Chapter 6

The Risk and Term Structure of

Interest Rates

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 Risk and Term Structure of Interest Rates
• Risk structure of interest rates looks at the
relationship among interest rates on bonds
with the same term to maturity.
(Risk, Liquidity, & Income Tax Treatment)

• Term structure of interest rates looks at the

relationship among interest rates on bonds
with different terms to maturity.
(Term to maturity)
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 Risk Structure of Interest Rates

Figure 1 Four Long-Term Bond Yields, 1919–2011. Sources: Board of Governors of the
Federal Reserve System, Banking and Monetary Statistics.
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 Risk Structure of Interest Rates
U.S. data has shown:
1). Interest rates on bonds of the same maturity
differ in any given year;
2). The spread btw. the interest rates varies over
time.

Q: What factors are responsible for these facts?

Default Risk, Liquidity, and Income Tax Treatment
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 I. Default Risk
• Default risk - occurs when the issuer of the
bond is unable or unwilling to make interest
payments or pay off the face value
– Gov’t bonds (T-bills) are considered default-free
– Corporate bonds would have high default risk
• Risk premium - the spread between the
interest rates on bonds with default risk and
bonds without default risk
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Response to an Increase in Default Risk
on Corporate Bonds

Default risk ↑ => Risk Premium ↑ 6-6

 Credit Ratings Agencies

investment-grade security (Baa/BBB & above) vs.

Junk Bonds (Below Baa/BBB) 6-7
 II. Liquidity
• Liquidity – how quickly and cheaply a bond
can be converted to cash.
- Liquidity↓=> Demand for the bond↓ &
Demand for gov’t bond↑=>Risk Premium↑
- Corporate bonds are less liquid than gov’t bonds
=> corporate bonds have higher interest rates.

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 III. Income Tax Considerations
• Income tax considerations – in U.S. certain
government bonds are not taxable.
– Interest payments on Treasury bonds are taxed as
ordinary income.
– Interest payments on municipal bonds are exempt
from federal income tax.
ie. i=10%, t=4% => after tax i=6%. (T-bill)
i=8%, t=0% => after tax i=8%. (municipal bond)
i is lower on tax-exempt bonds even they are more risky
and less liquid than T-bills.
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 Term Structure of Interest Rates
• Bonds with identical risk, liquidity, and tax
characteristics may have different interest rates
because the time remaining to maturity is different.
• Yield curve - a plot of the yield on bonds with
differing terms to maturity but the same risk,
liquidity and tax considerations.
– Upward-sloping  long-term rates are above
short-term rates.
– Flat  short- and long-term rates are the same.
– Downward(Inverted)  long-term rates are below short-
term rates.
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 Term Structure of Interest Rates

Figure 4 Movements over Time of Interest Rates on U.S. Gov’t Bonds with Different Maturities.
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 Empirical Facts To Be Explained
by the Term Structure
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 rates are
high, yield curves are more likely to slope
downward and be inverted.
3. Yield curves almost always slope upward.

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 Three Theories to Explain the Three Facts

1. Expectations theory explains the first two

facts but not the third.
2. Segmented markets theory explains fact
three but not the first two.
3. Liquidity premium theory combines the two
theories to explain all three facts.

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 I. Expectations Theory

• The interest rate on a long-term bond will equal

an average of the short-term interest rates that
people expect to occur over the life of the long-
term bond.

• See class notes for details.

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 II. Segmented Markets Theory

• The interest rate for each bond with a different

maturity is determined by the demand for and
supply of that bond with no effects from expected
returns on other bonds with other maturities.

• See class notes for details.

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 III. Liquidity Premium & Preferred Habitat
Theories
• The interest rate on a long-term bond will equal
an average of short-term interest rates expected
to occur over the life of the long-term bond plus
a liquidity premium that responds to supply and
demand conditions for that bond.

• See class notes for details.

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 The Relationship Between Theories

Figure 5 The Relationship btw. the Liquidity Premium (Preferred Habitat) and Expectations Theory
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 Predictive Power of the Yield Curve
• Can use theories to make predictions about short-
term rates.
• Steeply rising yield curve short term rates are
expected to rise.
• Moderately steep yield curve short-term rates are
not expected to rise or fall substantially in the future.
• A flat yield curve  short-term rates are expected to
fall moderately in the future.
• Inverted yield curve  short-term rates are
expected to fall sharply in the future.

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Predictive Power of the Yield Curve

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