CA1 Paper 1 April 2013 Question 7 ii)

[Frances]

Hi,

I am struggling a bit with this question. Could someone please explain to me why higher government bond yields generally increase the cost of borrowing for companies? I am struggling to understand how we have used the theories of the yield curve in our answer.

It also says in the answer that if government bond yields increase due to the risk free yield increasing, but the corporate bond risk premium is unchanged, then corporate bond yields will also increase.

My understanding is, required return on conventional government bond = rf + E(inf) + IRP and required return corporate bond = rf + E(inf) + CBRP. When the answer is referring the the risk free yield increasing, does this refer to the nominal part, i.e. rf + E(inf) + IRP, as these would essentially cancel out between the two required returns? And when they say higher government bond yields may be linked with higher inflation, is this referring to the E(inf) + IRP bit?

Hope this makes some sense!

Thanks,

Fran

 

[Lindsay Smitherman]

Hello Fran - hopefully the following will help:

Could someone please explain to me why higher government bond yields generally increase the cost of borrowing for companies?

If government bonds offer higher yields, then investors would be more attracted to those. Hence companies have to offer higher yields when issuing their own bonds (i.e. borrowing money from investors in the market) - so the cost of borrowing is increased.

It also says in the answer that if government bond yields increase due to the risk free yield increasing, but the corporate bond risk premium is unchanged, then corporate bond yields will also increase.

My understanding is, required return on conventional government bond = rf + E(inf) + IRP and required return corporate bond = rf + E(inf) + CBRP. When the answer is referring the the risk free yield increasing, does this refer to the nominal part, i.e. rf + E(inf) + IRP, as these would essentially cancel out between the two required returns?

The risk free nominal yield is the "rf+E(inf)" part of your equation. So if this increases but CBRP is unchanged, the corporate bond yield (which as you say is rf+E(inf)+CRBP) will also increase.

And when they say higher government bond yields may be linked with higher inflation, is this referring to the E(inf) + IRP bit?

Yes it is: although bear in mind that the IRP relates to the level of uncertainty or volatility of inflation rather than the level of inflation itself. But inflation does tend to be more uncertain and volatile during periods of high inflation, so the two concepts are linked.