Chapter 07 - The Risk and Term Structure of Interest Rates

Chapter 7
The Risk and Term Structure of Interest Rates

Chapter Overview

In this chapter students are introduced to the three factors that affect bond yields: default
risk, taxes, and maturity. The chapter begins with a discussion of the ratings companies
that work to assess default risk, and moves to considering the relationship between
ratings and yields. This moves into a history of junk bonds, told largely as the story of
Michael Milken (and Drexel). Tax status is explored next, followed by an analysis of the
term structure of interest rates. Students are introduced to the two theories of the term
structure and the chapter concludes with an analysis of the information contained in the
risk structure and term structure of interest rates.

Reading this chapter will prepare students to:

Understand the ratings and risk structure of interest rates on bonds and
commercial paper and how the ratings affect yields;
Comprehend the term structure of interest rates, including the expectations
hypothesis;
Explain how tax status affects yield; and
Describe the information conveyed in interest rates.

Important Points of the Chapter

It is important to understand the differences among the many types of bonds that are sold
and traded in financial markets. Interest rate spreads, which reflect movement in the
prices of different bonds, provide important information about the workings of financial
markets. Indeed, in the example cited in this chapter (the Russian default of 1998), there
was a significant flight to quality (everyone wanted to hold safe U.S. Treasuries) and
markets ceased to function properly. Another example used in the chapter describes how
GEs issuance of additional short-term debt upset its investors because the increased
supply threatened to lower the prices of all the debt outstanding.

Application of Core Principles

Principle #2: Risk. The lower a bonds rating, the lower its price and the higher its yield.
The yield on any bond is the sum of the yield on the benchmark U.S. Treasury bond (the
closest to being risk free) plus a default risk premium that increases with the probability
of default. High yield is the compensation for high risk.

Principle #1: Time. Longer term bonds tend to have higher yields because of the
additional time involved. Their yields depend on what people expect to happen in years

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to come.

Principle #2: Risk. Uncertainty about inflation creates uncertainty about a bonds real
return, making bonds a risky investment. A bonds inflation risk increases with its time to
maturity.

Teaching Tips/Student Stumbling Blocks

You may wish to review the material in Chapter 6 that introduced students to the
idea that changes in risks can be seen as shifts in the demand for bonds. This
concept is illustrated in Figure 7.1 (page 154), which shows that increased risk
results in a decreased demand for bonds, a lower bond price, and a higher yield.
While the discussion of the tax implication for bonds (starts on page 159) is fairly
straightforward, some students may have difficulty with the calculations. To
reinforce the concept, have students compare a tax-free bond with a taxable bond
and see if they can derive the implied tax rate. For example, as noted on page
160, the rule is:

Tax-Exempt Bond Yield = Taxable Bond Yield x (1 Tax Rate)

Suppose that a tax-exempt bond yields 5 percent and a taxable bond yields 7
percent. What is the implied tax rate? Plugging in theses values results in an
implied tax rate of about .29. As a follow up, have students visit the website of
Bloomberg.com (given below in the Virtual Tools section) for current data on
taxable and tax-exempt bonds.
Students are likely to have difficulty with the model of the Expectations
Hypothesis that starts on page 162. Use the numerical example on page 162 to
illustrate the concept. Have students try the calculations with current data. A
point for discussion: when purchasing a 30 year bond, do you have to be
forecasting interest rates for the next 30 years?

Features in this Chapter

Lessons from the Crisis: Subprime Mortgages

The financial crisis of 20072009 initially was known as the subprime crisis because of
the mortgage-backed securities that helped trigger the crisis in the United States. A
residential mortgage is called subprime when it does not meet key standards of
creditworthiness that apply to a conventional prime mortgage. Conventional prime
mortgages are those that satisfy the rules for inclusion in a collection or pool of
mortgages to be guaranteed by a U.S. government agency. For this reason, conventional
prime mortgages also are called qualifying or conforming mortgages. Typically, a loan is
subprime if it is made to someone with a low credit score or whose income may be low
relative to the price of the home; or if the LTV is high; or if the borrower does not

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provide sufficient documentation of their ability to pay. Both conventional mortgages and
subprime mortgages comes in two forms: fixed-rate and adjustable-rate mortgages (the
latter are called ARMsChapter 6). During the housing bubble, starting in 2002, the
volume of subprime loans surged as mortgage lenders relaxed their lending standards.
Borrowers could obtain loans with lower down payments (high LTVs) and ever-poorer
documentation. A complacent belief that the rise in nationwide house prices that had
continued since the 1930s would persist indefinitely encouraged lending to borrowers
with progressively lower ability to pay. When house prices started to fall in 2006, home
values fell to less than the amount of the mortgageand lenders became unwilling to
refinance many subprime loans. A wave of defaults followed resulting in problems with
MBSs.

