Providence College School of Business

FIN 417
Fixed Income Securities
Fall 2021
Instructor: Matthew Callahan
 Fixed Income Securities
Fundamental Concepts of Fixed Income Securities
- Common Terms and Bond Jargon
- Bond Prices and Measuring Yield
- Bond Price Volatility and Risk: Duration and Convexity
- Yield Curve and Term Structure of Interest Rates

Fixed Income Asset Classes and Securities Valuation Techniques

Portfolio Techniques, Asset-Liability Management and Derivatives

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 Benchmark Interest Rates
• All bonds are not created equally.
• There are a multitude of reasons that bonds have different yields (returns).
- Characteristics of the bond (Coupon, Maturity, Duration, Convexity)
- Type of Issuer (Credit, Default and Liquidity Risks)
- State of the Economy and Risk Appetite of Investors
• Minimum interest rate that investors desire is called Benchmark Interest Rate. All
other interest rates for non-benchmark bonds will be at some spread to the yields
available on benchmark bonds.

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 Benchmark Interest Rates
 Securities Issued by the US Department of the Treasury have long been considered
to be the benchmark for key interest rates in the United States as well as in
international capital markets.
 US Treasury Bonds are backed by Full Faith and Credit of the United States.
- Ability to tax and control printing press.
- Although downgraded by some Ratings Agencies to AA+ in
2011, still considered one of the world’s safest credits.

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Benchmark US Interest Rates

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Benchmark US Interest Rates

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 Benchmark Spreads

Yield Spread: The difference in yield-to-maturity between any two bonds:

Yield Spread = Yield Bond A – Yield Bond B

- quoted in basis points (bps).

- referred to as absolute yield spread.

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 Benchmark Spreads
Benchmark Yield Spread: The difference in yield when Bond B is a
benchmark bond and Bond A is a non-benchmark bond.

Benchmark Yield Spread = Yield Non-Benchmark – Yield Benchmark

Reflects the compensation that market demands for risks associated in

investing in non-benchmark bonds.

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Benchmark German Interest Rates

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 Benchmark Spreads
Factors Affecting Benchmark Yield Spreads:

- Type of Issuer and Perceived Credit Worthiness

- Term to Maturity of Instruments
- Embedded Optionality of Securities
- Taxability of Interest Received by Investors
- The Expected Liquidity of the Security

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 Time Value of Money
Interest Rate: 1. Amount of compensation which a
lender is willing to accept in order to
forgo consumption today to some
period in the future. It represents an
opportunity cost for the use of their
capital.

2. It represents the cost that a borrower

is willing to pay to have use of capital.

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5000 Years of Interest Rates
 Determinants of Interest Rates

r = r* + IP + DRP + LP + MRP

r = required return on a debt security (YTM)

r* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
 Term Structure of Interest Rates
Term to Maturity: The time remaining on life of bond before maturity.

Bonds are classified into three maturity sectors:

- Short-term bonds have maturities between 0 to 5 years.
- Intermediate bonds have maturities between 5 to 11 years.
- Long-term bonds have maturities greater than 11 years.

The spread between any two maturity sectors is called a maturity spread.
The relationship between yields of otherwise comparable maturities is called
the term structure of interest rates.

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 Yield Curve and the Term Structure of Interest Rates

• Term Structure: Relationship

between interest rates (yields)
and maturities.
• The yield curve is a graphical
representation of the term
structure.
• October 13, 2017 Treasury yield
curve is shown at the right.

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Yield Curve and the Term Structure of Interest Rates

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Various Historical Shapes of Yield Curve

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Various Shapes of Yield Curve: “Normal”, Steep or Positive

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Various Shapes of Yield Curve: Flat Yield Curve

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Various Shapes of Yield Curve: Inverted Yield Curve

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Various Shapes of Yield Curve: Humped Yield Curve

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 3 Term Structure Observations to Be Explained
1. Interest rates for different maturities tend to move
together in the same direction. (Correlated)
2. Yield curves tend to have a steep upward slope when
short rates are low and downward slope when short
rates are high.
3. Yield curves are typically upward sloping.

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Three Theories of Term Structure of Interest Rates

1. Pure Expectations Theory

- Explains points 1 and 2 fairly well, but not 3.
2. Market Segmentation Theory
- Explains points 2 and 3, but not point 1.
3. Liquidity Premium Theory/Preferred Habitat
- Combines features of Pure Expectations Theory
and Market Segmentation Theory to explain all 3.

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 Pure Expectations Theory
Pure Expectations Theory: contends that the shape of the yield
curve depends on investors’ expectations about the level of future
interest rates.

• If interest rates are expected to increase in the future, long-term (LT)

rates will be higher than short-term(ST) rates, and vice-versa. Thus,
the yield curve can slope up, down, or even bow.
• Long-term rates are an average of the market’s expectation of short-
term rates in the future.

