Chapter 2: Part 2

Structure of Interest Rates

 Structures of interest rates

— Why do debt securities with the same maturity have

different interest rates?
o 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?
o Because of the variations in time to maturity
ÞTerm structure of interest rate
2
Contents
1. Risk structure of interest rates
2. Term structure of interest rates
1. Risk structure of interest rates
1. Risk structure of interest rates

5
1. Risk structure of interest rates

6
 1. Risk structure of interest rates
Characteristics of Debt Securities

• Credit (default) risk

• 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
7
 1. Risk structure of interest rates
Characteristics of Debt Securities
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) 8
C DDD, D
 1. Risk structure of interest rates
Characteristics
CHAPTER 6
ofTheDebt Securities
Risk and Term Structure of Interest Rates 119

○ Credit (default)
MyLab Economics risk (cont’d)
Mini-lecture

Step 1. An increase in default Step 2. and shifts the demand

risk shifts the demand curve curve for Treasury bonds to
Price of Bonds, P for corporate bonds left . . . Price of Bonds, P the right . . .

ST

Sc
i T2
P T2

Risk
P c1 Premium P T1

P c2 i c2

Step 3. which raises the price of DT2

D c1 Treasury bonds and lowers the price D T1
D c2 of corporate bonds, and therefore
lowers the interest rate on Treasury
Quantity of Corporate Bonds bonds and raises the rate on Quantity of Treasury Bonds
corporate bonds, thereby increasing
(a ) Corporate bond market the spread between the interest rates (b) Default-free (U.S. Treasury) bond market
on corporate versus Treasury bonds.

FIGURE 2 Response to an Increase in Default Risk on Corporate Bonds

Initially, P c1 = P T1, ic1 = iT1, and the risk premium is zero. An increase in default risk on corporate bonds
shifts the demand curve from Dc1 to Dc2; simultaneously, it shifts the demand curve for Treasury bonds from
DT1 to DT2. The equilibrium price for corporate bonds falls from P c1 to P c2, and the equilibrium interest rate on
corporate bonds rises to ic2. In the Treasury market, the equilibrium bond price rises from P T1 to P T2, and the
equilibrium interest rate falls to iT2. The brace indicates the difference between ic2 and iT2, the risk premium on
corporate bonds. (Note that because P c2 is lower than P T2 , ic2 is greater than iT2.)
9
 1. Risk structure of interest rates
Characteristics of Debt Securities
○ Credit (default) risk (cont’d)

10
 1. Risk structure of interest rates
Characteristics of Debt Securities

11
 1. Risk structure of interest rates
Characteristics of Debt Securities

○ 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

12
 1. Risk structure of interest rates
Characteristics of Debt Securities

• 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

13
 1. Risk structure of interest rates
Characteristics of Debt Securities

— 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)

14
 1. Risk structure of interest rates
Characteristics of Debt Securities

— 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

15
 1. Risk structure of interest rates
Characteristics of Debt Securities
— Tax status

16
 1. Risk structure of interest rates
Characteristics of Debt Securities
— Tax status

17
 1. Risk structure of interest rates
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?
Ybt = Yat / (1-T) = 9%/(1-30%) = 12.86%

18
 1. Risk structure of interest rates
Characteristics of Debt Securities

• 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

19
 1. Risk structure of interest rates
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

20
 1. Risk structure of interest rates
Explaining Actual Yield Differentials

○ 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

21
 1. Risk structure of interest rates
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

22
 1. Risk structure of interest rates
Estimating 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?
Yn = 7 + 0.8 +0.2 +0.1 = 8.1%

23
2. Term structure of interest rates
2. Term structure of interest rates

25
2. Term structure of interest rates
Yield Curve

26
2. Term structure of interest rates
Yield Curve

Source: US Treasury Department

27
2. Term structure of interest rates
Yield Curve

28
 2. Term structure of interest rates

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 interest rates are
high, yield curves are more likely to slope downward and be
inverted.

3. Yield curves almost always slope upward.

29
 4. Cấu trúc của lãi suất
4.2. Cấu trúc kỳ hạn của Lãi suất

To explain the term structure and 03 facts:

○ Pure expectation theory
○ Segmented market theory
○ Liquidity Premium - Preferred habitats theory

30
 2. Term structure of interest rates
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

31
 2. Term structure of interest rates
Pure expectations theory

ü The expectations theory explains fact 1

ü Example:
□ Option 1: Buying two 1-year Bonds
□ Option 2: Buying one 2-year Bond
Ø Because long-term rates are the average of expected future short-term
rates, a rise in short-term rates will also raise long-term rates, causing
short- and long-term rates to move together.

32
 2. Term structure of interest rates
Pure expectations theory

• Rate of return of buying two 1-year bonds:

(1 + 0 i1 )(1 +1 i2 ) - 1 = 1 + 0 i1 +1 i2 + 0 i1 *1 i2 - 1 =0 i1 +1 i2 + 0 i1 *1 i2 =0 i1 +1 i2

• Rate of return of buying one 2-year bond:

2
(1 + 0 i2 )(1 + 0 i2 ) - 1 = 1 + 2 *0 i2 + 0 i2 - 1 = 2 *0 i2
• The returns are expected to be equal
i +1 i2
2 *0 i2 =0 i1 +1 i2 => 0 i2 = 0 1
2
• Relationship between long-term interest rate and short-term interest rates
i +1 i2 + ... + n -1 in
0 in =
0 1
n
33
 2. Term structure of interest rates
Pure expectations theory

ü The expectations theory explains fact 2

When short-term rates are low, expect to rise in the future, and the
average of future expected short-term rates is high relative to the current
short-term rate.
Long-term interest rates will be substantially higher than current short-
term rates, and the yield curve will have an upward slope.

34
 2. Term structure of interest rates
Pure expectations theory

ü Cannot explain the fact 3 (yield curves usually slope upward)

Ø In practice, short-term interest rates are just as likely to fall as
they are to rise, and so the expectations theory suggests that the
typical yield curve should be flat rather than upward-sloping.

35
 2. Term structure of interest rates
Segmented market theory

• 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

47
 2. Term structure of interest rates
Segmented market theory

○ Segmented market theory (contʼd)

□ 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

48
 2. Term structure of interest rates
Segmented market theory

○ Segmented market theory (contʼd)

□ 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

49
 2. Term structure of interest rates
Liquidity premium theory

• 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

50
 2. Term structure of interest rates
Liquidity premium theory

○ Liquidity premium theory (contʼd)

□ 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

51
 2. Term structure of interest rates
Liquidity premium theory

• 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

52
 2. Term structure of interest rates
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 )
1.08 2
= - 1 - [.007 / 1.10]
1.10
= 5 .4 %

53
 2. Term structure of interest rates

○ 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

54
 2. Term structure of interest rates

○ 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

55
 2. Term structure of interest rates

○ Uses of the term structure (contʼd)

□ 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

56
 Problem

○ Some economists and policymakers have proposed eliminating the federal income tax
and replacing it with a value-added tax (VAT). A VAT is like a sales tax, but rather
than being collected from consumers when they buy goods in stores, it is collected at
each stage of production as firms sell goods to each other. An income tax applies to
both the income individuals save and to any return on their investments. A VAT can
encourage saving and investment because it does not tax either saving or returns on
investments.
○ Suppose the federal government eliminates the federal income tax and replaces it
with a VAT. Explain the effect of this policy change on the interest rates on municipal
bonds, corporate bonds, and Treasury bonds. Draw three graphs, one for each market,
to illustrate your answer.

57