Chapter 6

The Structure of Interest Rates

 Topics Covered
1. The Term Structure of Interest Rates

2. Default Risk

3. Tax Treatment

4. Marketability

5. Options of Debt Securities

The Term Structure of Interest Rates

• Long maturity securities, yield more than short term.

• Term Structure of interest rates:

“Relationship between yield and term to maturity on

securities that differ only in length of time to maturity”

Assuming constant:
- Default risk
- Tax treatment
The Term Structure of Interest Rates

• Term structure can be approximated graphically

by plotting yield (vertical axis) and maturity
(horizontal axis) at point of time.
• Yield Curve:

“A yield curve is a graphical representation of the

term structure; it shows the relationship between
maturity and a security's yield at a point in time.”
The Term Structure of Interest Rates

• Shape and level of yields and curves do not

remain constant over time.
• Yield curve can be:

Ascending Most common

Flat Occur from time to time

Descending Occur periodically

The Term Structure of Interest Rates
The Term Structure of Interest Rates

• What economic forces explain shapes of yield

curves?
• Why is it important to understand the curves?

• Several theories explain the shape of the yield

curve.
1. Expectation Theory
2. Market Segmentation
3. Preferred-Habitat Theories
The Term Structure of Interest Rates

• Expectation Theory

“ The shape of the yield curve is determined by the

investor’s expectations of future interest rate
moments and that changes in these expectations
change the shape of the yield curve”
The Term Structure of Interest Rates

• Expectation Theory

Assumptions of the theory:

1. Investors are profit maximizers .

2. Investors have no preference between holding a

long term security and holding a series of short
term securities. ( they are indifferent toward
interest rate risk).
The Term Structure of Interest Rates

• Expectation Theory

• There two ways to invest for a period of 2

years.

1. Buying a 2 year bond

2. Buying two successive 1-year bonds.

 The investor would select the alternative with

the highest yield over the two years.
The Term Structure of Interest Rates

• Expectation Theory

• Example:

An investor has a 2-year investment horizon and

that only 1-year bonds and 2-year bonds are
available to purchase. Assume that both bonds
yield 6%.
The shape of the yield will be flat.
The Term Structure of Interest Rates

• Expectation Theory

• Example: (Cont’d):

Now, suppose that investors expects interest rates on 1-

year securities to rise to 12% within a year.
This expected 1 year interest rate is called: Forward rate

Then, investors will buy 1-year bond and sell 2 year

bonds if they own them.
Shape of the yield?
The Term Structure of Interest Rates

• Expectation Theory

Yield Curve would be:

• Flat: Future interest rates are expected to remain the

same.
• Ascending: future interest rates are expected to
increase.
• Descending: future interest rates are expected to
decrease.
The Term Structure of Interest Rates

• Expectation Theory

• In our example: investor would buy:

1. 2- year bond will yield: 6% (given), or

2. Two 1-year bonds: [6%+12%]/2 = 9%

Investors will buy 1 year bonds driving their prices

up and yield down, and sell 2 year bond, driving
their prices down and yields down.
The Term Structure of Interest Rates

• Expectation Theory
• The Term Structure Formula

The theory imply a formal relationship between

long and short term interest rates.

In other words: “ the long term rate of interest is

a geometric average of the current short term
interest rate and a series of expected short term
forward rates”
 The Term Structure of Interest Rates

• Expectation Theory
• The Term Structure Formula
1
1+ R = é 1+ R 1+ f 1+ f … 1+ f
( t n ) ë( t 1 ) ( t+1 1 ) ( t+2 1 ) ( t+n- 1 1 ) û ù n

where:
R = the observed market rate,
f = the forward rate,
t = time period for which the rate is applicable,
n = maturity of the bond.
The Term Structure of Interest Rates

• Expectation Theory
• The Term Structure Formula

• How to read formula notations:

- tR1: the current market interest rate for a one
year security.
- tR19: the current market interest rate for a 19
year security.
The Term Structure of Interest Rates

• Expectation Theory
• The Term Structure Formula

• How to read formula notations:

- f 1 year interest rate 1 year from now

t+1 1:

- f 1 year interest rate 2 years from now

t+2 1:

- f 3 years interest rate 5 years from now.

