When bonds (debt) are issued, the greatest risk to the buyer of the
bonds is a change in interest rates.
The change or ?volatility? means that there?s a risk that the bonds
could go down in value if inflation increases. And there?s also the
possibility of inflation and interest rates going down ? resulting in
a gain for the bond holder. It might appear that the two
possibilities ? a gain and a loss ? would offset each other but
financial markets don?t work that way.
The Capital Asset Pricing Model (CAPM) predicts that a risk will carry
a premium in the prices of bonds or stocks. The Capital Asset Pricing
Model was developed in the 1960s by William F. Sharpe and has become
the cornerstone of corporate finance. It also enabled the development
of options and futures markets in the
Sharpe was awarded the Nobel Prize for the work in 1990:
?THIS YEAR'S LAUREATES ARE PIONEERS IN THE THEORY OF FINANCIAL
ECONOMICS AND CORPORATE FINANCE,? (Oct. 16, 1990)
The CAPM allows one to measure the ?beta? or covariance of a bond with
the market and actually price out the premium. It will be
proportional to the quality/financial rating of the public agency.
Here?s another article that talks about why it?s better to hold
floating rate bonds ? this time from an investor?s standpoint:
?Let Your Investments Float . . . ? (November 23, 2003)
One final note: floating rate bonds have been cheaper for about the
last 2 decades. However, there are periods when the yield curve for
bonds is distorted ? with short-term yields much higher than long-term
yields. Such a period occurred during the early 1980s, when inflation
had pushed some short-term yields up to the 18% range, while long-term
bonds were yielding only 12%. In this extreme case a floating rate
bond might carry little or no premium.
Google search strategy:
CAPM + ?debt beta?