Chapter 6. Risk and Term Structure of Interest Rates - PowerPoint PPT Presentation

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Chapter 6. Risk and Term Structure of Interest Rates

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Title: Chapter 6. Risk and Term Structure of Interest Rates


1
Chapter 6. Risk and Term Structure of Interest
Rates
  • Risk Structure
  • Term Structure

2
Not all interest rates are created equal!
  • many interest rates at one time
  • interest rates move together over time

3
January 2004
  • 3 mo Tbill 2.33
  • 3 mo Commerical Paper 2.52
  • prime rate 5.25
  • 10 yr. Tnote 4.23
  • 10 yr. AAA corporate 5.46
  • 10 yr. BAA corporate 6.15
  • 30 yr. mortgage 5.71

4
measurement
  • difference between two interest rates
  • spread
  • measured in
  • percentage points
  • basis points
  • 1 percentage pt. 100 basis pts.

5
example 1
  • 3 mo. Tbill 2.33
  • 3 mo. Commercial paper 2.52
  • spread
  • .19 percentage pts.
  • 19 basis pts.

6
example 2
  • 10 yr Tnote 4.23
  • 10 BAA corporate 6.15
  • spread
  • 1.92 percentage pts.
  • 192 basis pts.

7
I. Risk Structure of Interest Rates
  • debt with same maturity,
  • but different characteristics
  • default risk
  • liquidity
  • tax treatment

8
(No Transcript)
9
Patterns
  • Baa always the highest yield
  • Municipals always the lowest (1940)
  • Baa AAA U.S. municipal
  • size of the spread varies

10
A. Default Risk
  • risk of not receiving timely payment of principal
    and interest
  • depends on
  • creditworthiness of issuer
  • structure of bond

11
U.S. government debt
  • zero default risk
  • backed by full faith and credit
  • of U.S. government
  • why?
  • power to tax largest economy
  • power to issue stable currency

12
Other issuers
  • private
  • foreign
  • municipal
  • all have some default risk
  • rated for default risk

13
Bond ratings
  • bond issuer pays rating agency
  • Moodys, SP, Fitch
  • p. 123
  • high credit rating
  • low default risk
  • bond ratings may change over time

14
default risk yield
  • investors are risk averse

higher default risk
lower credit rating
higher yield
15
  • so default risk explains

BAA Corp yields
AAA Corp yields
Treasury yields


16
default risk is not constant!
  • varies over the business cycle
  • higher in recessions
  • lower in expansions
  • Baa vs. Treasury bond yield
  • 12/99 191 basis pts.
  • 12/01 296 basis pts.

17
B. Liquidity
  • how quickly/cheaply can bond be sold for cash?

lower yield
higher liquidity
18
liquidity is not rated
  • Treasuries most liquid
  • depends on size of issuer
  • related to default risk
  • bonds in default very illiquid
  • higher-rated bonds tend to be more liquid

19
C. Tax treatment
  • Q. why do municipal bonds have lower yields than
    Tbonds?
  • munis less liquid
  • munis not default-free
  • A. tax treatment

20
municipal bond interest
  • exempt from federal income tax
  • possibly exempt from state income tax
  • if issuer bondholder are in same state

21
Treasury bond interest
  • exempt from state income tax

Corporate bond interest
  • fully taxable

22
example federal taxes
  • bond where F10,000
  • coupon rate 10
  • annual coupon pmts 1000

23
municipal bond
  • before taxes
  • 1000 in interest pmts.
  • after taxes
  • 1000 in interest pmts

24
Corporate bond
  • before taxes
  • 1000 interest pmts.
  • after taxes
  • (33 marginal rate)
  • 1000(1-.33)
  • 670 interest pmts.

25
So, after taxes
  • muni has 10 coupon rate
  • corp has 6.7 coupon rate
  • muni can offer a lower yield and still be
    competitive

26
tax treatment explains
muni yields
Treasury yields
Corp yields
27
impact of tax rates
  • higher tax brackets derive more benefit from
    munis
  • changing tax rates will affect the
    corporate-municipal yield spread

28
II. Term structure of interest rates
  • bonds with the same characteristics,
  • but different maturities

29
  • focus on Treasury yields
  • same default risk, tax treatment
  • similar liquidity
  • many choices of maturity
  • -- 4 weeks to 30 years

30
Treasury yields over time
31
  • relationship between yield maturity is NOT
    constant
  • sometimes short-term yields are highest,
  • sometimes long-term yields are highest

32
A. Yield curve
  • plot of maturity vs. yield
  • slope of curve indicates relationship between
    maturity and yield

33
upward sloping
  • yields rise w/ maturity (common)
  • July 1992, currently

34
downward sloping (inverted)
  • yield falls w/ maturity (rare)
  • April 1980

35
3 facts about the yield curve
  • based on historical data on U.S. Treasury yields
  • 1. interest rates on bonds of different
    maturities generally move together

36
  • 2. If short-term rates are low, the yield curve
    slopes up.
  • If short-term rates are high, the yield curve
    slopes down.
  • 3. The yield curve usually slopes up.