Your Financial World: Your Credit Rating

In this section students will find a brief discussion of credit scores, what influences them,
and why they matter.

Lessons from the Crisis: Rating Agencies

Ratings mistakes contributed significantly to the financial crisis of 2007-2009. Ratings

that agencies had awarded to mortgage backed securities (MBS) were higher than they
should have been. When US housing prices started to decline, MBS ratings were
downgraded sharply, which reinforced the decline in MBS prices. Several things
contributed to the rating errors, including the fact that issuers consulted (and paid for the
consultation) with rating agencies to see which bond structure would yield the highest
rating. When the agency actually rated the structure, there was a conflict of interest in
rating what they had been consulted on. Further, agencies evaluating the mortgage debt
estimated the risk of default using mathematical models, but these models did not have
any period of time in which housing prices fell nationwide. Bond issuers also paid rating
agencies, and the rating system had only one scale for every kind of default probability.

Lessons from the Crisis: Asset-Backed Commercial Paper

Asset-backed commercial paper (ABCP) is a short-term liability with a maturity of up to

270 days. The ABCP is collateralized assets in a special portfolio. In the housing boom
that preceded the financial crisis of 2007-2009, some large banks created shadow banks
to lower their costs and limit their own asset holding. These shadow banks issued ABCP
and used the money to buy mortgages and other loans. The off-balance-sheet financing
allowed the banks to boost leverage and take more risk. The long-term maturity of the
assets and the short-term maturity of the liabilities (the ABCP) posed a roll-over risk to
the ABCP issuers. That is, that issuers would be unable to borrow or sell the asset to be
able to return the principle to the ABCP holders. When the value of some mortgages
became highly uncertain in 2007, purchasers of ABCP grew anxious that their
commercial paper might plunge in value. Firms that issued the ABCP faced an
immediate threat to their survival. Some banks failed while other banks absorbed the loss
on the commercial paper after they were unable to sell the mortgages.

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Tools of the Trade: Reading Charts

Using a Treasury yield curve chart from The Wall Street Journal, this section gives a step-
by-step illustration of how to read charts. It provides a very good illustration of how
changes in the vertical scale of a graph can be misleading for its interpretation.

Applying the Concept: The Flight to Quality (page 163)

Russias 1998 default on its bonds is used as an example of how dramatic changes in
financial markets can occur as investors react to changing circumstances. The shock set
off an almost unprecedented flight to quality which resulted in a more than doubling of
the spread between U.S. Treasury bill and commercial paper rates. William McDonough,
then President of the New York Federal Reserve Bank, called it the most serious
financial crisis since World War II and worried that the problems in financial markets
would spread to the wider economy.

In the News: Banks Decline Yield Curve Invitation to Party On

This article from Business Week, January 7, 2007, discusses how the occurrence of an
inverted yield curve typically precedes a recession. The yield curve is considered to
have predictive power because long-term interest rates represent the markets
expectations for future short-term rates. Prior to 2007, some predicted that the inverted
yield curve was going to defy history this time. The article points out that the yield curve
was right, it just took longer to get to recession this time.

Lessons of the article:

The yield curve predicts changes in the economy. At the beginning of 2006 the
yield curve was unusually flat, and occasionally downward-sloping. This
raised concerns that a recession might be on the way. What is missing from
this article is any mention of the risk spread. As you can see from Figure 7.8,
in 2006 Baa bond yields were less than two percentage points above U.S.
Treasury yields, well below levels associated with recessions.

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Additional Teaching Tools

Credit scores are important for getting a loan and affect the cost of a loan in terms of the
interest rate assessed (as pointed out in this chapter on page 157). However, paying
attention to your credit report can also give you an edge in avoiding identity theft. In an
article entitled Safeguard Identity with Regular Checks of Credit Reports (by Kim
Komando with reporting by Ted Rybka, The Journal News, May 10, 2004) the author
points out that credit reporting services watch for early warning signs of identity theft.
They let you know if a merchant has checked your address or if someone has submitted a
change of address for you. The credit reporting services may also be able to provide, for
a fee, access to an identity theft specialist and insurance against losses incurred due to
identity theft. The author points out that to really be safe a consumer would need to
subscribe to all three credit-reporting services because a credit check could go to any one
of them.