t+5 3:
The Term Structure of Interest Rates

• Expectation Theory
• The Term Structure Formula

• Example: suppose the current 1-year rate is 6

percent. Also, the market expects the 1-year a
year from now to be 8 percent and the 1-year
rate 2 years from now to be 10 percent.
Calculate the current 3-year rate of interest?
• Answer: 7.99%
The Term Structure of Interest Rates

• Expectation Theory
• Using Term Structure Formula To Calculate
Implied Forward Rates

  1t Rn n 
t n1 f1     1
 1t Rn1 
n1
The Term Structure of Interest Rates

• Expectation Theory
• Using Term Structure Formula To Calculate
Implied Forward Rates
• Using the following term structure of interest rates, find
the one-year implied forward rate for year three.
• 1-year Treasury note 1.95%
• 2-year Treasury note 2.39%
• 3-year Treasury note 2.71%

  1  .0271   3

f1   2
 1  0 .0335 or 3.35%
  1  .0239  
3
The Term Structure of Interest Rates

• Expectation Theory
• Using Term Structure And Liquidity Premiums
- It is not always true that investors are indifferent
between purchasing long term or short term
securities.
- Investors who seek long term funds must pay
lenders a liquidity premium.
- Liquidity premium increases as maturity increases
- The liquidity premium explains why the yield curve
slopes upward most of the time.
The Term Structure of Interest Rates
The Term Structure of Interest Rates
• Expectation Theory

• Yield Curve: Watch Now

The Term Structure of Interest Rates

• Market Segmentation Theory

“Market participants have strong preferences for

securities of particular maturity and buy and sell
securities consistent with their maturity
preferences.”
The Term Structure of Interest Rates

• Market Segmentation Theory

- Maturity preferences by investors may affect

security prices (yields), explaining variations in
yields by time
- If market participants do not trade outside their
maturity preferences, then discontinuities and
spikes are possible in the yield curve.
The Term Structure of Interest Rates

• Market Segmentation Theory

The Term Structure of Interest Rates

• Preferred Habitat Theory

• The Preferred Habitat Theory (PH) is an extension of the

Market Segmentation Theory.
• PH allows market participants to trade outside of their
preferred maturity if adequately compensated for the
additional risk.
• PH allows for humps or twists in the yield curve, but
limits the discontinuities possible under Segmentation
Theory. PH is consistent with a smooth yield curve.
The Term Structure of Interest Rates

• Which theory is right?

There is no agreement that a specific theory is

totally correct.
Market participants favor preferred-habitat
theory
Economists favor expectation and liquidity
premium approaches.
The Term Structure of Interest Rates

• Which theory is right?

• Day-to-day changes in the term structure are

most consistent with the Preferred Habitat
Theory.
• However, in the long-run, expectations of future
interest rates and liquidity premiums are
important components of the position and
shape of the yield curve.
The Term Structure of Interest Rates

• Yield Curve and Business Cycles

Interest rates are directly related to the level of

economic activity.
• An ascending yield curve notes the market
expectations of economic expansion and/or
inflation.
• A descending yield curve forecasts lower rates
possibly related to slower economic growth or
lower inflation rates.
The Term Structure of Interest Rates

• Yield Curve and Business Cycles

• Security markets respond to updated new

information and expectations and reflect their
reactions in security prices and yields.
The Term Structure of Interest Rates

• Yield Curve and Business Cycles

The Term Structure of Interest Rates

• Yield Curves and Financial Intermediaries

- Slope of the yield curve is important in managing

financial institutions.
Business Cycle Yield Curve Slope Interest Rates Strategy

Beginning of Upward Low Borrow short term

expansion Lend long term
Mid-cycle Flat High Profits squeeze and cost
reduction
Beginning of Downward Higher Shorten maturity of liabilities
contraction Lengthen maturity of loans
 Default Risk
• “the failure on the part of the borrower to meet
any condition of the bond contract”
• Most investors are risk averse. Meaning, they
prefer certain (guaranteed) return.
• Losses may range from “interest a few days late”
to a complete loss of principal.
• Risk averse investors want adequate
compensation for expected default losses.
 Default Risk
• Investors charge a default risk premium (above
riskless or less risky securities) for added risk
assumed
• The default risk premium (DRP) is the difference
between the promised or nominal rate and the
yield on a comparable (same term) riskless
security (Treasury security).

