Chapter 2: Interest rates

Part 2: Structure of Interest Rates

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 Chapter Outline
— Risk structure of interest rates: Characteristics of debt
securities that cause their yields to vary
— Explaining actual yield differentials
— Estimating the appropriate yield

— Term structure of interest rates

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 Structures of interest rates
— Why do debt securities with the same maturity have different
interest rates?
— Because of variations in their characteristics: credit risk,
liquidity risk and tax status
Þ Risk structure of interest rate

• Why do debt securities with the same characteristics have

different interest rates?
• Because of the variations in time to maturity
ÞTerm structure of interest rate

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 Characteristics of Debt Securities
• Credit (default) risk
• Securities with a higher degree of risk have to offer higher
yields to be chosen
• Credit risk is especially relevant for longer-term securities
• Investors must consider the creditworthiness of the
security issuer
• Can use bond ratings of rating agencies
• The higher the rating, the lower the perceived credit risk
• Ratings can change over time as economic conditions change
• Ratings for different bond issues by the same issuer can vary

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 Characteristics of Debt Securities
(cont d)
• Credit (default) risk (cont d)
• Rating agencies
• Moody s Investor Service and Standard and Poor s Corporation
are the most popular
• Agencies use different methods to assess the creditworthiness of
firms and state governments
• A particular bond issue could have different ratings from each agency,
but differences are usually small
• Financial institutions may be required to invest only in investment-
grade bonds rated Baa or better by Moody s and BBB or better by
Standard and Poor s

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Characteristics of Debt Securities
(cont d)
Ratings Assigned by:
Description of Security Moody s Standard and
Poor s
Highest quality Aaa AAA
High quality Aa AA
High-medium quality A A
Medium quality Baa BBB
Medium-low quality Ba BB
Low quality (speculative) B B
Poor quality Caa CCC
Very poor quality Ca CC
Lowest quality (in default) C DDD, D
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 Characteristics of Debt Securities
(cont d)
— Credit (default) risk (cont d)
— Shifts in credit risk premiums
— The risk premium corresponding to a particular bond
rating can change over time
— Accuracy of credit ratings
— In general, credit ratings have served as reasonable
indicators of the likelihood of default
— Credit rating agencies do not always detect financial
problems of firms

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 Characteristics of Debt Securities
(cont d)
— Liquidity
— Liquid securities can be easily converted to cash without
a loss in value
— Short-maturity securities with an active secondary
market are liquid
— Securities with lower liquidity have to offer a higher yield
to be preferred

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 Characteristics of Debt Securities
(cont d)
— Tax status
— Investors are more concerned with after-tax income than
before-tax income
— Taxable securities have to offer a higher before-tax yield to be
preferred

— The after-tax yield is equal to:

Yat = Ybt(1-T)

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 Characteristics of Debt Securities
(cont d)
— Tax status
— Computing the equivalent before-tax yield
— The before-tax yield necessary to match the after-tax yield on a tax-
exempt security is:

Yat
Ybt =
(1− T )
• State taxes should be considered along with federal taxes

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 Computing the Equivalent Before-
Tax Yield
Assume a firm in the 30 percent tax bracket is aware of
a tax-exempt security that pays a yield of 9 percent.
To match this after-tax yield, taxable securities (with
similar maturity and risk) must offer a before-tax
yield of:

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 Characteristics of Debt Securities
(cont d)
• Term to maturity
• The term structure of interest rates defines the relationship
between maturity and annualized yield

• Special provisions
• A call feature allows the issuer of bonds to buy the bonds back
before maturity
• The yield on callable bonds should be higher than on non-callable
bonds
• A convertibility clause allows investors to convert the bond into a
specified number of common stock shares
• The yield on convertible bonds is lower than on nonconvertible
bonds

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Explaining Actual Yield Differentials
• Yield differentials are often measured in basis points
• 100 basis points equal 1 percent
• Yield differentials of money market securities
• Commercial paper rates are higher than T-bill rates
• Eurodollar deposit rates are higher than yields on other
money market securities
• Market forces cause the yields of all securities to move in
the same direction

