The Risk and

Term Structure of Interest Rates

Kanjaraj Tangtatswas

1
The Risk and Term Structure of Interest
Rates

• High risk, high expected return

• Interest rate or yield should cover the
risk of the underlying bond or fixed
income instrument.

2
Term Structure of Interest Rates

• Bonds with identical risk, liquidity, and

tax characteristics may have different
interest rates because the time
remaining to maturity is different.
• Yield curve—a plot of the yield on
bonds with differing terms to maturity but
the same risk, liquidity and tax
considerations
3
Thai government bond yield curve

Source: ThaiBMA

4
Risk Structure of Interest Rates
• Risk premium —indicates how much
additional interest people must earn to be
willing to hold that risky bond.
• Default risk —occurs when the issuer of the
bond is unable or unwilling to make interest
payments or pay off the face value
U.S. T-bonds are considered default free.
• Other factors
Liquidity —the ease with which an asset can be
converted into cash
Income tax considerations
bonds
government has less default risk than corporate .

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6
Source: www.thaimba.or.th 27 May 2020 7
http://www.thaibma.or.th/EN/Market/YieldCurve/Corporate.aspx

Source: www.thaimba.or.th 27 May 2020 8

Risk premium

Source: ThaiBMA

http://www.thaibma.or.th/EN/Market/YieldCurve/Corporate.aspx
 • Predict what will happen to interest rates
on a corporation’s bonds if the
government guarantees today that it will
pay creditors if the corporation goes
bankrupt in the future. What will happen
to the interest rates on government
securities?
Relative risk of corporate bond decrease make it more attraction , demand 9 → bond price 9 → YTM d
,

Government bond guarantee payment → same → less attractive →

demand to →
priced
risk
bond YTM 9
as
corporate →

:< risk premium declined

10
Long-Term Bond Yields, 1919–2017

Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970;
Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2
COVID and Credit Spread

Source: MUFG Global Market Monthly July 2021 12

 to asset
→
people go
same

bonds
→
asset that safe :
government , currency
• If junk bonds are “junk”, then why would
investors buy them?

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Thai government bond yield curve

Source: ThaiBMA

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 Term Structure of Interest Rates
common
most
Interest Rates

✓ Upward-sloping: long-term rates

are above short-term rates

Time to Maturity
Interest Rates

Flat: short- and long-term rates

are the same
Time to Maturity
Interest Rates

Inverted: long-term rates are

below short-term rates

Time to Maturity humped

15
 Aug 2018

Aug 2019

Source: Wall Street Journal (Aug 11, 2019) 16

Facts Theory of the Term Structure of
Interest Rates Must Explain

1. Interest rates on bonds of different

maturities move together over time
2. When short-term interest rates are low,
yield curves are more likely to have an
upward slope; when short-term rates are
high, yield curves are more likely to slope
downward and be inverted
3. Yield curves almost always slope upward
Movements over Time of Interest Rates on U.S. Government
Bonds with Different Maturities

Sources: Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/

Term Structure Theories

• Expectations Theory
• Segmented Markets Theory
• Liquidity Premium Theory
(Preferred Habitat Theory)

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Expectations Theory

• The interest rate on a long-term bond will

equal an average of the short-term interest
rates that people expect to occur over the life
of the long-term bond

• Assumption: These bonds are said to be

perfect substitutes.

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 Expectations Theory
• There are 2 investment strategies.
1. Purchase a one-year bond, and when it
matures, purchase another one-year
bond.
2. Purchase a two-year bond and hold it
until maturity.
For an investment of $1
it = today's interest rate on a one-period bond
ite 1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond
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Expectations Theory
Strategy I
Today Year Year
0 it 1 ite 1 2

Value of investment at the end of year 2

= (1 + it)(1 + iet+1)
Strategy II
Today Year Year
0 i2t 1 i2t 2

Value of investment at the end of year 2

= (1 + i2t)2
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Expectations Theory—Example

• Let the current rate on one-year bond be 2%.

• You expect the interest rate on a one-year
bond to be 3% next year.
• Then the expected return for buying two one-
year bonds averages (2% + 3%)/2 = 2.5%.
• The interest rate on a two-year bond must be
2.5% for you to be willing to purchase it.

