Adopted from “Financial Markets and Institutions” – Mishkin & Eakins (9E)

For TCHE401/TCH401E Classes in FTU only, no further distribution/reproduction allowed.

In the last chapter, we examined interest rates, but made a big
assumption—there is only one economy-wide interest rate. Of course,
that isn’t really the case.
In this chapter, we will examine the different rates that we observe for
financial products.
We will fist examine bonds that offer similar payment streams but differ
in price. The price differences are due to the risk structure of interest
rates. We will examine in detail what this risk structure looks like and
ways to examine it.
Next, we will look at the different rates required on bonds with different
maturities. That is, we typically observe higher rates on longer-term
bonds. This is known as the term structure of interest rates. To study
this, we usually look at Treasury bonds to minimize the impact of other
risk factors.
So, in sum, we will examine how the individual risk of a bond affects its
required rate. We also explore how the general level of interest rates
varies with the maturity of the debt instruments. Topics include:
• Risk Structure of Interest Rates
• Term Structure of Interest Rates
To start this discussion, we first examine the yields for several categories
of long-term bonds over the last 90 years.
You should note several aspects regarding these rates, related to
different bond categories and how this has changed through time.

Personally, I suggest the name “Structure of IR”, without the “Risk” term
The figure shows two important features of the interest-rate behavior of
bonds.
Rates on different bond categories change from one year to the next.
Spreads on different bond categories change from one year to the next.
To further examine these features, we will look at three specific factors.
Default Risk
Liquidity
Income Tax Considerations
One attribute of a bond that influences its interest rate is its risk of
default, which occurs when the issuer of the bond is unable or unwilling
to make interest payments when promised.
U.S. Treasury bonds have usually been considered to have no default risk
because the federal government can always increase taxes to pay off its
obligations (or just print money). Bonds like these with no default risk
are called default-free bonds.
But are these bonds truly default-free bonds? During the budget
negotiations in Congress in 1995–1996, and then again in 2011–2013,
the Republicans threatened to let Treasury bonds default, and this had
an impact on the bond market. If these bonds were truly “default-free,”
we should not have seen any reaction.
The spread between the interest rates on bonds with default risk and
default-free bonds, called the risk premium, indicates how much
additional interest people must earn in order to be willing to hold that
risky bond.
A bond with default risk will always have a positive risk premium, and an
increase in its default risk will raise the risk premium.
Corporate Bond Market
1. Re on corporate bonds ↓, Dc ↓, Dc shifts left
2. Risk of corporate bonds ↑, Dc ↓, Dc shifts left
3. Pc ↓, ic ↑
Treasury Bond Market
1. Relative Re on Treasury bonds ↑, DT ↑, DT shifts right
2. Relative risk of Treasury bonds ↓, DT ↑, DT shifts right PT ↑, iT ↓
Outcome
Risk premium, ic − iT, rises
Default risk is an important component of the size of the risk premium.
Because of this, bond investors would like to know as much as possible
about the default probability of a bond.
One way to do this is to use the measures provided by credit-rating
agencies: Moody’s and S&P are examples.
