury and corporate bonds make semi-annual coupon payments. So, you need to multiply the

number of years by 2 to get the number of semi-annual periods. YTM to be used should be the

semi-annual yield, which can be obtained by dividing the annual YTM by 2. Dollar coupon should

be the semi-annual dollar coupon instead of the annual dollar coupon.


At first sight, coupon rate is not in the formula. But it is there when you compute the C in the

above.
3)
Comparing Coupon Rate and Yield to Maturity

The relationship between interest rate and the coupon rate also gives us an idea of when bonds will be

selling at par/at a premium/at a discount. More specifically:

Bonds will be selling at a discount if and only if YTM > Coupon Rate
Bonds will be selling at a premium if and only if YTM < Coupon Rate
Bonds will be selling at par if and only if YTM = Coupon Rate

It is also important to develop an economic intuition for the above three scenarios. Remember YTM is

the market-wide discount rate that pertains to any similar bonds whereas coupon rate is the rate that

pertains to the bond in question and determines the dollar size of the coupon payment. If YTM is

greater than coupon rate, then essentially the bond is providing a rate of interest that is less desirable

than what can be obtained from the market, so bond issuers have to offer a discount in bond prices for

them to attract public investors. If on the other hand, YTM is less than coupon rate, then essentially the

bond is providing a rate of interest that is higher than what can be achieved in the market, so investors

are willing to pay a premium in bond prices. We will verify this relationship in Excel.

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4)
Excel Notes

In the above two examples, we solve either the bond price or the yield to maturity. By now it should be

clear that we can solve any unknown variable using the bond pricing formula. The following table

summarizes all the different cases based on the bond-pricing formula using corresponding Excel

functions:

Bond Element Excel Function Arguments of Excel Function

Bond Price PV = pv (rate, nper, pmt, fv)
Maturity NPER = nper (rate, pmt, -pv, fv)
Yield-to-Maturity RATE = rate (nper, pmt, -pv, fv)
Coupon Payment PMT = pmt (rate, pmt, -pv, fv)

I strongly recommend you have a clear idea of the meaning of each argument under each case. A

caveat is that in the above table, everything is per period. You may need to adjust your initial result

under certain cases. An example would be as follows: if you are solving the maturity in years for a

bond that pays semi-annual coupons, whatever results you get by using the above NPER Function, the

obtained number will be the total number of periods not total number of years. Consequently, you need

to divide your result by 2 to convert them back to number of years.

Example 3: Another Example of Bond Pricing:

Marry Wood Co. bonds are selling at $1202.50, which will mature after 27 years and pay interest

semi-annually. The coupon rate is 18%. If your required rate of return is 16%, would you buy these

bonds?

To solve this question, let’s first decide what the fair value of this bond is. If the fair value is higher

than the current price, then the bond is undervalued, and we should buy them. If on the other hand, the

fair value for the bonds is less than the current price, then we don’t buy!

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Please try this example on your own. Make sure you get the bond price at $1123.04. So, you don’t

buy!

3. Interest rate risk of bonds: an Excel illustration

Bond prices are mainly affected by three things: the interest rate, the coupon rate, and maturity.

Since interest rate is so important, it makes sense for us to examine how interest rate affects bond

prices in more detail. This brings up the topic of interest rate risk.

Interest rate risk refers to the risk that arises for bond owners from fluctuating interest rates.

We know that bond price is the present value of two components, and we know that there exists a

negative relationship between interest rate and present value. So, we know that if interest rates go up,

bond prices will go down and vice versa.

Example 4: Interest rate risk of bond

See Excel spreadsheet for an illustration.

How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes.

This sensitivity directly depends on two things: the time to maturity and the coupon rate. More

specifically, we have:

Rule No. 1: All other things being equal, the longer the time to maturity, the greater the interest

rate risk.

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Example 5: the longer the maturity, the greater the interest rate risk.