DRP = i - irf
 Default Risk

• The larger the default risk premium, the higher

the probability of default and the higher the
security’s market yield.
• As the credit quality declines, the default risk
premium increases.
 Default Risk
• Default risk and the business cycle:

- Default risk premiums vary systematically over

the business cycle.
- The pattern of the changes in the behavior of
default risk premium is because of the changes
in investors willingness to own bonds with
different credit ratings over the business cycle.
 Default Risk
• Default risk and the business cycle:

• It is called, the flight-to-quality argument.

• During periods of economic prosperity (growth),

investors are willing to hold bonds with low
credit rating. (little chance of default)
• During recession, investors’ only concern is
safety. Investors then will buy high credit rating
bonds and sell those with low credit ratings.
Default Risk
 Default Risk
• Default risk and the business cycle:

• Increase demand for high credit rating bonds,

increase their prices, and the decrease the yield.
• Selling low credit rating bonds, will decrease
their prices, and drives the yield up.
• Result: increase in default risk premium during
economic recession periods.
 Default Risk
• Bond Ratings

- They are assigned by rating agencies,

principally Moody’s Investors Services
(Moody’s), Standard & Poor’s (S&P), and Fitch
Rating (Fitch).
- They rank the bonds based on perceived
probability of default and publish the ratings
as letter grades.
Default Risk
 Default Risk
• Bond Ratings

- Investment bonds Vs. Speculative/ Junk bonds.

- Central bank require financial institutions only

to invest in investment bonds.
- We conclude that bond ratings are a
reasonable measure of default risk.
 Default Risk
• How credit ratings are determined

- the debt of a firm is a measure of default risk in the

opinion of the rating agency.
- Other factors that a credit ratings take into
consideration:
1. Expected cash flow
2. Fixed contractual cash payments
3. The length of time the firm has been profitable.
4. Variability of earnings.
 Tax Treatment
• Investors care about the rate of return after taxes

• Lower tax on the income from security  greater

demand on that security  increase the price of the
security  lower before tax yield.
• Tax exempt securities have lower market yields.

• Federal income tax

• We will consider the effect of the tax structure on

the market yield of security.
 Tax Treatment
• Coupon Income

- Coupon payments earned on state and local

government securities (municipal securities)
are tax exempt.
- So, their yield is lower than comparable
securities.
- Exemption from tax is because of the
separation of federal and state powers.
 Tax Treatment
• Coupon Income

- Aim of these securities is to help state to

borrow at lower interest rates.
- Investors decision to choose between taxable
and tax exempt securities depends on their
relative yields and investor’s marginal tax.
 Tax Treatment
• The after-tax return, iat, is found by multiplying
the pre-tax return by one minus the investor’s
marginal tax rate:
i at = ibt(1-t)
Where iat: is intreset aftet tax
ibt: inrerst before tax,
t: tax rate

The equation assumes that return on the security consist

entirely from coupon payments, with no capital gain.
 Tax Treatment
• Coupon Income

• For example, assume that a taxable corporate bond has a yield of

10% and a comparable municipal bond yield 7%. Yield after tax will
be as following:
 Tax Treatment
• Coupon Income

Rule:
- Investors in high tax brackets (wealthy and fully
taxed corporation such as commercial banks),
hold portfolios of municipal securities.
- Lower tax brackets (persons with lower income
and tax-exempt institutions such as pension
funds) invest in taxable securities.
 Tax Treatment
• Coupon Income

- Tax benefits of owning the municipal bond

offsets its increased default risk compared to
the treasury bond.
- Aaa-rated municipal bonds have lower yields
than Aaa corporate bonds because of the tax
treatment of municipal bond income.
 Tax Treatment
• Capital Gains Income

- Capital gains are taxed at a lower rate than ordinary

income.
- Advantage: taxes are not paid until the gains are
realized from the disposal of the security. (present
value of capital gains tax is less than income tax)
- Compared to coupon payments which are taxed on
receipts.
 Marketability
• Interest rates on securities varies with the
degree of marketability.
• Marketability – The costs and speed with which
investors can resell a security.
• Securities with good marketability have high
demand resulting in higher prices and lower
yields.
 Marketability
• Marketability depends on:
• Cost of trade.
• Physical transfer cost.
• Search costs.
• Information costs.

