On page 82, volume 6, the first sentence of the second paragraph, can somebody explain to me? I do not seem to get it. The premium on LT bonds over ST bonds tends to be countercyclical (high during recessions and low at the top of expansions) because investors demand greater rewards for bearing risk during bad times. The premium mention above is the price premium? If so, if the investors demand high rewards, shouldn’t they demand a lower premium or even discounts? Especially for long term bonds where the principal payments are much farther away compare to short term bonds? Please help. Thanks.
Bond premiums are expressed in terms of yield. A yield premium means that the price will be lower for long term bonds. This coincides with the higher required return that investors would need for the riskier bonds.
Also, think of this in terms of yield curve. As the economic cycle rolls over from expansion to contraction, the yield curve is often flat to inverted, which goes along with your premium of long term bonds and short term bonds converging. When the economy hits recession and the central bank reduces short-term interest rates to stimulate economic activity this increases the gap in yields between long-term bonds and short-term bonds. Again, thinking of this in terms of yield curve, if all goes as planned, the curve becomes very steep. Typically, investors will not want to obtain long term bonds as a recession ensues (and assuming the central bank has acted to lower short-term rates) because it is likely yields will rise as the economy comes out of recession; therefore, investors will want to be shielded from interest rate risk and stay on the short-end of the curve. Once yields have risen and the economy is humming along nicely, then loading up on long-term bonds can be very profitable if you accurately estimate a recession before the market does and the central bank has not started to lower rates.