CHAPTER 6

THE STRUCTURE OF
INTEREST RATES
 Interest Rate Changes &
Differences Between Interest
Rates Can Be Explained by
Several Variables
 Term to Maturity.
 Default Risk.
 Tax Treatment.
 Marketability.
 Call or Put Features.
 Convertibility.

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 Need to Understand Yields
 Individual and institutional investors must
understand why quoted yields vary so they can
determine whether the extra yield is worth the
risk.
 Financial managers of corporations or
government agencies in need of funds must
understand why quoted yields vary, so they can
estimate the yield they would have to offer in
order to sell new debt securities.

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 Selected Rates of Interest,
February 9, 2005 (Wall Street Journal)
Financial Security Interest Rate (%)
Dealer Commercial Paper, 3 months 2.70%
GE Capital Commercial Paper, 90 to 119 days 2.68%
Banker’s Acceptances, 90 days 2.70%
U.S. Government Securities
13 weeks Treasury bills 2.480%
26 weeks Treasury bills 2.710%
10 year Treasury notes 4.03%

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 Selected Rates of Interest,
February 9, 2005 (Wall Street Journal)
Financial Security Interest Rate(%)
AA Municipals (General Obligations) 7-12 year 3.35%
AA Municipals (General Obligations) 12-22 year 3.65%
High Quality Corporate Bonds 1-10 year 4.10%
Medium Quality Corporate Bonds 1-10 year 4.46%
High Quality Corporate Bonds 10+ years 5.14%
Medium Quality Corporate Bonds 10+ years 5.49%
High Yield Corporate Bonds 6.88%
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 Yield Curve
 The Term to Maturity of a financial claim is the
length of time until the principal amount
becomes payable.
 The relationship between yield and Term to
Maturity on securities that differ only in length
of time to maturity is called the Term Structure
of Interest Rates. Shown by the Yield Curve.
 The Yield Curve is the graph of the relationship
between interest rates on particular securities
and their yield to maturity. Same default risk.

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 Term (Maturity) Structure

 May Be Studied Visually by Plotting a

Yield Curve at a Point in Time
 The yield curve may be ascending, flat,
or descending.
 Several theories explain the shape of
the yield curve.

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Yield Curves in the 2000s

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Yield Curve (February 10, 2005)

Source: Bloomberg Web Site:

http://www.Bloomberg.com/markets/C13.html
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 The Expectations Theory of
the Term Structure
 The slope of the yield curve reflects investors’
expectations about future interest rates.
 Ascending: future interest rates are expected to
increase.
 Descending: future interest rates are expected to
decrease.
 Long-term interest rates represent the
geometric average of current and expected
future (implied, forward) interest rates.
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 The Expectations Theory of
Term Structure (concluded)
 Investors are assumed to trade in a
very efficient market with excellent
information and minimal trading costs.
 Other theories discussed later presume
less efficient markets.

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Expectations Theory Notations
R
t 1 = The actual market rate of
interest on a one year
security today (time t)

R = The current rate of interest

t 10
for a 10 year security

f = The one year interest rate one

t+1 1
year in the future

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 Term Structure Formula from
Expectation Theory
1 t Rn    1 t R1 1 t 1f1 1 t 2 f1   1 t n1f1  
1
n

where :
R  the observed market rate,
f  the forward rate,
t  time period for which the rate is applicable ,
n  maturity of the bond.
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An Implied One Year Forward
Rate From the Term Structure
Formula

 1 t Rn   n
t  n 1 f1     1
 1 t Rn 1  
n 1

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 Finding a One-Year Implied
Forward Rate
 Using term structure of interest rates from January 29,
1999, find the one-year implied forward rate for year
three.
 1-year Treasury bill 4.51%
 2-year Treasury note 4.58%
 3-year Treasury note 4.57%

 1  .0457  3 
3 f1   2
 1  0.0455 or 4.55%
 1  .0458 

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 Expectations Theory
Calculations
Year One year Expected
Coupon Rate Yield
1 8.75% 8.75%
2 9.20% 8.97%
3 9.65% 9.20%
4 10.45% 9.51%
5 10.85% 9.97%
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 Liquidity Premium Theory