• It is gauged by the volume of a security's secondary

market
• Short term treasury bills have the largest and most
active secondary markets.
Options on Debt Securities
• Some bonds contain options that permit the
borrower or lender to change the nature of
the bond contract before maturity.
• An option is:

“ a contract that gives the holder the right, but

not the obligation, to buy or sell an asset at
some specified price and date in the future.”
• We will discuss three types of options:

1. Call option: the holder of the option has the

right to buy the underlying security.

2. Put option: the holder has the right to sell the

underlying security.

3. The holder has the right to convert the

security into another type of security.
• Call option:

- It is sometimes called a call provision.

- It gives the issuer of the bond the option to buy back

the bond at a specified price in advance of the
maturity date.
- The price is called: “ call price”

- This price is usually set at the bond’s par value or

slightly over par.
• Call option:

• Bonds that contain a call option sell at a higher

market yield than otherwise comparable non-
callable bonds. i.e.

i bond+option > i bond only

So, it is a penalty yield on callable bonds because

callable bonds works to the benefit of the
borrower.
• Call option:

• Investors in callable securities bear the risk of losing their high-

yielding security.
• A buyer of a bond call option is expecting a decline in interest rates
and an increase in bond prices.
• Investors demand a call interest premium (CIP).
• CIP = ic - inc

• Where;
ic: interest on callable bond
inc: interest on non callable bond
- Call option:

- In other words, it is a compensation paid to

investors who own callable bonds for potential
financial injury in the event that their bonds
are called.
- For proper comparison, bonds should have
similar default risk, tax treatment, term to
maturity and marketability.
- Call option:

- Call option is most likely to be exercised when

interest rates are declining.
- A call option is valuable when rates are
expected to fall, and investors are paid greater
CIP.
• Put Options:

- “it allows an investor to sell a bond back to the

issuer before maturity at a predetermined price”
- It is exercised when interest rates are rising and
bond prices are declining.
- A put option sets a floor, or a minimum price of a
bond at the exercise price, which is below or at
par value.
• Put Options:

- It is an advantage for to investor.

- It is sold at a rate lower than the comparable non-putable bonds.

Why?
• That is because investors can protect themselves against capital
losses as a result of unexpected rise in interest rates.
• The difference in interest rates between putable and non-putable
contracts is called the put interest discount (PID).
• PID = ip – inp
• Where ip: yield on a putable option, i np: yield on non-putable option
• Put Options:

- Example: if interest rates increased above the bond’s

coupon rate on a putable bond, the investor can sell
the bond back to the issuer at the exercise price, and
then buy a new bond at the current market yield
(lower price).
- Value of put option depends on interest rate
expectations, the higher the interest rates are
expected to rise, the more valuable the option and
thus, the greater the interest discount.
• Conversion Option

- “ it allows the investor to convert a security into

another type of security at a predetermined price”
- Common types of conversion feature:

1. The option to convert a bond into an issuer stock

2. Conversion of a variable-coupon bond into a fixed-

coupon bond
• Conversion Option

- Timing of conversion is at the option of the investor.

- Terms are agreed on when the security is purchased.

- It is an advantage for the investors. So, they will pay

higher prices ( require lower rates) for convertible
securities.
- Convertible bonds have lower yields than similar
bonds without this option.
• Conversion Option

• The conversion yield discount (CYD) is the

difference between the yields on convertibles
relative to non-convertibles.
• CYD = icon - incon. Investors accept lower yields on
convertibles because they have an opportunity
for increased rates of return through conversion.
• Conversion Option

- Example: if an investor that is convertible into

common stock:

1. If stock price falls: the investor earns fixed rate of

return in the form of interest income form the bond.

2. If stock price rises: the investor would exercise the

option and earn a capital gain. (stock market price >
option exercise price)
• Conversion Option

- Example: an investor owns a variable-coupon bond

convertible into a fixed-coupon bond.
- If interest rates are increasing:
Investor will hold the variable-coupon bond and earn higher
interest income as the coupon rates are adjusted to the market
rate.

- If the interest rates are near peak:

the investor would exercise the option to convert into a fixed
coupon bond, and lock in the higher rate of interest.
• Conversion Option

- The value of the conversion option depends on

interest rate expectations.
- The higher interest rates are expected to rise,
the more valuable the option, and the greater
is the yield discount.
End of Chapter 6