Question

Knowing the Fundamentals of interest rates and knowing that rates are impacted by inflation, risk concerns, and liquidity concerns. Based on your understanding of those fundamentals, explain why the interest rate on a 3 month Treasury Bill is 1.50% while the interest rate on a 10-year bond issued by a very risky Company might be 8%.

Answer 1

Inflation risk is the risk caused due to the inflation in the market. This risk is higher with long time period because there are more chances of having inflation in 10 years than in 3 Months. In this case the duration of the corporate bond is more so it has higher inflation risk.

Risk of a corporate bond is more because it has a longer time period and also because there can be more uncertainty in the long time period.

Liquidity concern is related to how fast it can be converted to cash. Treasury bond is for 3 months , so it can be converted to cash much earlier than corporate bonds.

As all the risk concerns for corporate bond is higher than treasury bond, Corporate bond has higher discount rate or ytm than treasury bond.