Structure of Interest Rates  Accuracy of Credit Ratings — The ratings issued by the

agencies are opinions, not guarantees. Bonds that are

Chapter Objectives assigned a low credit rating experience default more
 Describe how characteristics of debt securities cause their frequently than bonds assigned a high credit rating, which
yields to vary. suggests that the rating can be a useful indicator of credit
 Demonstrate how to estimate the appropriate yield for any risk. However, credit rating agencies do not always detect
particular debt security. firms’ financial problems.
 Explain the theories behind the term structure of interest
rates (relationship between the term to maturity and the  Oversight of Credit Rating Agencies — The Financial
yield of securities). Reform Act of 2010 established an Office of Credit Ratings
within the Securities and Exchange Commission in order to
Why Debt Security Yields Vary regulate credit rating agencies. Rating agencies must
The yields on debt securities are affected: establish internal controls.
 Credit (default) risk
 Liquidity Exhibit 3.1 Rating Classification by Rating Agencies
 Tax status
 Term to maturity DESCRIPTION OF RATINGS RATINGS
SECURIT Y ASSIGNED BY: ASSIGNED BY:
Credit (default) Risk MOODY ’S STANDARD &
 Investors must consider the creditworthiness of the security POOR’S
issuer.
 All else being equal, securities with a higher degree of default Highest quality Aaa AAA
risk must offer higher yields.
 Especially relevant for longer term securities. High quality Aa AA

Use of Ratings Agencies to Assess Credit Risk High–medium quality A A

 Rating Agencies — Investors can personally assess the
creditworthiness of corporations that issue bonds, but they
may prefer to rely on bond ratings provided by rating Medium quality Baa BBB
agencies.(Exhibit 3.1).
Medium–low quality Ba BB
 Credit Ratings and Risk Premiums over Time — Rating
agencies can change bond ratings over time in response to Low quality (speculative) B B
changes in the issuing firm’s financial condition.
Poor quality Caa CCC
Very poor quality Ca CC 10% 1.80% 3.60% 5.40% 7.20%

Lowest quality (in C DDD, D 15 1.70 3.40 5.10 6.80

default)
25 1.50 3.00 4.50 6.00

28 1.44 2.88 4.32 5.76

35 1.30 2.60 3.90 5.20

Liquidity
 The lower a security’s liquidity, the higher the yield
preferred by an investor. •Computing the Equivalent Before-Tax Yield:
 Debt securities with a short-term maturity or an active
secondary market have greater liquidity.

Tax Status (Exhibit 3.2)

 Investors are more concerned with after-tax income.
 Taxable securities must offer a higher before-tax yield.
 The formulae for expected yields after-tax is calculated as
follows:
Yat = Ybt (1 − T)

Yat = after-tax yield

Ybt = before-tax yield Term to Maturity
T = investor’s marginal tax rate  Maturity dates will differ between debt securities.
 The term structure of interest rates defines the relationship
Exhibit 3.2 After-Tax Yields Based on Various Tax Rates and between possible terms to maturity and the annualized yield
Before-Tax Yields for a debt security at a specific moment in time while holding
other factors constant.
BEFORE- BEFORE- BEFORE- BEFORE- BEFORE-
TAX TAX TAX TAX TAX Modeling the Yield to be Offered on a Debt Security
YIELD YIELD YIELD YIELD YIELD When a company wants to issue debt, it needs to
TAX RATE 2% 4% 6% 8% consider all the characteristics just described so that it
can determine the appropriate yield to offer that will
 entice investors to buy its debt securities. The following
model incorporates the key characteristics for 2. t+1 r1 = Flat Same as today’s rate
determining the appropriate yield to be offered on a debt ti1

security:
3. t+1 r1 < Downward slope Lower than today’s rate
Yn = Rf,n + DP + LP + TA ti1

where:
Yn  =  yield of an n-day debt security
Exhibit 3.3 How Interest Rate Expectations Affect the Yield
Rf,n  =  yield of an n-day Treasury (risk-free) security
Curve
DP  =  default premium to compensate for credit risk
LP  =  liquidity premium to compensate for less liquidity
TA  =  adjustment due to difference in tax status

