A bond yield (or the interest rate of a mortgage based on that bond) is composed of the risk-free rate plus several premiums that, when added together, compensate investors or lenders for various risks and factors associated with holding the bond (or mortgage). When the risk-free rate and all the premiums are added together, you get the yield of a bond that a mortgage is based upon.
These premiums include:
Bond Call (Prepayment) Premium
Risk-Free Rate (Base Rate)
This is the yield on a risk-free security, typically government bonds (e.g., Government of Canada Treasury bonds), which are generally considered free of default risk. It serves as the foundation for all other bond yields.
Bond Sector Premium
This accounts for sector-specific risks or other unique factors affecting particular bonds. For example, bonds from emerging markets might carry additional premiums for political and economic instability.
Bond Call (Prepayment) Premium
This premium compensates investors for the risk that the issuer might repay the bond before its maturity date (calling the bond), which can happen when interest rates fall. Callable bonds generally offer higher yields to offset this risk.
Bond Taxability Premium
This accounts for the tax status of the bond. Bonds subject to higher taxes (e.g., corporate bonds) might offer higher yields compared to tax-exempt bonds (e.g., municipal bonds).
Bond Liquidity Premium
This premium compensates for the risk associated with the ease of buying or selling the bond without affecting its price significantly. Less liquid bonds, which are harder to trade, generally offer higher liquidity premiums.
Bond Credit (Default) Premium
This premium compensates investors for the risk that the bond issuer may default on its payments. Higher-risk issuers, such as corporations or lower-rated governments, must offer higher credit premiums.
Bond Inflation Premium
This compensates investors for the expected loss of purchasing power due to inflation over the bond’s term. If inflation is expected to be higher, the inflation premium will be higher to ensure investors earn a real return.
Bond Maturity (Term) Premium
This premium compensates investors for the increased risk associated with longer-term bonds. The maturity premium accounts for the greater uncertainty and potential price volatility over a longer period.
These premiums collectively determine the yield on a bond, reflecting the various risks and conditions affecting the investment. Investors evaluate these premiums when deciding whether the bond’s yield adequately compensates them for its associated risks.
