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Bloopers & Blunders: Attractive Yield?

Quotation

"The yield on Lockheed's 30-year bond is 7.80 percent, significantly higher than the U.S. Treasury's, which closed Thursday at 6.91 percent. And the yield on Lockheed's 3-year note -- 6.56 percent -- also beat the government's -- which stands at 6.26 -- making Lockheed's debt very appealing to investors," according to CNNfn May 16, 1996.

Analysis

Why is yield on Lockheed’s debt "very appealing"? It should be as appealing as the debt of comparable risk companies. What would you do if the yield was truly more appealing than that on comparable risk debt?

You should simultaneously buy Lockheed’s bonds and "sell short" similar bonds. This will ensure you a riskless profit, also referred to as arbitrage or "free lunch." The reason this is a riskless profit transaction is that attractive yield means low price (inverse relationship between yield and price). But if everyone starts buying this "appealing" bond, its price will go up, leaving you with a handsome profit. If this were true, you would retire and not worry about studying finance anymore. This is why such a situation, if it were true, would be a "free lunch."

Some Related Issues

What does the difference between the yields on the 3-year Treasury notes (6.26%) and the yield on Lockheed’s 3-year notes (6.26%) represent?

From the yield relationship, we have:

yield = YTM = RF + IP + LP + MP + DP (*)

Where,

1. Pure "time value of money," that is, for tying up your money in a risk-free investment; denote this compensation by "RF."

2. Uncertain future inflation; call the associated compensation "IP."

3. Liquidity of the asset; the longer you need to wait to sell an asset, the lower the liquidity, and thus, the higher the compensation; call it "LP"

4. The longer the maturity of the bond, the higher the compensation; call it "MP".

5. The possibility of not getting paid, i.e., default risk. Call it "DP." In the case of a government bond, the DP is assumed to be zero.

Assuming that the Lockheed notes are as liquid as the Treasury’s, and since both have the same maturity, then the only source of difference between them would be a compensation for the possibility of default; that is, investors in Lockheed’s notes require a higher compensation for the associated default. Thus, DP will be positive for Lockheed, and, as noted earlier, is zero for the U.S. Treasury.

Why is the yield on Lockheed’s 30-year bonds 7.80% but only 6.26% on the 3-year notes?

The difference has to do with the difference in maturity. In general, the longer the maturity, the higher the yield, other things being equal.

By Alex Tajirian