Chapter 8

The Risk Structure of Interest Rates:

Defaults, Prepayments, Taxes, and
Other Rate-Determining Factors
 8-2

Learning Objectives

To see the effects of financial assets marketability, liquidity,

default risk, call privileges, prepayment risk, convertibility and
taxability upon their interest rates and prices.
To understand why there are so many different interest rates
within the global economy.
To learn how the structure of interest rates is built and why it
changes constantly.

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 8-3

Learning Objectives

To see why it is so difficult to forecast interest rates and

financial asset prices accurately.

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 8-4

Introduction

In the preceding chapter, we examined how expected

inflation and security maturity affect interest rates.
In this chapter, we will look at how some other factors
influence interest rates:
marketability,
default risk,
call privileges,
taxation of security income,
prepayment risk,
convertibility.

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 8-5

Marketability

Marketability Can an asset be sold quickly?

Marketability is positively related to the size and reputation of
the institution issuing the securities and to the number of
similar securities outstanding.
However, marketability is negatively related to yield.

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Liquidity

Liquidity A liquid financial asset is readily marketable.

Moreover, its price tends to be stable over time and it is
reversible.
Popular measures of liquidity include the bid-ask spread,
trading volume, frequency of trades, and average trade size.

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 8-7

Default Risk and Interest Rates

Default risk The risk that a borrower will not make all the
promised payments at the agreed-upon times.
Promised yield on a risky asset
= risk-free interest rate + default risk premium
The promised yield on a risky debt security is the yield to
maturity that will be earned by the investor if the borrower
makes all promised payments when they are due.

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Default Risk and Interest Rates

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Default Risk and Interest Rates

Among the leading U.S. bankruptcy filers in modern history

are WorldCom, Enron, Conseco, Texaco, Global Crossing,
UAL, Pacific Gas and Electric Company, Kmart, etc.
Expected yield on a risky asset = S piyi
pi = probability that the ith possible yield, yi, occurs
Anticipated default loss on a risky asset
= promised yield expected yield

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 8 - 10

Default Risk and Interest Rates

Factors Influencing Default Risk Premiums

Credit ratings by rating companies such as Moodys and
Standard & Poors
- Highly-rated securities are perceived as having negligible default
risk.

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 8 - 11

Default Risk and Interest Rates

Bond-Rating Categories

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Default Risk and Interest Rates

The Behavior of Interest Rates

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2006 Bank of St. Louis,
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Companies,
 8 - 13

Default Risk and Interest Rates

Market Yield

* Corporate bond ratings are from Moodys Investors Service. ** 2004 interest rates are averages for January.
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 8 - 14

Default Risk and Interest Rates

Factors Influencing Default Risk Premiums

Fluctuations (cycles) in business activity
- The yield spread between Aaa- and Baa-rated securities
increases during economic recessions.
For corporate securities, the period of time the firm has been in
operation, variability in company earnings, and the amount of
leverage employed

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 8 - 15

Default Risk and Interest Rates

Inflation and Default Risk Premiums

Default risk premiums tend to be higher and more volatile
when inflation is high and volatile.
Greater uncertainty about inflation tends to produce a flight to
quality in the financial markets, and investors simply become
more cautious about buying default-risk-exposed financial
instruments.

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Default Risk and Interest Rates

Yield Curves for Risky Securities

There is some evidence that the yield curves on high-default-
risk instruments often have a downward (negative) slope or
may have a significant bow or hump in them as maturity
increases.
Each required payment that is successfully made seems to
lower the risk that subsequent payments will be missed.

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Default Risk and Interest Rates

The Volatile History of Junk Bonds

Junk bonds are long-term debt securities whose full repayment
is judged to be significantly less certain than that for bonds
rated investment quality.

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Default Risk and Interest Rates

The Junk-Bond Spread and the Economy

Junk bond spread =
junk bond yields Aaa corporate bond yields
A rise in the junk bond spread indicates a growing fear among
bond market investors that marginal-quality corporate
borrowers are more likely to default on their debts (i.e. a
weakening economy).

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New Ways of Dealing with Default Risk:

Credit Derivatives

Credit derivatives are financial contracts that seek to protect

lenders against default risk by shifting that risk to someone else
willing to accept it for a fee.
In a credit swap, two or more lenders agree to exchange a
portion of their expected payments.
A credit option may enable the lender to be reimbursed if a
credit asset begins to lose value.

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New Ways of Dealing with Default Risk:

Credit Derivatives

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 8 - 21

Call Privileges and Call Risk

A call privilege on a bond contract grants the borrower the

option to retire all or a portion of a bond issue by buying back
the securities in advance of maturity at a specified call price.
A bond may be callable immediately, or the privilege may be
deferred for a specified period of time.