Virtual Tools

Students may find it of interest to visit the web sites of the three credit-reporting
services; they are TransUnion (www.transunion.com), Experian
(www.experian.com), and Equifax (www.equifax.com).
To find out more about identity theft and what to do if it happens to you. Visit the
website of the Federal Trade Commission at
http://www.ftc.gov/bcp/edu/microsites/idtheft/.
Bond market data is available on websites such as Bloomberg.com at
http://www.bloomberg.com/markets/rates/
The SmartMoney.com web site has current information about the bond market
and the yield curve, and a number of interesting tools including a bond calculator
and a Living Yield Curve. The Living Yield Curve section provides an
excellent illustration of how the yield curve can be used to predict economic
activity; it includes examples of a normal yield curve (from December 1984), a
steep curve (April 1992), an inverted curve (August 1981) and a flat or humped
curve (April 1989).

For More Discussion

In his Economic Scene column for The New York Times (Thursday, May 27, 2004),
Alan B. Krueger reports that James Carville once mused that instead of coming back as
the president or the pope or a .400 baseball hitter if there were reincarnation, he would
rather come back as the bond market because you can intimidate everybody.

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Chapter Outline

I. Ratings and the Risk Structure of Interest Rates

The risk of default (i.e., that a bond issuer will fail to make a bonds promised
payments) is one of the most important risks a bondholder faces, and it varies among
issuers. Credit rating agencies have come into existence to assess the default risk of
different issuers.
A. Bond Ratings
1. The best-known rating services are Moodys and Standard & Poors.
2. Companies with good credit earn high ratings, suggesting that they will have
little difficulty meeting the bonds payment obligations.
3. The two companies have similar letter-based ratings systems; these are
illustrated in Table 7.1.
4. Investment Grade comprises the top four ratings; the next group is the non-
investment speculative grades, which are often referred to as junk bonds.
5. There are two types of junk bonds: fallen angels which were once
investment grade but the companies situations have changed, and original
issue junk bonds which are bonds for which little is known about the risk of
the issuer.
6. The ratings companies continually monitor the situations of firms and
announce rating changes; a lowering of the rating is a downgrade and an
improvement is an upgrade.
B. Commercial Paper Ratings
1. Commercial paper is a short-term version of a bond, issued both by
corporations and governments.
2. This is unsecured debt because the borrower offers no collateral.
3. Commercial paper is issued on a discount basis, and most of it has a maturity
of between 5 to 45 days.
4. Moodys and Standard & Poors provide rations of commercial paper issuers
in the same way they do bonds. The lowest default risk issues are now termed
prime grade or investment grade.
C. The Impact of Ratings on Yields
1. The lower a bonds rating the lower its price and the higher its yield.
2. A bond yield can be thought of as the sum of two parts: the yield on the U.S.
Treasury bond (called benchmark bonds because they are close to being
risk-free) and a risk spread or default risk premium.
3. The default risk premium should increase as the bond rating decreases.

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4. Considering yield this way also allows us to see that when U.S. Treasury bond
yields change all other yields will change in the same direction.
5. Data on the risk structure of interest rates supports these predictions; this is
illustrated in Figure 7.2 on page 155.
6. The difference of a couple of points in yield has a big affect on the cost of
debt. For instance, as noted on page 156, the difference between a 5 percent
rate and a 7 percent rate is a 40% difference.
II. Differences in Tax Status and Municipal Bonds
1. The second important factor that affects the return on a bond is taxes.
2. Bondholders must pay income tax on the interest income they receive from
privately issued bonds, but government bonds are treated differently.
3. Interest payments on bonds issued by state and local governments, called
municipal or tax-exempt bonds are specifically exempt from taxation.
4. The general rule in the United States is that one level of government does not
tax the interest income from bonds issued by another level of government
(although the issuing government may tax it).
5. A tax exemption affects a bonds yield because it affects how much of the
return the bondholder gets to keep.
6. The yield on a tax-exempt bond equals the taxable bond yield times one minus
the tax rate.
III.The Term Structure of Interest Rates
1. A third factor that affects a bonds yield is its maturity.
2. The relationship among bonds with the same risk characteristics but different
maturities is called the term structure of interest rates. A plot of this, the yield
curve, is shown in Figure 7.4.
3. Three conclusions can be drawn from studying the data:
a. Interest rates of different maturities tend to move together.
b. Yields on short-term bonds are more volatile than those on long-term
bonds.
c. Long-term yields tend to be higher than short-term yields.
4. There are two explanations for these relationships, the Expectations
Hypothesis and the Liquidity Premium Theory.
A. The Expectations Hypothesis
1. The hypothesis begins with the observation that the risk-free interest rate can
be computed, assuming that there is no uncertainty about the future.