Rule No. 2: All other things being equal, the lower the coupon rate, the greater the interest rate

risk.

Example 6: the lower the coupon rate, the greater the interest rate risk.

4. Some different types of bonds

Thus far, we have considered only “plain vanilla” corporate bonds. In this section, we briefly look at
bonds issued by governments and at bonds with unusual features. Many of these features will be
detailed in the bond indenture, so we discuss this first. The indenture is the written agreement
between the corporation (the borrower) and its creditors.

1) Government bonds

The biggest borrower in the world is the United States government. In early 2021, the total debt of the
U.S. government was approaching $27.5 trillion, or about $84,000 per U.S. citizen (and growing
rapidly). When the government wishes to borrow money for more than one year, it sells what are
known as Treasury notes and bonds to the public (in fact, it does so every month). Currently, Treasury
notes and bonds have original maturities ranging from 2 to 30 years.

Most U.S. Treasury issues are just ordinary coupon bonds. There are two important things to keep in
mind, however. First, U.S. Treasury issues, unlike essentially all other bonds, have no default risk
because (we hope) the Treasury can always come up with the money to make the payments. Second,
Treasury issues are exempt from state income taxes (though not federal income taxes). In other
words, the coupons you receive on a Treasury note or bond are only taxed at the federal level.

State and local governments also borrow money by selling notes and bonds. Such issues are called
municipal notes and bonds, or just “munis”. Unlike Treasury issues, munis have varying degrees of
default risk, and, in fact, they are rated much like corporate issues. Also, they are almost always
callable.

The most intriguing thing about munis is that their coupons are exempt from federal income taxes
(and state income taxes in some cases), which makes them very attractive to high-income, high-tax
bracket investors.

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2) Zero-coupon bonds

A bond that pays no coupons at all must be offered at a price that is much lower than its stated value.
Such bonds are called zero coupon bonds, or just zeroes.

Even though no interest payments are made on the bond, zero coupon bond calculations use
semiannual periods to be consistent with coupon bond calculations. For tax purposes, the issuer of a
zero-coupon bond deducts interest every year even though no interest is actually paid. Similarly, the
owner must pay taxes on interest accrued every year, even though no interest is received.

3) Floating-rate bonds (Floaters)

With floating-rate bonds (floaters), the coupon payments are adjustable. The adjustments are tied to an
interest rate index such as the Treasury bill interest rate or the 30-year Treasury bond rate. For
example, U.S. Government EE Savings Bonds pay interest at a rate that is adjusted every six months.
The rate is set equal to 90 percent of the average yield on ordinary five-year Treasury notes over the
previous six months. The coupon rate has a floor and a ceiling, meaning that the coupon is subject to a
minimum and a maximum. In this case, the coupon rate is said to be “capped”, and the upper and
lower rates are sometimes called the collar.

A particularly interesting type of floating-rate bond is an inflation-linked bond. Such bonds have
coupons that are adjusted according to the rate of inflation (the principal amount may be adjusted as
well). The U.S. Treasury began issuing such bonds in January of 1997. The issues are sometimes
called “TIPS” or Treasury Inflation Protection Securities.