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Call Privileges and Call Risk

The yield on called financial assets can be calculated by

equating the securitys price (P) with the present value of all its
future cash flows (I):

n = the number of periods until maturity

k = the time period in which the security is called, k < n
C = call price
i = the interest rate the call price is reinvested at
h = holding period yield

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Call Privileges and Call Risk

Advantages and Disadvantages

The call option is an advantage to the security issuer because it
grants greater financial flexibility and the potential for
reducing future interest costs.
However, it is a disadvantage to the security buyer. The
holding-period yield may decline if the security is called, and
the potential for capital gains is limited.

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Call Privileges and Call Risk

The Call Premium & Interest Rate Expectations

Issuers of callable securities must pay a call premium in the
form of a higher interest rate.
The call premium is higher if
the market expects interest rates to fall (such that the call risk is
higher),
the call deferment period is shorter, and
the call price is lower.

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 8 - 25

Call Privileges and Call Risk

Research Evidence
Research studies generally support the expected inverse
relationship between interest rate expectations and the value of
the call privilege.
Research also suggests that calling in bonds to save on interest
costs may be a zero sum game between the bondholders and
stockholders of a company.

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 8 - 26

Prepayment Risk and the Yields on

Loan-Backed Securities

Prepayment risk is the risk that the purchaser may receive

higher-than-expected repayments of principal early in the life
of loan-backed securities.
Prepayment risk is especially valid for the investors in
securities that are backed by home mortgage loans, as many
home loans will be retired early due to loan refinancing and
home-owner turnover.

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Prepayment Risk and the Yields on

Loan-Backed Securities

Since prepayments may lower the investors return, loan-

backed securities with greater prepayment risks are priced
lower.

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Prepayment Risk and the Yields on

Loan-Backed Securities

One of the most popular devices today to reduce prepayment

risk is to divide the loan-backed security issue into classes or
tranches.
Each tranche promises a different rate of return based on a
different maturity and risk profile.

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 8 - 29

Taxation of Returns on Financial Assets

Taxes imposed by the federal, state, and local governments can

have a profound effect on the returns earned by investors on
financial assets.
Thus, governments can use their taxing power to encourage
the investment in certain financial assets, thereby redirecting
the flow of savings and investment toward areas of critical
social need.

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Taxation of Returns on Financial Assets

In particular, governments may

- vary the income brackets and tax rates
- tie the applicable tax rates to the length of time that securities
were held
- grant certain amounts of tax exemptions for various categories
- enable the deduction of capital losses (up to specified limits)
- change the permissible annual contributions to educational or
retirement accounts

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Taxation of Returns on Financial Assets

Tax-exempt securities represent a subsidy to induce investors

to support local governments.
The exemption privilege shifts the burden of federal taxation
from buyers of municipal bonds to other taxpayers.
However, the privilege lowers the interest rates at which
municipals can be sold in the open market relative to
comparable taxable bonds.

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Taxation of Returns on Financial Assets

After-tax yield = (1 t ) Before-tax yield

where t is the investors marginal tax rate
An investor will be indifferent between taxable and tax-
exempt securities when
Tax-exempt yield = (1 t ) Taxable yield
To make valid comparisons between taxable and tax-exempt
issues, the taxed investor should convert all expected yields to
an after-tax basis.

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Taxation of Returns on Financial Assets

Recent Marginal Federal Income Tax Rates

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 8 - 34

Convertible Securities

Convertible (or hybrid) securities are special issues of

corporate bonds or preferred stock that can be exchanged for a
specific number of shares of the issuing firms common stock.
Convertibles offer the investor the prospect of a stable interest
or dividend income, as well as capital gains on common stock
on conversion.
Hence, investors are generally willing to pay a premium for
convertibles.

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Convertible Securities

For the corporate bond issuer, the advantages of convertible

bonds is a significantly lower interest cost and being able to
avoid issuing more common stock.
Interest on convertible bonds is often a tax-deductible expense
in many countries too.
Note that the issuer may call in the securities early, forcing
conversion.

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 8 - 36

The Structure of Interest Rates

The risk-free interest rate underlies all interest rates and is a

component of all rates.
All other interest rates are scaled upward by varying degrees
from the risk-free rate, depending on such factors as inflation,
the term (maturity) of a loan, the risk of borrower default, the
risk of prepayment, and the marketability, liquidity,
convertibility, and tax status of the financial assets to which
those rates apply.

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The Structure of Interest Rates

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