3

Structure of Interest Rates

Chapter Objectives

Learn

why individual interest rates differ or why security prices vary or change Analyze theories explaining why rates vary by term or maturity, called the term structure of interest rates

Factors Affecting Security Yields

Risk-averse investors demand higher yields for added riskiness Risk is associated with variability of returns Increased riskiness generates lower security prices or higher investor required rates of return

Factors Affecting Security Yields

Security yields and prices are affected by levels and changes in:
Default

risk (also called Credit Risk) Liquidity Tax status Term to maturity Special contract provisions such as embedded options

Factors Affecting Security Yields

Benchmarkrisk-free

treasury securities

for given maturity Default risk premium = risky security yield treasury security yield of same maturity Default risk premium = market expected default loss rate Rating agencies set default risk ratings Anticipated or actual ratings changes impact security prices and yields

Factors Affecting Security Yields

The Liquidity of a security affects the yield/price of the security. A liquid investment is easily converted to cash at minimum transactions cost. Investors pay more (lower yield) for liquid investment. Liquidity is associated with short-term, low default risk, marketable securities.

Factors Affecting Security Yields

Tax status of income or gain on security impacts the security yield Investor concerned with after-tax return or yield Investors require higher yields For higher taxed securities

Factors Affecting Security Yields

Yat = Ybt(1 T)
Where:
Yat = after-tax yield Ybt = before-tax yield T = investors marginal tax rate

Factors Affecting Security Yields

Example: a taxable security that offers a before-tax yield of 14 percent. The investors tax rate is 20 percent. Calculate the after-tax yield.

Yat

= 14%(1 0.2) = 11.2%

The fully taxable pre-tax equivalent corporate bond for a 11.2% municipal bond is:

Ybt = 11.2%/(1 .2) = 14%

Factors Affecting Security Yields

Term to maturity

Interest rates typically vary by maturity. The term structure of interest rates defines the relationship between maturity and yield.
The Yield Curve is the plot of current

interest yields versus time to maturity.

Yield Curve

Yield %

Time to Maturity

An upward-sloping yield curve indicates that Treasury Securities with longer maturities offer higher annual yields

Yield Curve Shapes

Normal

Level or Flat

Inverted

Factors Affecting Security Yields

Special Provisions

Call Feature: enables borrower to buy back the bonds before maturity at a specified price

Call features are exercised when interest rates have declined Investors demand higher yield on callable bonds, especially when rates are expected to fall in the future

Factors Affecting Security Yields

Special provisions
Convertible

bonds

Convertibility

feature allows investors to convert the bond into a specified number of common stock shares Investors will accept a lower yield for convertible bonds because investor returns include expected return on equity participation

Estimating the Appropriate Yield

The appropriate yield to be offered on a debt security is based on the risk-free rate for the corresponding maturity plus adjustments to capture various security characteristics Yn = Rf,n + DP + LP + TA + CALLP + COND

Estimating the Appropriate Yield

Yn = Rf,n + DP + LP + TA + CALLP + COND
Where:

Yn Rf,n

= yield of an n-day security = yield on an n-day Treasury (risk-free) security DP = default premium (credit risk) LP = liquidity premium TA = adjustment for tax status CALLP = call feature premium COND = convertibility discount

The Term Structure of Interest Rates

Theories Explaining Shape of Yield Curve Pure Expectations Theory Liquidity Premium Theory Segmented Markets Theory

The Term Structure of Interest Rates

Pure Expectations Theory

Long-term rates are average of current short-term and expected future shortterm rates Yield curve slope reflects market expectations of future interest rates Investors select maturity based on expectations

The Term Structure of Interest Rates

Pure Expectations Theory

Assumes investor has no maturity preferences and transaction costs are low Long-term rates are averages of current short rates and expected short rates

Forward rate: markets forecast of the future interest rate

The Term Structure of Interest Rates

UpwardSloping Yield Curve
Expected

DownwardSloping Yield Curve

higher interest rate levels Expansive monetary policy Expanding economy

Expected lower interest rate levels Tight monetary policy Recession soon?

The Term Structure of Interest Rates

Liquidity Premium Theory

Investors prefer short-term, more liquid, securities Long-term securities and associated risks are desirable only with increased yields Explains upward-sloping yield curve When combined with the expectations theory, yield curves could still be used to interpret interest rate expectations

The Term Structure of Interest Rates

Segmented Markets Theory

Theory explaining segmented, broken yield curves Assumes investors have maturity preference boundaries, e.g., short-term vs. long-term maturities Explains why rates and prices vary significantly between certain maturities

The Term Structure of Interest Rates

Uses of the term structure

Forecast interest rates

The

market provides a consensus forecast of expected future interest rates Expectations theory dominates the shape of the yield curve Flat or inverted yield curves have been a good predictor of recessions. See Exhibit 3.14. Lenders/borrowers attempt to time investment/financing based on expectations shown by the yield curve Riding the yield curve Timing of bond issuance

Forecast recessions

Investment and financing decisions

Exhibit 3.14 Yield Curve as a Signal for Recessions

Interest Rate Differential (10-Year Rate Minus Three-Month Rate) 7 6 5 4 3 2 1 0 1 2 3 4 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2001

Year

The general shape of the yield curve is measured as the differential between annualized 10-year and three-month interest rates. Recessionary periods are shaded.
*

Treasury Debt Management and the Yield Curve

U.S. Treasury attempts to finance federal debt at the lowest overall cost Treasury uses a mixture of Bills, Notes, and Bonds to finance periodic deficits and refinance outstanding securities Treasury focuses on short-term issuance, phasing out 30-year bonds Treasury 10-year bond now the standard issue Leave the long-term issuance to private

Historic Review of the Term Structure

Yield curves levels and shapes at various times indicate:

Inflation expectations Level of economic activity or phase of business cycle Monetary policy at the time Represents demand for liquidity Short-term securities desired; higher prices; lower rates Short-term securities provide liquidity with maturity

Usually high positive slope in short-term

Exhibit 3.17 Yield Curves at Various Points in Time

17 16 15 14 February 17, 1982

Annualized Treasury Security Yields

13 January 2, 1985 12 11 10 9 August 2, 1989 8 7 6 5 September 18, 2001 4 3 2 0 5 10 15 20 25 30 October 15, 2000 October 22, 1996

Number of Years to Maturity

Exhibit 3.18 Change in Term Premium Over Time

20

15

Percentages

10

30-year T-Bond Yield

Three-month T-Bill Rate

0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

International Structure of Interest Rates

Capital

flows to the highest expected aftertax, real (inflation and other risk-adjusted), foreign exchange adjusted rates of return

International Structure of Interest Rates

Yield

differences between countries are related to:

Expected

changes in forex rates Varied expected real rates of return Varied expected inflation rates Varied country and business risk Varied central bank monetary policy