4) Other types of bonds and associated terminologies

 Bearer Bonds — these are bonds on which coupons are attached. The bond holder presents the
coupons to the issuer for payments of interest when they come due.
 Registered Bonds — with a registered bond, the owner’s identification information is recorded by
the issuer and the coupon payments are mailed to the registered owner.
 Term Bonds — bonds in which the entire issue matures on a single date.
 Serial Bonds — bonds that mature on a series of dates, with a portion of the issue paid off on
each.
 Mortgage Bonds — bonds that are issued to finance specific projects that are pledged as collateral
for the bond issue.
 Debentures — bonds backed solely by the general credit of the issuing firm and unsecured by
specific assets or collateral, usually with a maturity of 10 years or more.
 Notes: unsecured debt, usually with a maturity of under 10 years.
 Subordinated Debentures — these are unsecured debentures that are junior in their rights to
mortgage bonds and regular debentures.
 Stock Warrants — bonds that give the bond holder an opportunity to purchase common stock at a
specified price up to a specified date.
 Callable Bonds — bonds that allow the issuer to force the bond holder to sell the bond back to the
issuer at a price above the par value (at the call price). The amount by which the call price exceeds
the par value is referred to as the call premium.
 Deferred call provision — A call provision prohibiting the company from redeeming the bond
prior to a certain date.
 Call protected bond — A bond that currently cannot be redeemed by the issuer.
 Sinking Fund Provisions — bonds that include a requirement that the issuer retire a certain
amount of the bond issue each year.

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 Income bonds are similar to conventional bonds, except that coupon payments are dependent on
company income. Specifically, coupons are paid to bondholders only if the firm’s income is
sufficient. This would appear to be an attractive feature, but income bonds are not very common.
 A convertible bond can be swapped for a fixed number of shares of stock any time before
maturity at the holder’s option. Convertibles are relatively common, but the number has been
decreasing in recent years.
 A put bond allows the holder to force the issuer to buy the bond back at a stated price. The put
feature is therefore just the reverse of the call provision and is a relatively new development.
 Protective covenants — part of the indenture or loan agreement that limits certain actions a
company might otherwise wish to take during the term of the loan. Protective covenants can be
classified into two types: negative covenants and positive (or affirmative) covenants. A
negative covenant limits or prohibits actions that the company might take. For instance, the firm
must limit the amount of dividend it pays according to some formula. A positive covenant
specifies an action that the company agrees to take or a condition the company must abide by. For
instance, the company must maintain its working capital at or above some specified minimum
level.

5. Bond Markets

1) An overview of the bond markets

Bonds are bought and sold in enormous quantities every day. You may be surprised to learn that the
trading volume in bonds on a typical day is many, many times larger than the trading volume in stocks
(by trading volume, we simply mean the amount of money that changes hands). Here is a finance trivia
question: What is the largest securities market in the world? Most people would guess the New York
Stock Exchange. In fact, the largest securities market in the world in terms of trading volume is the
U.S. Treasury market.

Most trading in bonds takes place over the counter, or OTC. Recall that this means that there is no
particular venue at which buying and selling occurs. Instead, dealers around the country (and around
the world) stand ready to buy and sell. The various dealers are connected electronically.

One reason the bond markets are so big is that the number of bond issues far exceeds the number of
stock issues. There are two reasons for this. First, a corporation would typically have only one
common stock issue outstanding (there are exceptions to this that we discuss in our next chapter).
However, a single large corporation could easily have a dozen or more note and bond issues
outstanding. Beyond this, federal, state, and local borrowing is simply enormous.

Because the bond market is almost entirely OTC, it has historically had little or no transparency. A
financial market is transparent if it is possible to easily observe its prices and trading volume. On the
New York Stock Exchange, for example, it is possible to see the price and quantity for every single
transaction. In contrast, in the bond market, it is usually not possible to observe either. Transactions
are privately negotiated between parties, and there is little or no centralized reporting of transactions.

2) Bond price reporting

In 2002, transparency in the corporate bond market began to improve dramatically. Under new
regulations, corporate bond dealers are now required to report trade information through what is
known as the Transactions Report and Compliance Engine (TRACE). You can go to http://finra-
markets.morningstar.com/MarketData/Default.jsp to get TRACE prices.

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As we mentioned before, the U.S. Treasury market is the largest securities market in the world. As
with bond markets in general, it is an OTC market, so there is limited transparency. However, unlike
the situation with bond markets in general, trading in Treasury issues, particularly recently issued ones,
is very heavy. Each day, representative prices for outstanding Treasury issues are reported.