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 Pure Expectations Theory Assumptions
• Assumes that the Maturity Risk Premium for Treasury securities is
zero. (MRP = 0)
• Bonds of different maturities are perfect substitutes for each other.
• Long-term rates are an average of current and future short-term rates.
• If the Pure Expectations Theory is correct, you can use the yield
curve to “back out” expected future interest rates.

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 Calculating Forward Rates
Forward Rate: an Interest Rate that is determined today for a loan that will
be initiated in a future time period.
• Forward Rates help investors to understand the market’s consensus for future interest
rates:
- Alternative 1: Buy a 2 year bond.
- Alternative 2: Buy a 1 year bond and buy another when it matures.
• The Forward Pricing Model is expressed in the following terms:
f(T*,T) is T years forward rate T* years from now.
f(1,1) is 1 years forward rate 1 years from now.

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 Calculating Forward Rates
Example. Consider the following spot rates:
Maturity (T) 1 2 3
Spot rates r(1) = 9% r(2) = 10% r(3) = 11%

Calculate f(1,1), f(2,1) and f(1,2).

Solution:
1)

2)

3)

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 Calculating Forward Rates
Forward Rate Term Structure
• The term structure of forward rates for a loan made on a specific initiation date is
called the “forward curve.”
- Forward rates and forward curves can be mathematically derived from the current
yield curve.

When the yield curve is

upward sloping, the Conversely, when the yield
forward curve will lie curve is downward sloping,
above the yield curve. the forward curve will lie
below the yield curve.

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Forward Rate Term Structure

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 Calculating Forward Rates
Forward Rate as a Predictor of Actual Interest Rates:

 The forward rate may never be realized but is important in what it

tells investors about his expectation relative to what the market
consensus expects.
 Some market participants prefer not to talk about forward rates as
being market consensus rates but refer to forward rates as being
hedgeable rates.
• For example, by buying the one-year security, the investor can hedge the six-
month rate six months from now.

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Observed Treasury Rates and Pure Expectations

Maturity Yield

1 year .66%
2 years 0.83
3 years 1.00
5 years 1.26
10 years 1.75

If the pure expectations theory holds, what does the market expect
will be the interest rate on one-year securities, one year from now
f(1,1)? Three-year securities, two years from now f(2,3)?
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 One-Year Forward Rate
.66% x%

0 1 2

.83%

(1.0083)2 = (1.0066) (1 + X)
1.01773/1.00666 = (1 + X)
0.01099 = X
Pure Expectations Theory says that one-year securities
will yield 1.099%, one year from now.

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Three-Year Security, Two Years from Now

.83% x%

0 1 2 3 4 5
1.26%

(1.0126)5 = (1.0083)2 (1 + X)3

1.06461/1.01666 = (1 + X)3
0.01547% =X
Pure Expectations Theory says that three-year securities will
yield 1.547%, two years from now.

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Pure Expectations Theory and the Term Structure
Pure Expectations Theory does good job of explaining Observation 1
– that long and short rates tend to move together:
 If short rate it today, then the expected future rates at times
t+1,t+2, t+3 etc. are also expected to rise and vice versa. Bond
prices are correlated.
 Thus, the Pure Expectations Theory predicts that short and long
rates will tend to move together, i.e. they are substitutes.

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Pure Expectations Theory and the Term Structure
Pure Expectations Theory also explains why yield curve has different slopes
(Observation #2):
1. When short rates are expected to rise in future, the average of future
short rates is above today’s short rate; therefore the yield curve is upward
sloping.
2. When short rates are expected to stay the same in the future, the yield
curve will be flat.
3. When short rates are high and expected to fall in the future, then the yield
curve will be inverted, or down-ward sloping.

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Pure Expectations Theory and the Term Structure
Pure Expectations Theory does not adequately explain why yield curve is
usually upward sloping (Observation #3):

 No explanation for why future short rates are generally expected to be higher than
today. It would reason that they should just as likely be lower or perhaps the same.

 Most evidence supports the general view that lenders prefer short-term securities, and
view long-term securities as riskier.
– Thus, investors demand a premium to persuade them to hold long-term securities
(i.e., MRP > 0).

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 Market Segmentation Theory
Market Segmentation Theory contends that the shape of the yield curve
is a result of the supply and demand considerations in each of its maturity
sectors.
 The interest rate at each maturity segment is determined independently
by the forces of supply and demand in that segment.
 Investors nor borrowers are willing to shift outside of their maturity
sector to take advantage of different rate levels. (Asset/Liability
Constraints)

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Market Segmentation Theory Assumptions

 Bonds of various maturities are not substitutes for each other.

