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Riskterm Print

The document discusses factors that influence interest rates for bonds of different risk, liquidity, and maturity. It explains that the "risk structure" of interest rates is better termed the "risk and liquidity structure" as both risk and liquidity affect rates. Default risk, credit ratings, tax treatment, and expectations of future interest rates all impact bond yields in different ways depending on the bond characteristics. The term structure of interest rates, as illustrated by the yield curve, demonstrates how rates vary with time to maturity and can be explained by expectations theory and liquidity theory.

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26 views6 pages

Riskterm Print

The document discusses factors that influence interest rates for bonds of different risk, liquidity, and maturity. It explains that the "risk structure" of interest rates is better termed the "risk and liquidity structure" as both risk and liquidity affect rates. Default risk, credit ratings, tax treatment, and expectations of future interest rates all impact bond yields in different ways depending on the bond characteristics. The term structure of interest rates, as illustrated by the yield curve, demonstrates how rates vary with time to maturity and can be explained by expectations theory and liquidity theory.

Uploaded by

smit9993
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Risk and Term Structure of Interest Rates

Economics 301: Money and Banking

1
1.1 Goals
Goals and Learning Outcomes

• Goals:
– Explain factors that can cause interest rates to be different for bonds
of different risk, liquidity, and maturity.
• Learning Outcomes:

– LO3: Predict changes in interest rates using fundamental economic


theories including present value calculations, behavior towards risk,
and supply and demand models of money and bond markets.

1.2 Reading
Reading

• Hubbard and O’Brien, Chapter 5.

2 Risk and Liquidity Structure


Risk Structure

• Risk structure of interest rates: explanation for why different secu-


rities with the same maturity have different prevailing interest rates in
secondary market.

• Examples:
– Federal government bonds.
– Municipal bonds.
– Aaa corporate bonds.
– Baa corporate bonds.

1
• “Risk” structure actually includes multiple factors:
– Default risk
– Capital gains risk
– Differences in liquidity
– Differences in tax rules

2.1 Default Risk


Default Risk

• Risk-free bonds aka default-free bonds: bonds that have zero chance
of default. Treasury bonds are often considered risk-free bonds.

• Default risk premium: additional interest above risk-free bonds paid


for securities with a risk of default.
• Use a supply/demand analysis for two securities: Treasury bonds and Baa
corporate bonds

• Higher risk of default → higher risk premium.

Credit Rating Agencies

• Three major credit rating agencies determine risk of default for many
corporate and government bonds.

– Moody’s Investor Service


– Standard and Poor’s Corporation
– Fitch Ratings
• “Investment-grade” securities have ratings Baa/BBB or above.

• “Junk bonds” or “high-yield” bonds have ratings below Baa/BBB.

Credit Rating Agencies

Moody’s S&P and Fitch Definition


Aaa AAA Prime Maximum Safety
Aa1, Aa2, Aa3 AA+, AA, AA- High Grade High Quality
A1, A2, A3 A+, A, A- Upper Medium Grade
Baa1, Baa2, Baa3 BBB+, BBB, BBB- Lower Medium Grade
Ba1, Ba2, Ba3 BB+, BB, BB- Speculative
B1, B2, B3 B+, B, B- Highly Speculative
Caa1, Caa2, Caa3 CCC+, CCC, CCC- Extremely Speculative

2
2.2 Liquidity
Liquidity

• Bonds that differ on risk, usually also differ on liquidity.


• Treasury bonds are most highly liquid - traded worldwide.
• For a given corporation, far fewer bonds are traded, many financial in-
vestors may not be familiar with security.
• Credit rating agencies help increase liquidity.
• Supply and demand analysis of Treasury bonds vs. corporate bonds again
demonstrates premium paid for liquidity.

• What is called “risk structure” of interest rates: more appropriately should


be called risk and liquidity structure.

2.3 Income Tax


Municipal Bonds and Income Tax

• Municipal bonds have higher risk, lower liquidity than Treasury bonds.

• Yet, municipal bonds often have lower interest rates than risk-free Trea-
sury bonds.
• Earnings on holding municipal bonds are exempt from Federal income
taxes.

• Example - consider two hypothetical, one year maturity, discount bonds:


– Treasury bond: Face value = $1000, Price = $952.
– Municipal bond: Face value = $1000, Price = $961.50.
– Your marginal income tax rate = 25%
– Compute before-tax and after-tax yield to maturity.

• Supply and demand analysis of Treasury bonds vs. municipal bonds


demonstrates effect on interest rates.

3 Term Structure
3.1 Yield Curve
Yield Curve

• Bonds with otherwise identical risk, liquidity and tax rules may have dif-
ferent interest rates due to different times remaining to maturity.

3
• Yield curve: illustration of how interest rates for a particular type of
bond differ for different maturity dates.

Yield Curve

• Yield curve shape:

– Yield curves are often, but not always, upward sloping.


– Inverted yield curve: downward sloping.
– Sometimes have more complicated shape.
• Theories that explain shape:

– Expectations theory.
– Liquidity theory.

3.2 Expectations Theory


Expectations Theory

• Bonds with different maturity dates, but otherwise similar features, should
be nearly perfect substitutes to one another. → Consequently, interest
rates should be the same.
• Simple example: compare return of one-year security (rolled over for a
second year) and a two-year security.

– Let it denote today’s (time t) interest rate for a one year security.
– Let Et it+1 denote today’s (time t) expectation of tomorrow’s (time
t + 1 interest rate) on a one-year security.
– Let i2,t denote the interest rate negotiated today (t) over the life of
a two-year bond.

4
Expectations Theory

• Expected net return on holding one-year securities:

E t R1 = (1 + it )(1 + Et it+1 ) − 1
= it + Et it+1 + it Et it+1
≈ it + Et it+1

• Expected net return on holding two-year security:

R2 = (1 + i2,t )(1 + i2,t ) − 1


= 2i2,t + i22,t
≈ 2i2,t

• Perfect substitutes - set returns equal to another:


it + Et it+1
Et R1 = R2 i2,t =
2

• Return on long-term bond is approximately equal to average expected


interest rates until maturity date.

Expectations Theory

• When should yield curve be...


– upward sloping?
– downward sloping?
– flat?

• Yield curves are almost always upward sloping. What explains that?

3.3 Liquidity Theory


Liquidity Theory

• Long term bonds are subject to interest rate risk.

– Holders of long-term bonds seldom plan to hold security.


– Even if they did, higher interest rates in the future increase the op-
portunity cost of holding the bond.
• Liquidity theory: short-term and long-term bonds are close, but not
perfect substitutes.

• In addition to paying interest equal to the average expected interest rate,


bond issuers must pay a liquidity premium.

5
• The further is the maturity date, the larger is the interest rate risk, the
larger is the liquidity premium.
• Suppose the current interest rate is equal to the long-run average expected
interest rate. What should be the shape of the yield curve under expec-
tations theory and liquidity theory?

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