37
Understanding the yield curve
  • what causes the 3 facts?
  • what does the shape of the yield curve tell us?
  • must understand why/how maturity affects yield

38
3 theories of term structure
  • assumptions about investor preference
  • implications for maturity and yield
  • check implications against 3 facts about yield
    curve

39
B. The Expectations Theory
  • Assume
  • bond buyers do not have any preference about
    maturity
  • i.e.
  • bonds of different maturities are perfect
    substitutes

40
  • if assumption is true,
  • then investors care only about expected return
  • for example,
  • if expect better return from short-term bonds,
    only hold short-term bonds

41
  • but investors hold both short-term an long-term
    bonds
  • so,
  • must EXPECT similar return
  • long-term yields
  • average of the expected
  • short-term yields

42
example
  • 5 year time horizon
  • investors indifferent between
  • (1) holding 5-year bond
  • (2) holding 1year bonds, 5 yrs. in a row
  • as long as expected return is same

43
  • expected one-year interest rates
  • 5, 6, 7, 8, 9
  • over next 5 years
  • so 5-year bond must yield (approx)

44
yield curve
  • if ST rates are expected to rise,
  • yield curve slopes up

45
under exp. theory,
  • slope of yield curve tells us direction of
    expected future short-term rates

46
ST rates expected to fall
47
ST rates expected to stay the same
48
ST rates expected to rise, then fall
49
theory vs. reality
  • does the theory explain the 3 facts?
  • 1. interest rates move together?
  • YES.
  • If ST rates rise, then average will rise (LT rate)

50
  • 2. interest rates low, slopes up
  • interest rates high, slopes down
  • YES.
  • ST rates low, must be expected to rise,
  • so yield curve slopes up
  • ST rates high, must be expected to fall,
  • so yield curve slopes down

51
  • 3. yield curve usually slopes up
  • NO.
  • Under expectations theory,
  • we would expect the yield curve to slope up only
    about 50 of the time
  • but it slopes up most of the time

52
what went wrong?
  • back to assumption
  • bonds of different maturities are perfect
    substitutes
  • but this is not likely
  • long term bonds have greater price volatility
  • short term bonds have reinvestment risk

53
C. Segmented Markets Theory
  • assume
  • bonds of different maturities are NOT
    substitutes at all

54
  • if assumption is true,
  • exp. return of ST bonds does not affect demand
    for LT bonds,
  • and vice versa
  • separate markets for ST and LT bonds

55
theory vs. reality
  • does the theory explain the 3 facts?
  • 1. interest rates move together?
  • NO.
  • if they are not related, why would they move
    together?

56
  • 2. interest rates low, slopes up
  • interest rates high, slopes down
  • NO.
  • ST yields do not affect LT yields,
  • so they will not affect the slope

57
  • 3. yield curve usually slopes up
  • YES.
  • LT bonds have greater interest rate risk.
  • LT bonds have lower demand
  • LT bonds have a higher yield
  • so LT yield ST yield,
  • and yield curve slopes up

58
D. Liquidity Premium Theory
  • assume
  • bonds of different maturities are imperfect
    substitutes,
  • and investors PREFER ST bonds

59
  • so if true,
  • investors hold ST bonds
  • UNLESS
  • LT bonds offer higher yield as incentive
  • higher yield liquidity premium

60
  • so,
  • LT yield average exp. ST yields
  • liquidity premium

61
example
  • 5 years
  • 1 yr. bond yields
  • 5, 6, 7, 8, 9
  • AND 5yr. bond has 1 liquidity prem.

62
theory vs. reality
  • does the theory explain the 3 facts?
  • 1. 2?
  • YES.
  • LT rates are still based in part on
  • exp. about ST rates

63
  • 3. yield curve usually slopes up
  • YES.
  • IF LT bond yields have a liquidity premium,
  • then usually LT yields ST yields
  • or yield curve slopes up.

64
Problem
  • How do we interpret yield curve?
  • slope due to 2 things
  • (1) exp. about future ST rates
  • (2) size of liquidity premium
  • do not know size of liq. prem.

65
yield curve
small liquidity premium
  • if liquidity premium is small,
  • then ST rates are expected to rise

66
yield curve
large liquidity premium
  • if liquidity premium is larger,
  • then ST rates are expected to stay the same

67
E. What does the yield curve tell us?
  • expected future ST rates?
  • expected inflation?
  • business cycle?

68
  • slope of yield curve is useful in predicting
    recessions
  • slight upward slope
  • normal GDP growth
  • steep upward slope
  • recovery from recession

69
  • flat curve
  • uncertainty
  • could mean recession,
  • or slow growth
  • inverted curve
  • exp. lower interest rates
  • followed by slowdown or
  • recession
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