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So from my past studies i know that if the interest rate is expected to decrease, then the expected return will increase and the demand for long term bonds shifts to the right.

If investors believe that interest rates will decrease in the future, then investors will buy more bonds now. If you believe interest rates will fall, then bond prices will increase. You will buy bonds now, because you will be buying bonds for a cheaper price (high IR) and resell bonds in the future for a higher price, when market IR decrease.

As a conclusion , if IR decrease in the future, it will make people expect higher return on long term bonds today , since there is more risk. There is a negative relationship between IRs and and expected returns.

Then why , all of a sudden , my text book says :

'If the possibility of a default increases because a corporation begins to suffer large losses, the default risk on corporate bonds will increase, and the expected return on these bonds will decrease'.

SO now all of a sudden expected return decreases when there is more default risk ? Shouldn't expected return increase when there is more default risk?

What am i missing?

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1 Answer 1

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If interest rates decrease, people have less alternatives to lend at higher rates. Thus people are willing to accept lower yields. Hence, bonds prices go up (and yields go down).

If the default risk increases, people want higher yields to make up for that risk. Hence, bonds prices go down (and yields go up).

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  • $\begingroup$ But then what about the expected return ? If the default risk increases, people want higher returns to make up for the risk and i get that . Then yields increase, but why would the expected return decrease? $\endgroup$
    – Ginevra Bianco
    Oct 9, 2019 at 8:03
  • $\begingroup$ The expected returns will decrease (assuming yields remain the same) because there is a higher probability of default. Hence, people want higher yields to make up for that risk. $\endgroup$
    – Kent Shikama
    Oct 9, 2019 at 8:06
  • $\begingroup$ But then wouldn't that mean that in the first case, where interest rates decrease, there is a higher probability of risk (which is similar to default) then implying lower expected returns too? $\endgroup$
    – Ginevra Bianco
    Oct 9, 2019 at 8:07
  • $\begingroup$ When interest rates decrease, yields go down, and thus expected returns go down. $\endgroup$
    – Kent Shikama
    Oct 9, 2019 at 8:39
  • $\begingroup$ Maybe you're getting confused by the fact that it is advantages to purchase bonds right before surprise interest rate decreases are announced. But after interest rate decreases are announced, since yields are now lower, expected returns will be lower in the future. $\endgroup$
    – Kent Shikama
    Oct 9, 2019 at 8:42

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