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Expectations Theory

If bonds are perfect substitutes, the expected return

on these bonds must be equal.

Return on Strategy I = Return on Strategy II

(1 + it)(1 + iet+1) = (1 + i2t)2

Or for simplicity,

it ite 1 ite 2 ... ite ( n 1)

int
n
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 BOT MPC meeting (Aug 4, 2021)

Source: Barclays (August 4, 2021) 25

MPC meeting impact on THB government bond yield

After MPC meeting with 2

Before MPC members voting for a rate
cut + growth downgrade
Yield move down
slightly
Aug 3, 2021 - Aug 4, 2021

26
Rate Expectation (Monetary Policy Expectation)
and Yield Curve
• March 2021: Market believe that Fed will not let inflation get out of hand. As a result, the expect
Fed to increase its policy rate soon.
• July 2021: Fed Chairman Powell gave repeated assurances that the post-lockdown surge in
inflation didn’t yet warrant a tapering of stimulus. Treasuries yield decline, due to growing
concerns that the spread of the delta variant Covid virus could impact economic growth.

Yield curve
was flattened.

Source: MUFG Global Market Monthly July 2021 27

 More example: Short-term US interest rate movement

https://fred.stlouisfed.org/series/FEDFUNDS

28
 More example: Short-term US interest rate movement

2019

2018

https://fred.stlouisfed.org/series/FEDFUNDS

29
 Aug 2018

Aug 2019

Source: Wall Street Journal (Aug 11, 2019) 30

Segmented Markets Theory

• Assumption: Bonds of different maturities are not

substitutes at all.
• Investors have preferences for bonds of one maturity
over another.
• The interest rate for each bond with a different
maturity is determined by the demand for and
supply of that bond.
• If investors prefer bonds with shorter maturities that
have less interest-rate risk, then this explains why
yield curves usually slope upward.

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Liquidity Premium
(Preferred Habitat) Theory
• Investors have a preference for bonds of one
maturity over another.
• They will be willing to buy bonds of different
maturities only if they earn a somewhat higher
expected return.
• Investors are likely to prefer short-term bonds
over longer-term bonds.
• Explain why short-term yield is lower than
long-term yield.

32
 Liquidity Premium Theory

• Assumption: Bonds of different maturities are

substitutes but not perfect substitutes.

it ite 1 ite 2 ... ite ( n 1)

int lnt
n
where lnt is the liquidity premium for the n-period bond at time t

lnt is always positive and rises with the term to maturity.

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34
Facts Theory of the Term Structure
of Interest Rates Must Explain
Facts Expectation Segmented Liquidity
Interest rates on bonds of ✓
✓
different maturities move
together over time.
When short-term interest rates
are low, yield curves are more ✓ ✓
likely to have an upward
slope; when short-term rates
are high, yield curves are
more likely to slope downward
and be inverted.
Yield curves almost always
slope upward. ✓ ✓

35
Yield Curves and the Market’s
Expectation – Liquidity Premium Theory

9} Int =

liquidity
" premium

-4kt
'

'
-
- -
-
-
- -
-

e-

"
"

"

g) Int
-
-
-

f) two
-

- -
-

36
The yield curve as a forecasting tool for
inflation and the business cycle
interest rate 9 → inflation 9

• The yield curve contains information about future

expected interest rates.
• It can help forecast inflation and real output
fluctuations.
• The slope of the yield curve is part of the tool kit of
many economic forecasters.
central bank 9 interest rate
•

people and steve

upward sloping
,

have few incentive Yield curve

to borrow /
spend
short term interest 9 future
↳ demand for asset to ↳ expect -
rate in

↳ price level
- will fall
Yield curve is inverted →
expect lower interest rate

↳ to recession
economy
is
going
↳ people wants Bond → Demand for bond 9 → price 9 → 37
yield d
Source: CNBC (Aug 9, 2019)
Source: CNBC
39
Source: CNBC (Aug 28, 2019)
Sep 3, 2021

https://www.gurufocus.com/yield_curve.php
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42
 bond and
corporate bond ?
Which bond has
higher liquidity between gov
.

gov
bond > corp bond
-

. .