 Long-term securities have greater risk and

investors require greater premiums to give up
liquidity.
 Long-term securities have greater price variability.
 Long-term securities have less marketability.
 The liquidity premium explains an upward
sloping yield curve.
 Investors are not indifferent between
purchasing long-term vs. short term securities
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 Liquidity Premium Theory
(Concluded)
 Today’s long-term rates reflect the geometric
average of intervening short-term rates plus a
premium that investors demand for holding long-
term securities instead of a series of short-term
risky investments.
 The liquidity premium increases as maturity
increases, because the longer the maturity of a
security, the greater its price risk.
 Thus, an investor would not be indifferent between
a 5-year bond and a series of five 1-year bonds.

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 Market Segmentation Theory
 Maturity preferences by investors may affect
security prices (yields), explaining variations
in yields by time
 Market participants have strong preferences
for securities of particular maturity and buy
and sell securities consistent with their
maturity preferences.
 If market participants do not trade outside
their maturity preferences, then
discontinuities are possible in the yield curve.

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 Market Segmentation Theory
(Concluded)
 For instance, commercial banks may
prefer short-term investments while
pension funds and life insurance
companies make generally long-term
investments that coincide with their
long-term liabilities.

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 Preferred Habitat Theory
 The Preferred Habitat Theory is an extension
of the Market Segmentation Theory.
 The Preferred Habitat Theory allows market
participants to trade outside of their preferred
maturity if adequately compensated for the
additional risk.
 The Preferred Habitat Theory allows for
humps or twists in the yield curve, but limits
the discontinuities possible under
Segmentation Theory.
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 Which Theory is Right?
 Day-to-day changes in the term
structure are most consistent with the
Preferred Habitat Theory.
 However, in the long-run, expectations
of future interest rates and liquidity
premiums are important components of
the position and shape of the yield
curve.

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Yield Curves and the Business
Cycle
 Interest rates are directly related to the level of
economic activity.
 An ascending yield curve notes the market

expectations of economic expansion and/or inflation.

 A descending yield curve forecasts lower rates

possibly related to slower economic growth or lower

inflation rates.
 Security markets respond to updated new information
and expectations and reflect their reactions in security
prices and yields.

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 Interest-rate and Yield-curve
Patterns Over the Business Cycle

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 Default Risk Is the Probability
of the DSU Not Honoring the
Security Contract
 Losses may range from “interest a few days
late” to a complete loss of principal.
 Risk averse investors want adequate
compensation for expected default losses.
 Measured as the difference paid on a risky
security and the rate paid on a default-free
security, all other factors held constant.

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 Default Risk, cont.
 Investors charge a default risk premium
(above riskless or less risky securities) for
added risk assumed
 DRP = i - irf
 The default risk premium (DRP) is the
difference between the promised or nominal
rate and the yield on a comparable (same
term) riskless security (Treasury security).
 Investors are satisfied if the default risk
premium is equal to the expected default
loss.

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 Risk Premiums (2/02)
Exhibit 6.5
Notice that as bond rating quality declines, the default risk premium increases.

SECURITY SECURITY YIELD EQUIVALENT RISK-FREE RATEa RISK PREMIUM

(PERCENT) (PERCENT) (PERCENT)

Corporate bonds: Aaa 6.51 5.61 0.90

Corporate bonds: Aa 6.95 5.61 1.34
Corporate bonds: A 7.37 5.61 1.76
Corporate bonds: Baa 7.89 5.61 2.28

Twenty-year Treasury bond yield.

a

Source: Federal Reserve Statistical Release H.15 and Dow Jones Market Data

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 Default Risk, Cont.