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2. This means that an investor would be indifferent between holding a two-year

bond or a series of two one-year bonds because certainty means that bonds of
different maturities are perfect substitutes for each other.
3. Therefore, when interest rates are expected to rise long-term rates will be
higher than short-term rates and the yield curve will slope up (and vice versa);
if interest rates are expected to remain unchanged, the yield curve will be flat.
4. From this we can construct investment strategies that must have the same
yield. Assuming the investor has a two-year horizon, the investor can:
a. Invest in a two-year bond and hold it to maturity.
b. Invest in a one-year bond today and a second one a year from now
when the first one matures.
5. The hypothesis tells us that investors will be indifferent between the two
strategies, so the strategies must have the same return.
6. Therefore the rate on the two-year bond must be the average of the current
one-year rate and the expected future one-year rate.
7. The implications are the three conclusions we noted above (IV, 3).
8. However, in order to explain why the yield curve normally slopes upward, we
need to extend the hypothesis to include risk.
B. The Liquidity Premium Theory
1. Risk is the key to understanding the slope of the yield curve.
2. The upward slope is due to long-term bonds being riskier than short-term
bonds.
3. The longer the term the greater the inflation and interest-rate risk.
a. Inflation risk increases over time because investors, who care about
the real return, must forecast inflation over longer periods.
b. Interest-rate risk arises when an investors horizon and the bonds
maturity do not match. If holders of long-term bonds need to sell them
before maturity and interest rates have increased, the bonds will lose
value.
4. Including risk in the model means that we can think of yield as having two
parts: one that is risk-free and one that is a risk premium.
5. Again, we arrive at the same three conclusions about the term structure of
interest rates.
IV. The Information Content of Interest Rates
1. The risk and term structure of interest rates contain useful information about
overall economic conditions.

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2. These indicators are helpful in evaluating both the present health of the
economy and its likely future course.
3. Risk spreads provide one type of information, the term structure another.
A. Information in the Risk Structure of Interest Rates
1. An impending recession raises the risk premium on privately issued bonds
because of the increasing risk that corporations cannot meet their obligations.
2. An economic slowdown or recession does not affect the risk of holding
government bonds.
3. Recessions do not affect all companies equally, and the impact on those with
high ratings is likely to be small. Therefore the spread between U.S.
Treasuries and highly rated bonds is not likely to move by much.
4. For firms with lower ratings, the situation is quite different; the lower the
initial grade of the bond, the more the default risk premium rises as general
economic conditions deteriorate.
A. Information in the Term Structure of Interest Rates
1. Information on the term structure also helps us to forecast general economic
conditions.
2. The yield curve usually slopes upward, but on rare occasions it can be
inverted and slope downward (short-term rates exceed long-term yields).
3. An inverted yield curve predicts an economic slowdown because it signals a
fall in short-term interest rates. Figure 7.8 on page 167 illustrates this.

Terms Introduced in Chapter 7

benchmark bond
commercial paper
expectations hypothesis of the term structure
fallen angel
flight to quality
interest-rate spread
inverted yield curve
investment-grade bond
junk bond
liquidity premium theory of the term structure
municipal bonds
prime-grade commercial paper
rating
ratings downgrade
ratings upgrade

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risk spread
risk structure of interest rates
spread over Treasuries
tax-exempt bond
taxable bond
term spread
term structure of interest rates

yield curve

Lessons of Chapter 7

1. Bond ratings summarize the likelihood that a bond issuer will meet its payment
obligations.
a. Highly rated investment-grade bonds are those with the lowest risk of default.
b. If a firm encounters financial difficulties, its bond rating may be downgraded.
c. Commercial paper is the short-term version of a privately issued bond.
d. Junk bonds are high-risk bonds with very low ratings. Firms that have a high
probability of default issue these bonds.
e. Investors demand compensation for default risk in the form of a risk premium.
The higher the risk of default, the lower a bonds rating, the higher its risk
premium, and the higher its yield.