 Investors have distinct investment horizons and require a meaningful
premium or reason to buy securities outside their “preferred” maturity.
(MRP>0)
 Generally believes that there are more short-term investors in fixed
income markets, therefore long-term rates tend to be higher than short-
term rates.

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Market Segmentation Theory and Term Structure
Market Segmentation Theory explains why yield curve is generally
upwardly sloping (Observation #3) and why inverted yield curves
(Observation #2) exist.

 Investors generally prefer short holding periods and have higher demand for short-
term bonds. To buy bonds with longer maturities and greater risks, they need to be
compensated with higher yields. (MRP>0)
 A downwardly sloping yield curve is just an unusual occurrence resulting from
highly contractionary monetary policy.

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Market Segmentation Theory and Term Structure
Market Segmentation Theory does not adequately explain why interest
rates for different maturities tend to move together (Observation #1).

 Interest rates of bonds across maturities tend to move together (i.e. they are
positively correlated).
 Truly independently determined interest rates should not move together.

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 Liquidity Premium/Preferred Habitat Theory
Liquidity Premium/Preferred Habitat Theory combines elements of both
Pure Expectations Theory and Market Segmentation Theory to explain the
term structure of rates. It asserts that long-term interest rates not only
reflect investors’ assumptions about future rates but also include a
premium for the uncertainty and risk associated with holding longer term
bonds.

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Liquidity Premium/Preferred Habitat Theory Assumptions
 Bonds of different maturities are substitutes for each other, but not perfect
substitutes.
 Implied forward rates are not an unbiased estimate of the market’s expected
future interest rate because they embody a maturity risk premium.
 Investors prefer shorter rather than longer bonds, therefore, they must be
paid a positive premium to purchase bonds outside their “preferred”
maturity, or habitat. (MRP>0)

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Liquidity Premium/Preferred Habitat Theory Assumptions
 Bonds of different maturities are substitutes for each other, but not
perfect substitutes.
 Implied forward rates are not an unbiased estimate of the market’s
expected future interest rate because they embody a maturity risk
premium.
 Investors prefer shorter rather than longer bonds, therefore, they must be
paid a positive premium to purchase bonds outside their “preferred”
maturity, or habitat. (MRP>0)
 Liquidity Premium and Preferred Habitat Theories differ in belief
that risk premium must rise uniformly with maturity.

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Liquidity Premium/Preferred Habitat Theory and Term Structure

 Liquidity Premium/Preferred Habitat Theory explains Observation #1

and Observation #2 because it uses much of the same explanations as
Pure Expectations Theory to describe that rates are correlated and that
average expected future short rates are determinant of long rate.
 Explains Observation #3 because the usual upward slope of the yield
curve is a function of a liquidity premium for longer dated bonds. (i.e.
MRP >0)

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Liquidity Premium/PH Expected 1 Year Interest Rates Over Next 5 Years
Date Yield MRP
1 year 5.0% 0%
2 years 6.0 0.25%

3 years 7.0 0.50%

4 years 8.0 0.75%

5 years 9.0 1.0%

 Interest rate on a two-year bond:

0.25% +(5% +6%)/2 = 5.75%
 Interest rate on a five-year bond:
1.0 + (5%+6%+7%+8%+9%)/5 = 8%
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 Hypothetical Treasury Yield Curve

Interest • An upward-
Rate (%)
15 Maturity risk premium
sloping yield
curve.
• Upward slope
10 Inflation premium due to an
increase in
5 expected
inflation and
Real risk-free rate
Years to increasing
0 Maturity maturity risk
1 10 20
premium.
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Premiums Added to r* for Different Types of Debt
IP MRP DRP LP
Short Term Treasury 
Maturity < 2yrs

Intermediate/Long Term  
Treasury >2yrs

Short Term Corporate <   

2yrs
Intermediate/Long Term    
Corporate >2yrs

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Yield Spreads Between Corporate and Treasury Yield Curves

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Corporate Bond Sector Spreads to US Treasuries Sep. 2016

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Representative Interest Rates on 5-Year Bonds in March 2018

5 Year Security Rate Spread = DRP + LP

US Treasury 1.62% ----------

AAA Corporate 1.83% 0.21 bp

AA Corporate 2.05% 0.43 bp

A Corporate 2.20% 0.58 bp

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Relationship Between Treasury and Corporate Yield Curves
• Corporate yield curves are higher than that of Treasury securities,
though not necessarily parallel to the Treasury curve.
• The spread between corporate and Treasury yield curves widens
as the corporate bond rating decreases.
• Since corporate yields include a default risk premium (DRP) and
a liquidity premium (LP), the corporate bond yield spread can be
calculated as:

Corporate bond
 Corporate bond yield  Treasury bond yield
yield spread
 DRP  LP

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