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Explaining Actual Yield Differentials
(cont d)
— Yield differentials of capital market securities
— Municipal bonds have the lowest before-tax yield
— After-tax yield is higher than that of Treasury bonds
— Treasury bonds have the lowest yield
— No default risk
— Very liquid
— Investors prefer municipal or corporate bonds over Treasury
bonds only if the after-tax yield compensates for default risk
and lower liquidity

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 Estimating the Appropriate Yield
• The yield on a debt security is based on the risk-free
rate with adjustments to capture various characteristics:

Yn = Rf ,n + DP + LP + TA + CALLP + COND

• Maturity is controlled for by matching the maturity of

the risk-free security to that of the security of concern

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 Computing the Appropriate Yield

A company wants to issue 180-day commercial paper. Six-month

T-bills currently have a yield of 7 percent. Assume that a
default risk premium of 0.8 percent, a liquidity premium of
0.1 percent, and a 0.2 percent tax adjustment are necessary to
sell the commercial paper to investors. What is the
appropriate yield the company should offer on its
commercial paper?

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 A Closer Look at the Term Structure
— Pure expectations theory
— Pure expectations theory suggests that the shape of the yield
curve is determined solely by expectations of future interest
rates
— Assuming an initially flat yield curve:
— The yield curve will become upward sloping if interest rates are
expected to rise
— The yield curve will become downward sloping if interest rates are
expected to decline

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 Sudden Expectation of Higher
Interest Rates
Market for short-term risk-free debt Market for long-term risk-free debt

S1 S2 S2 S1

i1 i2

D1 D2
i2 i1
D2 D1

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Sudden Expectation of Higher
Interest Rates (cont d)

Yield Curve

YC2

YC1

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 Sudden Expectation of Lower
Interest Rates
Market for long-term risk-free debt Market for short-term risk-free debt

S1 S2 S2 S1

i1 i2

D1 D2
i2 i1
D2 D1

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Sudden Expectation of Lower
Interest Rates (cont d)

Yield Curve

YC1

YC2

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A Closer Look at the Term Structure
(cont d)
— Pure expectations theory (cont d)
— Algebraic presentation
— The relationship between interest rates on two-year and one-
year securities is:

(1+ t i 2 )2 = (1+ t i1 )(1+ t +1r1 )

— The one-year interest rate in one year (the forward rate) can
then be estimated:
(1+ t i 2 )2
t +1 r1 = -1
(1+ t i1 )

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 Computing the Forward Rate

Assume that the annualized two-year interest rate today is 8

percent. Furthermore, one-year securities currently offer an
interest rate of 5 percent. What is an estimate of the forward
rate?
(1+ t i 2 )2
t +1 r1 = -1
(1+ t i1 )
1.082
= -1
1.05
= 11.09%

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A Closer Look at the Term Structure
(cont d)
— Pure expectations theory (cont d)
— Algebraic presentation (cont d)
— The one-year interest rate in two years (the forward rate) can
also be estimated:

(1+ t i 3 )3
t + 2 r1 = -1
(1+ t i1 )(1+ t +1r1 )

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 Computing the One-Year Interest Rate
Two Years from Now

Continuing with the previous example, assume that three-year

securities currently offer an interest rate of 10 percent. What
is an estimate of the one-year interest rate that will prevail
two years from now?
(1+ t i 3 )3
t + 2 r1 = -1
(1+ t i1 )(1+ t +1r1 )
1.103
= -1
(1.05)(1.1109)
= 14.11%

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A Closer Look at the Term Structure
(cont d)
— Pure expectations theory (cont d)
— Algebraic presentation (cont d)
— Future annualized interest rates for periods other than one year
can also be computed using the yield curve
— A one-year investment followed by a two-year investment
should offer the same yield as a three-year security:
3
(1+ t i 3 )
(1+ t +1r2 ) 2
=
(1+ t i1 )

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 Computing the Two-Year Interest Rate
One Year from Now
Continuing with the previous example, what is an estimate of
the two-year interest rate that will prevail in one year?

