Question

1. Describe how interest rates and credit risk affect the yield of corporate and government bonds. Why did the yield of Irish government bonds change so dramatically in recent years?

Answer 1

Let us first understand what is bond. Bond is nothing but debt instument. Bond usually has the duration of 10 year, 20 year, 30 year......

Every bond instrument has a face value. There are multiple types of bonds, eg: Zero coupon bonds, Coupon bonds....

Let us first understand Zero coupon bond:

When an investor put $ 70 in a railway pond, and after 30 years he is getting $ 1000., he is not earning fixed price every year.

Now the second one... Cupon bonds:

Where we recieve yield to maturity every year. Here, we need to compare coupon bonds with interest rate. For example when you invest $ 1000 you earn fixed interest every year. And interest rate changes with Government Policy.

There is an inverse reationship between yield to maturity and bond price. And there is an inverse relationship between bond price and interest rate. That means, if the interest rate goes up, bond price comes down.

And similarly, when the interest rate goes down, bond price comes up.

As mentioned, credit risk specified on the question is nothing but risk of the bond yield.

The recent changes happend to Irish bond is due to monetary policy of the Irish government, where they reduced the interest rate and hence the bond yield comes down. And as we mentioned earlier, the bond price comes up.