Moody’s S&P Rating Description Examples of Corporations with
Rating Bonds Outstanding in 2016
Aaa AAA Highest quality (lowest Microsoft, J&J
default risk)
Aa AA High quality Apple, General Electric
A A Upper-medium grade MetLife, Intel, Harley-Davidson
Baa BBB Medium grade McDonalds, BofA, HP, FedEx, Southwest
Airlines
Ba BB Lower-medium grade Best Buy, American Airlines, Delta
Airlines, United Airlines
B B Speculative Netflix, Rite Aid, J.C. Penney
Caa CCC,CC Poor (high default risk) Sears, Elizabeth Arden
C D Highly speculative Halcon Resources, Seventy-Seven Energy
Starting in 2007, the subprime mortgage market collapsed, leading to
large losses for financial institutions.
Because of the questions raised about the quality of Baa bonds, the
demand for lower-credit bonds fell, and a “flight- to-quality” followed
(demand for T-securities increased).
Result: Baa-Treasury spread increased from 185 bps to 545 bps.
Another attribute of a bond that influences its interest rate is its
liquidity; a liquid asset is one that can be quickly and cheaply converted
into cash if the need arises. The more liquid an asset is, the more
desirable it is (higher demand), holding everything else constant.
Corporate Bond Market
1. Liquidity of corporate bonds ↓, Dc ↓, Dc shifts left
2. Pc ↓, ic ↑
Treasury Bond Market
1. Relatively more liquid Treasury bonds, DT ↑, DT shifts right
2. PT ↑, iT ↓
Outcome
Risk premium, ic − iT, rises
Risk premium reflects not only corporate bonds’ default risk but also
lower liquidity
The differences between interest rates on corporate bonds and Treasury
bonds (that is, the risk premiums) reflect not only the corporate bond’s
default risk but its liquidity too. This is why a risk premium is sometimes
called a risk and liquidity premium.
An odd feature of Figure 5.1 is that municipal bonds tend to have a lower
rate the Treasuries. Why?
Munis certainly can default. Orange County (California) is a recent
example from the early 1990s.
Munis are not as liquid a Treasuries.
However, interest payments on municipal bonds are exempt from federal
income taxes, a factor that has the same effect on the demand for
municipal bonds as an increase in their expected return.
Treasury bonds are exempt from state and local income taxes, while
interest payments from corporate bonds are fully taxable.
For example, suppose you are in the 35% tax bracket. From a 10%-
coupon Treasury bond, you only net $65 of the coupon payment because
of taxes
However, from an 8%-coupon muni, you net the full $80. For the higher
return, you are willing to hold a riskier muni (to a point).
Municipal Bond Market
1. Tax exemption raises relative Re on municipal bonds,
Dm ↑, Dm shifts right
2. Pm ↑
Treasury Bond Market
1. Relative Re on Treasury bonds ↓, DT ↓, DT shifts left
2. PT ↓
Outcome
im  iT
The 2001 tax cut called for a reduction in the top tax bracket, from 39%
to 35% over a 10-year period.
This reduces the advantage of municipal debt over T-securities since the
interest on T-securities is now taxed at a lower rate.
The Bush tax cuts were repealed under President Obama. Our analysis is
reversed. The advantage of municipal debt increased relative to T-
securities, since the interest on T-securities is taxed at a higher rate.
Now that we understand risk, liquidity, and taxes, we turn to another
important influence on interest rates—maturity.
Bonds with different maturities tend to have different required rates, all
else equal.
For example, Yahoo.com publishes a plot of the yield curve (rates at
different maturities) for Treasury securities.
The picture on page 96 of your text is a typical example, from May 17,
2016.

