IR = interest rate

ER = expected return
D = demand

- The relative ease with

which an asset can be
U.S. Treasury bonds - the most liquid converted into cash Downward slopping (inverted yield curve): long-
long-term bonds because: o Cost of selling a bond term IR below the short-term IR
Corporate bonds, not liquid: o Number of buyers/sellers

in a bond market
Definition: A plot of the
yields on bonds with
Flat yield curves: long-term and short-term IR
differing terms to maturity
but the same risk, liquidity have the same
and tax considerations Equation
- The higher the IR on a high- The interest rate on a long-term bond = the average of the
risk bond, the larger the risk Definition: short-term interest rates that people expect to occur over
premium (positive) If Corporate bonds: less
+ The more liquid, the higher the Upward-slopping (normal yield curve): long-term the life of the long-term bond
liquid -> Demand decreases -
demand for the bond. IR above short-term IR
> shift D curve leftward ->
+ The difference in liquidity
Corporate bonds (a): an increased price falls, IR rises Bonds with the same
between two bonds increases the
default risk -> ER decreases -> Demand Definition: The spread Treasury bond: more liquid - liquidity, tax, and credit Yield curve
falls -> D.Curve shift left -> Price falls ->
difference in the IR also increases. Buyers of bonds do not prefer bonds of one maturity over
in IR on bonds with > D rises -> shift D curve ratings can still have
IR increases default risk and Key Assumption: Bonds with another
rightward -> price rises + IR variable IR. Then the ER on those bonds must
Treasury bonds (b): Switch to investing default-free bonds. different maturity said to be They will not hold any quantity of a bond if its ER is less than
in lower-risk bonds -> Demand falls =>The spread rises be equal.
perfect substitutes that of another bond with a different maturity
increases -> D.curve shift right -> price
rises -> IR falls.
The gap between IR of corporate
bonds and US treasury bonds is risk Risk Definition: The issuer of the bond LIQUIDITY TERM STRUCTURE
EXPECTATIONS THEORY
If short-term interest rates increase today → it
premium premium can not pay for the interest as tend to higher in the future. Long-term rates are the average of expected future short-term rates, a rise in short-
OF INTEREST RATE
promised or pay off the face value.

EXPLAINATION Fact 1
Because →
term rates will also raise long-term rates they move together.
A rise in short-term rates will raise people’s

expectations of future higher short-term rates.

Credit-rating If short-term rates are low, people expect them to rise to some normal
agencies The yield curve will have an
level in the future => average of future expected short-term rates are high
DEFAULT upward slope
RISK RISK TERM Fact 2 relative to the current short-term rate

Definition:
Investment
Defined by 3
largest credit-
STRUCTURE
OF INTEREST CHAP 6 STRUCTURE
OF INTEREST
THREE
THEORIES
If short-term rates are high, people usually expect them to come back
down. Long-term rates will then drop below short-term rates => average of
The yield curve will slope
downward and become inverted.
advisory firms that
rating agencies: RATES RATE expected future short-term rates will be lower than current short-term
Moody’s Example: Corona in March 2020
rate the probability rates
Standard and Default risk for Baa bonds increases ->
of default.
Poor’s less desirable -> quantity demanded
Fitch decreases -> shifted D curv to the left. Investors have a particular
They match the maturity of the holding period in mind
SEGMENTED MARKETS The interest rate for each bond with a different maturity is
THEORY determined by the demand for and supply of that bond. bond to desired holding period
IMPORTANT Obtain a certain
TAX INCOME return with no risk
Municipal bonds (a) are given a tax advantage -> A bond with tax-exempt FACTS
raises after-tax ER -> D rises -> D curve shifts to the CONSIDERATION (municipal bond) Because
will attract buyers Key assumption: Bonds of ER from holding a bond of one-
right -> Equilibrium bond price rises -> E. IR falls maturity has not effect on the Investors have strong preferences for bonds of one
different maturities are not
Treasury bonds (b) don't have a tax advantage -> Fact 1: The IR on bonds of different maturities demand for a bond of another maturity as opposed to another => They just
substitutes at all
lower after-tax ER -> D falls -> D curve shifts to the move together over time maturity
Liquidity premium concerned only with the ER on bonds they prefer
left -> Equilibrium bond price rise -> E. IR rises Municipal bonds: The IR of tax-
Tax - free
and preferred habitat
exempted bonds (or
Fact 2: theories
Not liquid bonds with lower
Short-term IR are low, yield curves slope
Lower IR taxes) will be lower
upward Short desired holding period
than the IR of bonds
with higher taxes.
Short-term IR are high, yield curves slope Fact 3: Risk-averse LT will have lower prices
downward (inverted) EXPLAINATION => Demand for LT bonds is
investors have => slope-upward
Prefer bonds with shorter lower than ST bonds Higher IR
maturities (less risk)

Fact 3: Yield curve almost always slopes upward

LIQUIDITY
PREMIUM The IR of a long-term bond = (average short-term
expected interest) + (the term premium responds
to the bond’s supply and demand)
liquidity premium always positive + rise with
PREFERRED the term to maturity
Combine 2 theories
HABITAT THEORY
to explain 3 facts
Key assumption:
Bonds of different maturities are not perfect
Short-term bonds are substitues => the ER on one bond does influence
prioritized over longer-term the ER on a bond of different maturity
There is a preference among bonds although the short-term
different maturity bonds, rate is lower. There must be a
investor will choose premium to choosing long-
whichever bond has higher ER term bonds (liquidity premium
theory) leading to the upward
trend of the yield curve