(1.10)3
(1+ t +1r2 )2
=
(1.05)
= 1.27
t +1 r2 = 1.27 - 1
= 12.59%

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A Closer Look at the Term Structure
(cont d)
— Pure expectations theory (cont d)
— The theory assumes that forward rates are unbiased
estimators of future interest rates
— If forward rates are biased, investors should attempt to
capitalize on the discrepancy

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A Closer Look at the Term Structure
(cont d)
• Segmented market theory
• According to segmented markets theory, investors and
borrowers choose securities with maturities that satisfy
their forecasted cash needs
• Pension funds and life insurance companies prefer long-term
investments
• Commercial banks prefer short-term investments
• Shifting by investors or borrowers between maturity
markets only occurs if the timing of their cash needs
change

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 A Closer Look at the Term Structure
(cont d)
— Segmented market theory (cont d)
— Limitations of the theory
— Some borrowers and savers have the flexibility to choose among
various maturity markets
— e.g., Corporations may initially obtain short term funds if they
expect long-term interest rates to decline
— If markets were segmented, an adjustment in the interest rate in one
market would have no impact on other markets, but evidence shows
this is not true

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A Closer Look at the Term Structure
(cont d)
— Segmented market theory (cont d)
— Implications
— The preference for particular maturities can affect the prices and
yields of securities with different maturities and therefore the
shape of the yield curve
— The preferred habitat theory is a more flexible perspective
— Investors and borrowers may wander from their markets given
certain events

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A Closer Look at the Term Structure
(cont d)
• Liquidity premium theory
• According to the liquidity premium theory, the yield
curve changes as the liquidity premium changes over
time due to investor preferences
• Investors who prefer short-term securities will hold long-term
securities only if compensated with a premium
• Short-term securities are typically more liquid than long-term
securities
• The preference for short-term securities places upward
pressure on the slope of the yield curve

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A Closer Look at the Term Structure
(cont d)
— Liquidity premium theory (cont d)
— Estimation of the forward rate based on a liquidity
premium
— The yield on a security will not necessarily be equal to the yield
from consecutive investments in shorter-term securities:

(1+ t i 2 )2 = (1+ t i1 )(1+ t +1r1 ) + LP2

— The relationship between the liquidity premium and the term to
maturity is:
0 < LP1 < LP2 < LP3 < ... < LP20

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A Closer Look at the Term Structure
(cont d)
• Liquidity premium theory (cont d)
• Estimation of the forward rate based on a liquidity premium
(cont d)
• The one-year forward rate can be derived as:
(1+ t i 2 )2
t +1 r1 = - 1 - [LP2 /(1+ t i1 )]
(1+ t i1 )

• A positive liquidity premium means that the forward rate

overestimates the market s expectations of the future interest
rate
• A flat yield curve means the market is expecting a slight
decrease in interest rates
• A slight upward slope means no expected change in interest rates

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Computing the Forward Rate With A
Liquidity Premium
Assume that one-year interest rates are currently 10 percent.
Further assume that two year interest rates are equal to 8
percent. The liquidity premium on a two-year security is 0.7
percent. What is an estimate of the one-year forward rate?

(1+ t i 2 )2
t +1 r1 = - 1 - [LP2 /(1+ t i1 )]
(1+ t i1 )
1.082
= - 1 - [.007 / 1.10]
1.10
= 5 .4 %

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A Closer Look at the Term Structure
(cont d)
— Research on term structure theories
— Interest rate expectations have a strong influence on the term
structure
— The forward rate from the yield curve does not accurately predict
future interest rates
— Variation in the yield-maturity relationship cannot be explained by
interest rate expectations or liquidity
— General research implications
— Some evidence for pure expectations, liquidity premium, and
segmented markets theory

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A Closer Look at the Term Structure
(cont d)
— Uses of the term structure
— Forecast interest rates
— Pure expectations and liquidity premium theories can be used
— Forecast recessions
— A flat or inverted yield curve may indicate a recession in the near
future since lower interest rates are expected

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A Closer Look at the Term Structure
(cont d)
— Uses of the term structure (cont d)
— Investment decisions
— Riding the yield curve involves investment in higher-yielding
long-term securities with short-term funds
— Financial institutions whose liability maturities are different
from their asset maturities monitor the yield curve
— Financing decisions
— Assessing prevailing rates on securities for various maturities
allows firms to estimate the rates to be paid on bonds with
different maturities

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