Conclusion

If we combine all of the things we have discussed regarding bond yields, we find that bond yields represent the combined effect of no fewer than six things. The first is the real rate of interest. On top of the real rate are five premiums representing compensation for (1) expected future inflation, (2) interest rate risk, (3) default risk, (4) taxability, and (5) lack of liquidity. As a result, determining the appropriate yield on a bond requires careful analysis of each of these effects.

taxability premium

The portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status.

liquidity premium

The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity.

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