Example 7: An example of Treasury notes and Treasury bonds

Use the following Treasury bond quotes to fill up the missing info for each of the quoted Treasury
note/bond. To calculate the number of years until maturity, assume that it is currently June 14, 2018.

Please follow me in Excel for a detailed explanation. Pay attention to the bid price, the asked price,
and the notion of the bid-ask spread.

3) Clean price vs. dirty price

If you buy a bond between coupon payment dates, the price you pay is usually more than the price you
are quoted. The reason is that standard convention in the bond market is to quote prices net of “accrued
interest,” meaning that accrued interest is deducted to arrive at the quoted price. This quoted price is
called the clean price. The price you pay, however, includes the accrued interest. This price is the
dirty price, also known as the “full” or “invoice” price.

Example 8: an example of clean vs. dirty prices

Suppose you buy a bond with a 12 percent annual coupon, payable semiannually. You actually pay
$1,080 for this bond, so $1,080 is the dirty, or invoice, price. Further, on the day you buy it, the next
coupon is due in four months, so you are between coupon dates. Notice that the next coupon will be
$60.

The accrued interest on a bond is calculated by taking the fraction of the coupon period that has
passed, in this case two months out of six, and multiplying this fraction by the next coupon, $60. So,
the accrued interest in this example is 2/6 × $60 = $20. The bond’s quoted price (i.e., its clean price)
would be $1,080 − 20 = $1,060.

6. Interest rate and the determinants of bond yield

1) Real vs. nominal interest rate: the Fisher Effect

In examining interest rates, or any other financial market rates such as discount rates, bond yields,
rates of return, and required returns, it is often necessary to distinguish between real rates and nominal

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rates. Nominal rates are called “nominal” because they have not been adjusted for inflation. Real rates
are rates that have been adjusted for inflation.

Example 9: An example of the effect of inflation

Now In 1 year
Investment 100 115.5
Rate of return in dollars 15.5%

Pizza price 5 5.25

No. of pizzas 20 22
Rate of return in pizzas 10.0%

What this illustrates is that even though the nominal return on our investment is 15.5 percent, our
buying power goes up by only 10 percent because of inflation. Put another way, we are only 10
percent richer. In this case, we say that the real return is 10 percent.

Our discussion of real and nominal returns illustrates a relationship often called the Fisher effect (after
the great economist Irving Fisher). Because investors are ultimately concerned with what they can buy
with their money, they require compensation for inflation. Let R stand for the nominal rate and r stand
for the real rate. The Fisher effect tells us that the relationship between nominal rates, real rates, and
inflation can be written as:

We can approximate the nominal rate by R = r + h since r*h is usually small and is often dropped.

2) The term structure of interest rates

We now focus on the interest rates of different maturities/terms. At any point in time, short-term and
long-term interest rates will generally be different. Sometimes short-term rates are higher, sometimes
lower. The relationship between short- and long-term interest rates is known as the term
structure of interest rates. More precisely, the term structure of interest rates tells us what nominal
interest rates are on default-free, pure discount bonds of all maturities. These rates are, in essence,
“pure” interest rates because they involve no risk of default and a single, lump-sum future payment. In
other words, the term structure tells us the pure time value of money for different lengths of time.

When long-term rates are higher than short-term rates, we say that the term structure is upward
sloping, and when short-term rates are higher, we say it is downward sloping. The term structure can
also be “humped”. When this occurs, it is usually because rates increase at first, but then begin to
decline as we look at longer- and longer-term rates. The most common shape of the term structure,
particularly in modern times, is upward sloping, but the degree of steepness has varied quite a bit.

The shape of the term structure of interest rates is determined by three basic components. The first two
are the ones we discussed in our previous section: the real rate of interest and the rate of inflation.
The real rate of interest is the compensation investors require for forgoing the use of their money. You
can think of it as the pure time value of money after adjusting for the effects of inflation.