A Closer Look at the Term Structure

Pure Expectations Theory

 According to pure expectations theory, the term structure of
interest rates is determined solely by expectations of interest
rates.
o Impact of an Expected Increase in Interest Rates
(Exhibit 3.3)
o Impact of an Expected Decline in Interest Rates
(Exhibit 3.3)
o Algebraic Presentation — If the term structure of
interest rates is solely influenced by expectations of
future interest rates, the following relationships hold:

SCENARI STRUCTURE OF EXPECTATIONS ABOUT THE

O YIELD CURVE FUTURE INTEREST RATE

1. t+1 r1 > Upward slope Higher than today’s rate

ti1

According to pure expectations theory, a one-year investment
followed by a two-year investment should offer the same
annualized yield over the three-year horizon as a three year
security that could be purchased today. This relation is
expressed as follows:
 1  t i3    1  t i1   1  t 1 i2 
3 2
Liquidity Premium Theory(Exhibit 3.4)
 The preference for the more liquid short-term securities
places upward pressure on the slope of a yield curve.
Liquidity may be a more critical factor to investors at some
times than at others, and the liquidity premium will
accordingly change over time.
 The model that explains these movements is called liquidity
premium theory
Exhibit 3.4 Impact of Liquidity Premium on the Yield Curve
under Three Different Scenarios
Estimation of the Forward Rate Based on a Liquidity
Premium — When expectations theory is combined with
liquidity theory, the yield on a security will not necessarily be
equal to the yield from consecutive investments in shorter-term
securities over the same investment horizon.
 1  t 1 i 2    1  t 1 i1   1  t 1 r1   LP2
2
Here, Exhibit 3.5 Effect of Conditions in Example of Yield Curve
LP2 denotes the liquidity premium on a two-year security.

The relationship between the liquidity premium and term to

maturity can be expressed as follows:
0 < LP1 < LP2 < LP3 < … LP20

Segmented Markets Theory: Investors choose securities with

maturities that satisfy their forecasted cash needs.
 Limitation of the Theory:
o Some borrowers and savers have the flexibility to
choose among various maturities.
 Implications: Preferred Habitat Theory
o Although investors and borrowers may normally
concentrate on a particular maturity market, certain
events may cause them to wander from their
“natural” or preferred market.

Integrating the Term Structure Theories

 Evidence suggests that expectations theory, liquidity
premium theory, and segmented markets theory all have
some validity.
 To understand how all three theories can simultaneously
affect the yield curve, first assume the following conditions:
o Investors and borrowers who select security
maturities based on anticipated interest rate
movements currently expect interest rates to rise.
o Most borrowers are in need of long-term funds,
whereas most investors have only short-term funds
to invest.
o Investors prefer more liquidity to less.
 Then all three conditions place upward pressure on long-
term yields relative to short term yields leading to upward
sloping yield curve. (Exhibit 3.5)
Integrating the Theories of the Term Structure
Use of the Term Structure
 Forecasting Interest Rates
o The shape of the yield curve can be used to assess the
general expectations of investors and borrowers
about future interest rates.
o The curve’s shape should provide a reasonable
indication (especially once the liquidity premium
effect is accounted for) of the market’s expectations
about future interest rates.
 Forecasting Recessions — Some analysts believe that flat
or inverted yield curves indicate a recession in the near
future
 Making Investment and Decisions —
 o If the yield curve is upward sloping, some investors
may attempt to benefit from the higher yields on
longer-term securities even though they have funds
to invest for only a short period of time.
o Firms can estimate the rates to be paid on bonds with
different maturities. This may enable them to
determine the maturity of the bonds they issue.
 Factors that affect the shape of the yield curve can vary
among countries, and the yield curve’s shape at any given
time also varies among countries.
 Interest rate movements across countries tend to be
positively correlated as a result of internationally integrated
financial markets. Actual interest rates may vary significantly
across countries at a given point in time.

How the Yield Curve Has Changed over Time

 The yield curve is usually upward sloping, but a slight
downward slope has sometimes been evident. The yield
curves for the last few years have been very low, reflecting a
low annualized interest rate at any possible time to maturity.

Exhibit 3.6 Impact of Liquidity Premium on the Yield Curve

under Three Different Scenarios

Source: Federal Reserve.

International Structure of Interest Rates