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Yield curve developments. Some theory


Well-Known Member
Hi All,

just stumbled over the following excellent sequence of papers (readings); one is officially accesible on the web, published by Antti Ilmanen (he is now with the prestigous AQR fund management shop) back in 1996 while being at Salomon Brothers (which is defunct as we all know from the core Part I reading).

Should be a good background reading on top of the bittersweet theory.

The one accesible is called 'The Dynamics of the Shape of the Yield Curve: Empirical Evidence, Economic Interpretations and Theoretical Foundations'

http://quantlabs.net/academy/download/free_quant_instituitional_books_/[Salomon Brothers] Understanding the Yield Curve, Part 7 - The Dynamic of the Shape of the Yield Curve.pdf

Following yesterday's (3 May 2017) FED meeting one key sentence of the paper (in line with a current flattening of the curve, as of 3 May 2017) is the following (to remember):

'Bond returns are high and yield curves are steep near troughs, and bond returns are low and yield curves are flat/inverted near peaks.'

Page 8 onwards discusses Bullet vs. Barbell and convexity. Could come as a good addition to the ongoing discussion about this in the forum and the numerous quotes from Fabozzi and the likes.
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Well-Known Member
Hey there @emilioalzamora1

Thanks for this wonderful lecture.

To get a better idea of what he is trying to convey, I have attached an Yield Curve based on Constant Maturity Treasury Instruments, calculated for 1M, 3M, 6M, 1, 2, 3, 5, 7, 10, 20, 30 Years.
Screen Shot 2017-08-05 at 6.35.37 PM.png

Src: Source Data for the graph: https://www.treasury.gov

As you can see from the above, for US Treasury Securities, as on Jan 2016, you had a typical Yield Curve where the Yields on ST instruments were low and those of LT ones were high, this was a general reflection of Risk prevailing in the economy with more rates charged for Liquidity Preference. You can see that as on Dec 2016 (The red curve), the entire Yield curve had shifted upwards with rates increasing throughout the entire tenor group as a reflection of General buoyancy perceived across the entire economy.

You can see that as on Aug 2017, we have a different picture with the rates on the ST instruments increasing reflecting the increasing interest rate environment on the short term and perhaps a greater degree of Bond buying on the Longer term sides with investors rushing towards the (relative) safety of Longer Term instruments wrt the Corporate Bonds and Equities. This shows that the Yield curve has flattened and in most cases points to a slowing economy. From this you can see that the spread between the instruments on the Longer term and the short term sides have narrowed.

This will be reflected in the decline in the spreads between the 10 Year Treasury vs the 3M Treasury as can be seen from the chart below:
Screen Shot 2017-08-05 at 6.36.46 PM.png

Src: FRED - Federal Reserve of St. Louis Database

Now, the funny thing is, this round of flattening has not shown any reduction in Equity buying or Corporate Debt selloff. The Spread between the Yield on a 10 Y Baa rated Corporate debt and 10 Y US Treasury has narrowed rather than show signs of an increase as it was before and during the Great Recession.
Screen Shot 2017-08-05 at 6.37.27 PM.png

Well, is this phenomenon strange? I have no idea and anyone's reflections on this is welcome:)
I am looking forward to @emilioalzamora1 next lecture on the same

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Well-Known Member
Dear @David Harper CFA FRM

I thought as there was a discussion on Endogenous Risks over here at https://www.bionicturtle.com/forum/...dity-vs-endogenous-liquidity.9310/#post-51818, thought, it might be appropriate to extend this discussion on the Yield Curves to incorporate the CDS spreads

One can see the classic case of spike in the CDS spreads as an indicator of default risk as also the Endogenous Risk playing out the Great Recession here.We can also see that the CDS spreads have also dropped for all major stocks indicating that there is a lower chance of default risk and a more stable economy.
Screenshot 2017-08-13 18.36.03.png
Src: Data from Grapple and for MBIA Insurance Corporation which was one of the sellers of CDS protection

I hope David, the above set of articles would fill the interregnum till your Week in Risk arrives!