What is the 3-month rate? The two-year rate? What is the shape of the
curve?
Besides explaining the shape of the yield curve, a good theory must
explain why:
Interest rates for different maturities move together. We see this on the
next slide.
Besides explaining the shape of the yield curve, a good theory must
explain why:
Interest rates for different maturities move together.
Yield curves tend to have steep upward slope when short rates are low
and a downward slope when short rates are high.
Yield curve is typically upward sloping.
1. Expectations Theory
Pure Expectations Theory explains 1 and 2, but not 3
2. Market Segmentation Theory
Market Segmentation Theory explains 3, but not 1 and 2
3. Liquidity Premium Theory
Combine features of both Pure Expectations Theory and Market
Segmentation Theory to get Liquidity Premium Theory and explain
partially all facts
Key Assumption: Bonds of different maturities are perfect substitutes
Implication: Re on bonds of different maturities are equal
To illustrate what this means, consider two alternative investment
strategies for a two-year time horizon.
1. Buy $1 of one-year bond, and when it matures, buy another one-year
bond with your money.
2. Buy $1 of two-year bond and hold it.
The important point of this theory is that if the Expectations Theory is
correct, your expected wealth is the same (at the start) for both
strategies. Of course, your actual wealth may differ, if rates change
unexpectedly after a year.
To help see this, here’s a picture that describes the same information:
This is an example, with actual #’s:
 it + i e
t +1 +i e
t +2 + +i e
t +( n −1)
i nt =
n
Don’t let this seem complicated. Equation 2 simply states that the
interest rate on a long-term bond equals the average of short rates
expected to occur over life of the long-term bond.
Numerical example
One-year interest rate over the next five years
are expected to be 5%, 6%, 7%, 8%, and 9%
Interest rate on two-year bond today:
(5% + 6%)/2 = 5.5%
Interest rate for five-year bond today:
(5% + 6% + 7% + 8% + 9%)/5 = 7%
Interest rate for one- to five-year bonds today:
5%, 5.5%, 6%, 6.5% and 7%
Explains why yield curve has different slopes
1. When short rates are expected to rise in future, average of future
short rates = int is above today’s short rate; therefore yield curve is
upward sloping.
2. When short rates expected to stay same in future, average of
future short rates same as today’s, and yield curve is flat.
3. Only when short rates expected to fall will yield curve be
downward sloping.
Pure expectations theory explains fact 1—that short and long rates move
together
1. Short rate rises are persistent
2. If it ↑ today, iet+1, iet+2 etc. ↑ 
average of future rates ↑  int ↑
3. Therefore: it ↑  int ↑
(i.e., short and long rates move together)
Explains fact 2—that yield curves tend to have steep slope when short
rates are low and downward slope when short rates are high
1. When short rates are low, they are expected to rise to normal level,
and long rate = average of future short rates will be well above today’s
short rate; yield curve will have steep upward slope.
2. When short rates are high, they will be expected to fall in future, and
long rate will be below current short rate; yield curve will have
downward slope.
Doesn’t explain fact 3—that yield curve usually has upward slope
Short rates are as likely to fall in future as rise, so average of expected
future short rates will not usually be higher than current short rate:
therefore, yield curve will not usually slope upward.
Key Assumption: Bonds of different maturities are not substitutes at all
Implication: Markets are completely segmented; interest rate at each
maturity are determined separately
Explains fact 3—that yield curve is usually upward sloping
People typically prefer short holding periods and thus have higher
demand for short-term bonds, which have higher prices and lower
interest rates than long bonds
Does not explain fact 1or fact 2 because its assumes long-term and short-
term rates are determined independently.
Key Assumption: Bonds of different maturities are substitutes, but are
not perfect substitutes
Implication: Modifies Pure Expectations Theory with features of Market
Segmentation Theory
Investors prefer short-term rather than long-term bonds. This implies
that investors must be paid positive liquidity premium, int, to hold long
term bonds.
Results in following modification of Expectations Theory, where lnt is a
liquidity premium added to the equation.
We can see this graphically on the next slide.
1. One-year interest rate over the next five years: 5%, 6%, 7%, 8%, and
9%
2. Investors’ preferences for holding short-term bonds so liquidity
premium for one- to five-year bonds: 0%, 0.25%, 0.5%, 0.75%, and
1.0%
Interest rate on the two-year bond:
0.25% + (5% + 6%)/2 = 5.75%
Interest rate on the five-year bond:
1.0% + (5% + 6% + 7% + 8% + 9%)/5 = 8%
Interest rates on one to five-year bonds:
5%, 5.75%, 6.5%, 7.25%, and 8%
Comparing with those for the pure expectations theory, liquidity
premium theory produces yield curves more steeply upward sloped.
Explains All 3 Facts
Explains fact 3—that usual upward sloped yield curve by liquidity
premium for long-term bonds
Explains fact 1 and fact 2 using same explanations as pure
expectations theory because it has average of future short rates as
determinant of long rate
Initial research (early 1980s) found little useful information in the yield
curve for predicting future interest rates.
Recently, more discriminating tests show that the yield curve has a lot of
information about very short-term and long-term rates, but says little
about medium-term rates.
The picture on the next slide illustrates several yield curves that we have
observed for U.S. Treasury securities in recent years.
What do they tell us about the public’s expectations of future rates?
Sources: Federal Reserve Bank of St. Louis; FRED database, https://fred.stlouisfed.org/series/TB3MS,
https://fred.stlouisfed.org/series/GS3, https://fred.stlouisfed.org/series/GS5,
https://fred.stlouisfed.org/series/GS20.
The steep downward curve in 1981 suggested that short-term rates
were expected to decline in the near future. This played-out, with rates
dropping by 300 bps in 3 months.
The upward curve in 1985 and 2016 suggested a rate increase in the
near future.
The moderately upward slopes in 1980 and 1997 suggest that short term
rates were not expected to rise or fall in the near term.
The steep upward slope in 2016 suggests short term rates in the future
will rise.
The relation can be generalized to the following formula:

(1 + i n +1t )n +1
i te+n = −1
(1 + i nt ) n
Liquidity Premium Theory: int − lnt = same as pure expectations theory;
replace int by int − lnt to get adjusted forward-rate forecast

(1 + i n +1t − ln +1t )n +1
ite+n = −1
(1 + i nt − lnt ) n
Risk Structure of Interest Rates: We examine the key components of risk
in debt: default, liquidity, and taxes.
Term Structure of Interest Rates: We examined the various shapes the
yield curve can take, theories to explain this, and predictions of future
interest rates based on the theories.