2 Credit Quality
In general, bonds issued by the Commonwealth Government are regarded as risk free as the probability of default is very small. This is because the Government can always use taxes to raise revenue to repay debt.
But issuers such as banks cannot raise taxes and therefore their probability of default is higher. The higher an issuer’s credit risk, the higher the yield the issuer must offer to attract investors.
The maturity date of a bond is underpinned by the yield curve. The yield curve gauges market expectations about future interest rates by plotting the yield-to-maturities ofvarious bonds at staggered maturities.
A ‘normal yield curve’ shape can suggest stable economic conditions and normal forecasted growth rates. Hence shorter dated securities are expected to receive lower yields than longer dated securities, reflecting a stronger chance of receiving the face value at maturity. Conversely, the increased uncertainty in relation to market conditions in the future imply that longer dated securities should carry a higher yield.
In contrast, an ‘inverse yield curve’ arises from extraordinary market conditions where volatility governs current investor sentiment. In this case, shorter dated securities generally attract higher yields than longer dated securities, as the market expects interest rates to decline over time following the current adverse market conditions.