2. Municipal bonds are usually exempt from income taxes. Because investors care
about the after-tax returns on their investments, these bonds have lower yields than
bonds whose interest payments are taxable.

3. The term structure of interest rates is the relationship between yield to maturity and
time to maturity. A graph with the yield to maturity on the vertical axis and the time
to maturity on the horizontal axis is called the yield curve.
a. Any theory of the term structure of interest rates must explain three facts:
i. Interest rates of different maturities move together
ii. The yields on short-term bonds are more volatile than the yields on long-term
bonds
iii. Long-term yields are usually higher than short-term yields.
b. The expectations hypothesis of the term structure of interest rates states that long-
term interest rates are the average of expected future short-term interest rates.
This hypothesis explains only the first two facts about the term structure of
interest rates.
c. The liquidity premium theory of the term structure of interest rates, which is
based on the fact that long-term bonds are riskier than short-term bonds, explains
all three facts described in 3a.

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4. The risk structure and the term structure of interest rates both signal financial
markets expectations of future economic activity. Specifically, the likelihood of a
recession will be higher when
a. The risk spread, or the range the between low- and high-grade bond yields, is
wide.
b. The yield curve slopes downward, or is inverted, so that short-term interest rates
are higher than long-term interest rates.

Conceptual Problems

1. Suppose your marginal federal income tax rate is 36 percent. What is your after-tax
return from holding a one-year corporate bond with a yield of 9 percent? What is your
after-tax return from a holding a one-year municipal bond with a yield of 5 percent?
How would you decide which bond to hold?

Answer:
After-tax return for corporate bond = 9% * (1-0.36) = 5.76%
After-tax return for municipal bond = 5%
If the bonds have an equal risk of default, you should choose the bond with the
highest after-tax yield, which, in this case, is the corporate bond.

2. Why do you think the amount of commercial paper outstanding fell significantly
during the 2007-2009 financial crisis?

Answer: Commercial paper is an unsecured form of financing, so as economic and

financial conditions worsened during the crisis, investors worried about the riskiness
of this form of debt and firms found it more difficult to issue new paper. As existing
paper matured and was not fully replaced by new issues, the amount outstanding fell.

3. *Taking into account your answer to question 2, how would you explain the fall in the
amount of asset-backed commercial paper outstanding that began in the third quarter
of 2007?

Answer: Unlike most forms of commercial paper, asset-backed commercial paper is

a collateralized form of financing. The problem in 2007 arose when investors began
to worry about the value of the assets backing the ABCP. As fears spread that the
value of these assets securing the ABCP would plunge, the perceived riskiness of the
ABCP rose and investors became unwilling to purchase it.

4. Go to the Federal Reserve Boards Web site (www.federalreserve.gov), and click first
on Economic Research and Data, and then on Statistical Releases and Historical
Data. Under the data download program, choose Selected Interest Rates (H. 15) and
build a package of data to include monthly series from 2006 for the yields on three-

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month non-financial commercial paper, three-month financial commercial paper and

the three-month Treasury bills sold on the secondary market. Compute the spread
between each of the two commercial paper yields and the Treasury bill yield, and
comment on the patterns you observe in the data.

Answer: The spreads between the commercial paper yields and the Treasury bill
yield rose significantly in the second half of 2007 as the financial crisis began to
unfold and spiked even higher in the later part of 2008 in the wake of the collapse of
Lehman Brothers. Before the onset of the crisis, these spreads were below 0.5 of a
percentage point. They more that doubled, however, for much of the subsequent 18
month period. Spreads for financial commercial paper were impacted more severely
than non-financial spreads, peaked at 2.52 percentage points in October 2008.

5. What was the connection between house price movements, the growth in subprime
mortgages, and securities backed by these mortgageson the one handandon the
other handthe difficulties encountered by some financial institutions during the
2007-2009 financial crisis?

Answer: The viability of many subprime mortgages in particular ARMs, depended

on being able to refinance the loan before the interest rate reset to a higher level.
When house prices began to fall in 2006, pushing home values below the loan amount
for many of these mortgages, refinancing was no longer an option. Unable to pay the
higher interest rates, borrowers began to default on these subprime mortgages at an

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increasing rate. This, in turn, led to significant falls in the prices of securities backed
by subprime mortgages, causing difficulties for institutions that had sizable holdings
of these securities.