 Default Risk Premiums Increase (Widen) in

Periods of Recession and Decrease in
Economic Expansion
 In good times, risky security prices are bid
up; yields move nearer that of riskless
securities.
 With increased economic pessimism,
investors sell risky securities and buy
“quality” widening the DRP.
 “Flight to Quality” during periods of

recession
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 Default Risk, cont.
 Credit Rating Agencies Measure and Grade
Relative Default Risk Security Issuers
 Cash flow, level of fixed contractual cash
payments, profitability, and variability of
earnings are indicators of default riskiness.
 As conditions change, rating agencies alter
rating of businesses and governmental
debtors.

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Corporate Bond-Rating Systems

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 Tax Effects on Yields
 The Taxation of Security Gains and Income Affects the
Yield Differences Among Securities
 The after-tax return, iat, is found by multiplying the pre-
tax return by one minus the marginal tax rate.
iat = ibt(1-t)
 Municipal bond interest income is currently tax exempt.
(See footnote 4, on page 147.)
 Capital gains for individuals are taxed differently than
ordinary income such as corporate bond interest.
 Maximum rate of 15% for gains on securities held by
individuals for more than one year (effective May 5, 2003).

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Should you buy a municipal or a
corporate bond?
CORPORATE AFTER-TAX
INVESTORS’ MARGINAL TAX RATE MUNICIPAL YIELD YIELD

0% 7% 10(1 - 0.00) = 10.0%

10 7 10(1 - 0.10) = 9.0
20 7 10(1 - 0.20) = 8.0
30 7 10(1 - 0.30) = 7.0
40 7 10(1 - 0.40) = 6.0
50 7 10(1 - 0.50) = 5.0

Tax Equivalent Yield (TEY) is a useful

concept, especially for wealthy individuals
and fully-taxed corporations.
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 Differences in Marketability
Affect Interest Yields
 Marketability -- The costs and rapidity with
which investors can resell a security.
 Cost of trade.
 Physical transfer cost.
 Search costs.
 Information costs.
 Liquidity.
 Securities with good marketability have higher
prices (in demand) and lower yields.

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 Contract Options and Yields
 Varied Option Provisions May Explain Yield
Differences Between Securities
 An option is a contract provision which gives
the holder the right, but not the obligation, to
buy,sell, redeem, or convert an asset at some
specified price within a defined future time
period.

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 Contract Options and Yields
 A Call Option Permits the Issuer (Borrower) to
Call (Refund) the Obligation Before Maturity
 Borrowers will “call” if interest rates decline.
 Investors in callable securities bear the risk of
losing their high-yielding security.
 With increased call risk, investors demand a
call interest premium (CIP).
 CIP = ic – inc > 0
 A callable bond, ic, will be priced to yield a higher
return (by the CIP) than a noncallable, inc, bond.

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 Call Option on Bonds
 Most corporate and municipal bonds and some
U.S. Government bonds contain a call option in
their contracts.
 Similar to a Mortgage
 Many corporate bonds have a Deferred Call
provision rather than an Immediate Call provision.
 With corporate bonds, the premium initially set is
usually one year’s interest above the par value. A
municipality may be able to call its bonds without
any premiums being paid.

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 Contract Options and Yields
 A put option permits the investor (lender) to
terminate the contract at a designated price
before maturity
 Investors are likely to “put” their security or
loan back to the borrower during periods of
increasing interest rates. The difference in
interest rates between putable and
nonputable contracts is called the put interest
discount (PID).
 PID = ip – inp < 0
 The yield on a putable bond, ip, will be lower
than the yield on the nonputable bond, inp, by
the PID.
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 Contract Options and Yields
 A Conversion Option Permits the Investor to
Convert a Security Contract Into Another
Security
 Convertible bonds generally have lower yields,
icon, than nonconvertibles, incon.
 The conversion yield discount (CYD) is the
difference between the yields on convertibles
relative to nonconvertibles.
 CYD = icon – incon < 0. Investors accept the lower
yield on convertible bonds because they have
an opportunity for increased rates of return
through conversion.
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 Conclusion
 Term Structure of Interest
Rates
 Expectations
 Liquidity Premium
 Market Segmentation
 Preferred Habitat
 Use of Yield Curve
 Default Risk
 Tax Equivalent Yield
 Options
 Put
 Call
 Convertible

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