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The real rate of interest is the basic component underlying every interest rate, regardless of the time to
maturity. When the real rate is high, all interest rates will tend to be higher, and vice versa. Thus, the
real rate doesn’t really determine the shape of the term structure; instead, it mostly influences the
overall level of interest rates.

In contrast, the prospect of future inflation very strongly influences the shape of the term structure.
Investors thinking about loaning money for various lengths of time recognize that future inflation
erodes the value of the dollars that will be returned. As a result, investors demand compensation for
this loss in the form of higher nominal rates. This extra compensation is called the inflation premium.

If investors believe that the rate of inflation will be higher in the future, then long-term nominal
interest rates will tend to be higher than short-term rates. Thus, an upward-sloping term structure may
reflect anticipated increases in inflation. Similarly, a downward-sloping term structure probably
reflects the belief that inflation will be falling in the future.

The last component of the term structure has to do with interest rate risk. As we have discussed,
longer-maturity bonds have great interest rate risk. Investors recognize this risk, and they demand
extra compensation in the form of higher rates for bearing it. This extra compensation is called the
interest rate risk premium. The longer the time to maturity, the greater is the interest rate risk, so the
interest rate risk premium increases with maturity.

Putting the pieces together, we see that the term structure reflects the combined effect of the real rate
of interest, the inflation premium, and the interest rate risk premium. The following figure shows how
the three effects interact to produce an upward-sloping or downward-sloping term structure.

Notice in Panel A, the rate of inflation is expected to rise gradually. At the same time, the interest rate
risk premium increases at a decreasing rate, so the combined effect is to produce a pronounced
upward-sloping term structure. In comparison, in Panel B, the rate of inflation is expected to fall in the
future, and the expected decline is enough to offset the interest rate risk premium and produce a
downward-sloping term structure.

3) Bond yields and the yield curve

Recall that we saw that the yields on Treasury notes and bonds of different maturities are not the same.
The Wall Street Journal provides a plot of Treasury yields relative to maturity. This plot is called the
Treasury yield curve (or just the yield curve).

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As you probably now suspect, the shape of the yield curve reflects the term structure of interest rates.
In fact, the Treasury yield curve and the term structure of interest rates are almost the same thing. The
only difference is that the term structure is based on pure discount bonds, whereas the yield curve is
based on coupon bond yields. As a result, Treasury yields depend on the three components that
underlie the term structure: the real rate, expected future inflation, and the interest rate risk premium.

Treasury notes and bonds have three important features that we need to remind you of: They are
default-free, they are taxable, and they are highly liquid. This is not true of bonds in general, so we
need to examine what additional factors come into play when we look at bonds issued by corporations
or municipalities.

The first thing to consider is credit risk, that is, the possibility of default. Investors recognize that
issuers other than the Treasury may or may not make all the promised payments on a bond, so they
demand a higher yield as compensation for this risk. This extra compensation is called the default risk
premium.

Next, recall that we discussed earlier how municipal bonds are free from most taxes and, as a result,
have much lower yields than taxable bonds. Investors demand the extra yield on a taxable bond as
compensation for the unfavorable tax treatment. This extra compensation is the taxability premium.

Finally, bonds have varying degrees of liquidity. There are an enormous number of bond issues, most
of which do not trade on a regular basis. As a result, if you wanted to sell quickly, you would probably
not get as good a price as you could otherwise. Investors prefer liquid assets to illiquid ones, so they
demand a liquidity premium on top of all the other premiums we have discussed. As a result, all else
being the same, less liquid bonds will have higher yields than more liquid bonds.

If we combine all the things, we have discussed regarding bond yields, we find that bond yields
represent the combined effect of no fewer than six things. The first is the real rate of interest. On top of
the real rate are five premiums representing compensation for (1) expected future inflation, (2) interest
rate risk, (3) default risk, (4) taxability, and (5) lack of liquidity. As a result, determining the
appropriate yield on a bond requires careful analysis of each of these effects.

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