6. Suppose that the interest rate on one-year bonds is 4 percent today, and is expected to
be 5 percent one year from now and 6 percent two years from now. Using the
Expectations Hypothesis, compute the yield curve for the next three years.

Answer:
Yield for one-year bond = 4%
Yield for two-year bond = (4% + 5%)/2 = 4.5%
Yield for three-year bond = (4% + 5% + 6%)/3 = 5%

7. *According to the liquidity premium theory, if the yield on both one-and two-year
bonds are the same, would you expect the one-year yield in one-years time to be
higher, lower or the same? Explain your answer.

Answer: According to the liquidity premium theory, the two-year yield (i2,t) is an
average of this years and next years one-year yields (i1,t+ie 1, t+1) plus a risk premium
(rp) to compensate for the inflation and interest-rate risk associated with the longer
maturity.
i2,t = (i1,t+ie 1, t+1)/2 +rp
We can see from the formula, if the current one-and two-year yields are the same and
there is a risk premium included in the two-year yield, then next years one-year yield
must be lower than this years.

8. You have $1,000 to invest over an investment horizon of three years. The bond
market offers various options. You can buy (i) a sequence of three one-year bonds;
(ii) a three-year bond; or (iii) a two-year bond followed by a one-year bond. The
current yield curve tells you that the one-year, two-year, and three-year yields to
maturity are 3.5 percent, 4.0 percent, and 4.5 percent respectively. You expect that
one-year interest rates will be 4 percent next year and 5 percent the year after that.
Assuming annual compounding, compute the return on each of the three investments,
and discuss which one you would choose.

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Answer:
Expected return for (i) = (1.035)*(1.04)*(1.05) 1 = 13.02%
Expected return for (ii) = (1.045)3 -1 = 14.12%
Expected return for (iii) = (1.04)2*(1.05) 1 = 13.57%
Options (c) and (b) have higher expected returns, but both options involve investing
in longer-term bonds (2-year and 3-year bonds, respectively). Long-term bonds have
higher inflation risk and interest-rate risk; investors require compensation for this
additional risk, which is why longer-term bonds generally have higher yields than
would be suggested by the expectations hypothesis. In selecting an investment
strategy, it is important to take these additional risks into account. An investors
investment horizon is also important; to reduce interest rate risk, someone with a
short-term horizon would be better off choosing option (a), while someone with a
three-year horizon should probably choose option (b).

9. *If inflation and interest rates become more volatile, what would you expect to see
happen to the slope of the yield curve?

Answer: Investors are likely to demand a higher risk premium in the face of increased
volatility. There is more uncertainty regarding the real return on investments and the
price you could sell a bond for before maturity. Therefore, you should expect the
yield curve to become steeper.

10. As economic conditions improve in countries with emerging markets, the cost of
borrowing funds there tends to fall. Explain why.

Answer: As economic conditions improve, the chance that businesses will default on
their loans decreases. The decline in default risk reduces the return demanded by
lenders.

11. When countries with emerging markets have financial problems, the yields on U.S.
Treasury issues tend to fall. Can you explain this phenomenon? What would happen
to the risk spread under such circumstances, and how would you use that
information?

Answer. This is known as a flight to quality. When emerging market countries have
financial problems, investors seek out safer investments. Demand for U.S. Treasury
bonds increases (raising prices and decreasing yields), while demand for bonds in
emerging markets falls (decreasing prices and raising yields). This increases the risk
spread.

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Analytical Questions

12. Suppose your local government decided to tax the interest income on its own bonds
as part of an effort to rectify serious budgetary woes. What would you expect to see
happen to the yields on these bonds?

Answer: You would expect the yields to rise to compensate investors for the loss of
the tax-exempt status.

13. *If, before the change in tax status, the yields on the bonds described in question 12
were below the Treasury yield of the same maturity, would you expect this spread to
narrow, to disappear, or to change sign after the policy change? Explain your answer.

Answer: We can attribute the lower yields on the local government bonds versus
treasuries to their tax-exempt status, as investors would view the federal government
as being at least as creditworthy as the local government. Given the serious
budgetary woes of the local government, it is most likely that investors would regard
their bonds as less safe than Treasuries and so demand a default risk premium. The
spread would change sign.

14. Suppose the risk premium on bonds increases. How would the change affect your
forecast of future economic activity, and why?

Answer: An increasing risk premium can be a sign of an impending recession, so you

would be more likely to forecast an economic downturn. During economic
slowdowns, private companies have a more difficult time repaying their debt, while
the government is not affected, increasing the risk premium.

15. If regulations restricting institutional investors to investment grade bonds were lifted,
what do you think would happen to the spreads between yields on investment grade
and speculative grade bonds?

Answer: If institutional investors were willing to hold speculative-grade bonds in the

absence of a legal restriction, the spread between investment and speculative grade
yields would narrow. Institutional demand would shift the demand for speculative
grade bonds to the right, increasing prices and lowering the yields.

16. Suppose a country with struggling economy suddenly discovered vast quantities of
valuable minerals under government-owned land. How might the governments bond
rating be affected? Using the model of demand and supply for bonds, what would
you expect to happen to the bond yields of that countrys government bonds?

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Answer: The ratings of the bonds would likely be upgraded, as the economic outlook
for the economy would improve and the reduction in the perceived riskiness of the
bonds would shift the demand curve to the right. Revenues from the minerals could
also mitigate the governments need to borrow, shifting the supply of bonds to the
left. Bond prices would increase and yields would fall.

17. The mis-rating of mortgage-backed securities by rating agencies contributed to the

financial crisis of 2007-2009. List some recommendations you would make to avoid
such mistakes in the future.

Answer: In the run up to the 2007-2009 crisis, the absence of data capturing a period
of falling house prices at a national level caused models to underestimate the default
risk of the mortgages underlying the mortgage-backed securities. Running tests with
to see what outcomes these models would predict in certain extreme circumstances
(stress testing) may help avoid such underestimations in the future.
Changing the relationship between the rating agencies and the securities issuers to
avoid conflicts of interest arising from the raters being paid by the issuers or
providing consulting advice to them could also improve the accuracy of ratings.

18. How do you think the abolition of investor protection laws would affect the risk
spread between corporate and government bonds?

Answer: These laws were likely to be much more important in protecting purchasers
of corporate bonds rather than in treasury bonds. Their abolition would raise the
relative riskiness of corporate bonds, widening the spread between corporate and
government bond yields.

19. You and a friend are reading The Wall Street Journal and notice that the Treasury
yield curve is slightly upward sloping. Your friend comments that all looks well for
the economy but you are concerned that the economy is heading for trouble.
Assuming you are both believers in the liquidity premium theory, what might account
for your difference of opinion?

Answer: The difference in opinion could reflect different views on the size of the risk
premium. A slightly upward-sloping yield curve, if the risk premium is large enough,
could mean that interest rates are expected to fall, indicating a weak economy. If the
risk premium is small enough, however, the slight upward slope could reflect
expectations that interest rates will rise and that the economy is expected to be
healthy.

20. Do you think the term spread was an effective predictor of the recession that started in
December 2007? Why or why not?

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Chapter 07 - The Risk and Term Structure of Interest Rates

Answer: An inverted yield curve (negative term spread) is often a sign that the
economy is about to go into recession. Looking at the term spread (10 year rate
versus the three month rate) in Figure 7.9, we see that the term spread did indeed turn
negative in late 2006/early 2007. On the other hand, the severity of the recession was
not predicted by the yield curve.

21. *Given the data in the accompanying table, would you say that this economy is
heading for a boom or for a recession? Explain your choice.
3-month 10-year Baa corporate
Treasury-bill Treasury bond 10-year bond
January 1.00% 3.0% 7.0%
February 1.05% 3.5% 7.2%
March 1.10% 4.0% 7.6%
April 1.20% 4.6% 8.0%
May 1.25% 5.0% 8.2%

Answer: The information in both the term structure and the risk structure point to
a healthy economy.
The term spread (the gap between the 3 month Treasury yield and the 10 year
Treasury bond yield) is positive and widening. This tells us that the yield curve is
upward sloping and getting more steeply upward sloping. This implies that
interest rates are expected to continue to rise in the futurea sign that the
economy is expected to do well.
The risk spread (the gap between the Treasury and corporate 10 year bonds) is
narrowing. This is a sign of a healthy economy as people do not require such a
high risk premium on corporate bonds.

* indicates more difficult problems

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