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Chapter 7' Risk and Term Structure of Interest Rates

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Title: Chapter 7' Risk and Term Structure of Interest Rates


1
Chapter 7. 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
  • But interest rates do move together over time

3
Interest rate structure
  • Why do yields differ?
  • Risk structure
  • bonds/debt with same maturity but different
    characteristics
  • Term structure
  • Bond with same characteristics but different
    maturities

4
Interest rates a snapshot
  • 1/07 1/08
  • 3 mo Tbill 4.98 2.75
  • 3 mo Com Paper 5.17 3.25
  • 10 yr. Tnote 4.76 3.74
  • 10 yr. AAA corp 5.4 5.33
  • 10 yr. BAA corp 6.34 6.54
  • 30 yr. mortgage 6.22 5.76

5
measurement
  • difference between two interest rates
  • spread
  • measured in
  • percentage points
  • basis points
  • 1 percentage pt. 100 basis pts.

6
example 1
  • 3 mo. Tbill 2.75
  • 3 mo. Commercial paper 3.25
  • spread
  • 0.5 percentage pts.
  • 50 basis pts.

7
example 2
  • 10 yr Tnote 3.74
  • 10 BAA corporate 6.54
  • spread
  • 2.8 percentage pts.
  • 280 basis pts.

8
I. Risk Structure of Interest Rates
  • debt with same maturity,
  • but different characteristics
  • default risk
  • tax treatment

9
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10
Patterns
  • Baa gt AAA gt U.S. Treasury
  • size of the spread varies

11
A. Default Risk
  • risk of not receiving timely payment of principal
    and interest
  • depends on
  • creditworthiness of issuer
  • structure of bond

12
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

13
Other issuers
  • private
  • foreign
  • municipal
  • all have some default risk
  • rated for default risk

14
Bond ratings
  • bond issuer pays rating agency
  • Moodys, SP, Fitch
  • p. 151 or p. 149
  • high credit rating
  • low default risk
  • bond ratings may change over time
  • Downgrades or upgrades

15
Investment grade
  • Moodys SP
  • Aaa AAA
  • Aa (Aa1, Aa2, Aa3) AA (AA, AA, AA-)
  • A A
  • Baa BBB

16
Noninvestment, speculative
  • Ba BB
  • B B

Highly Speculative (High-yield, Junk)
  • Caa CCC
  • Ca CC
  • C C
  • D (in default)

17
examples
  • AAA
  • GE, Toyota, Berkshire Hathaway, Pfizer
  • AA
  • Wells Fargo, Merck, Merrill Lynch, Gillette, NYC
    GO bonds, Rochester, Syracuse, Onondaga Co.
  • A
  • Caterpillar, Boeing, Dow Chemical, Coca Cola,
    California GO bonds,
  • BBB
  • DaimlerChrysler, Union Pacific, Mattel, Home Depot

18
  • BB
  • GM, Sears
  • B
  • Ford, Clear Channel, Univision
  • CCC
  • Revlon, Sirius, Pep Boys, JoAnn, ToysRUs
  • CC
  • Primus
  • C
  • Wolverine Tube

19
Defaults
  • Most likely in industrial sector
  • Defaults over past 10 years
  • Zenith Delta, Northwest
  • Enron Delphi
  • Daewoo
  • Purina Mills

20
Municipal defaults
  • NYC 1975, Cleveland 1978
  • Largest Washington Power SS
  • Over 2 billion
  • (failed nuclear plants in 1970s)
  • The Cicero Commons (2003)
  • Wilkes-Barre, PA (2002)

21
default risk yield
  • investors are risk averse

higher default risk
lower credit rating
higher yield
22
  • If Treasuries are the benchmark
  • Bond yield
  • Treasury yield default premium

23
  • so default risk explains

BAA Corp yields
AAA Corp yields
Treasury yields
lt
lt
24
default risk is not constant!
  • varies over the business cycle
  • higher in recessions
  • lower in expansions
  • Tnote vs. BAA yield
  • 1/07 158 basis pts. (6.34 vs. 4.76)
  • 1/08 280 basis pts. (6.54 vs. 3.74)

25
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26
B. Tax treatment
  • Q. why do municipal bonds have lower yields than
    Tbonds?
  • munis less liquid
  • munis not default-free
  • A. tax treatment

27
municipal bond interest
  • exempt from federal income tax
  • possibly exempt from state income tax
  • if issuer bondholder are in same state

28
Treasury bond interest
  • exempt from state income tax

Corporate bond interest
  • fully taxable

29
example federal taxes
  • bond where F10,000
  • coupon rate 10
  • annual coupon pmts 1000

30
municipal bond
  • before taxes
  • 1000 in interest pmts.
  • after taxes
  • 1000 in interest pmts

31
Corporate bond
  • before taxes
  • 1000 interest pmts.
  • after taxes
  • (25 marginal rate)
  • 1000(1-.25)
  • 750 interest pmts.

32
So, after taxes
  • muni has 10 coupon rate
  • corp has 7.5 coupon rate
  • After tax yield i(1- tax rate)
  • muni can offer a lower yield and still be
    competitive

33
tax treatment explains
muni yields
Treasury yields
Corp yields
lt
lt
34
impact of tax rates
  • higher tax brackets derive more benefit from
    munis
  • changing tax rates will affect the
    corporate-municipal yield spread

35
II. Term structure of interest rates
  • bonds with the same characteristics,
  • but different maturities

36
  • focus on Treasury yields
  • same default risk, tax treatment
  • many choices of maturity
  • -- 4 weeks to 10 years

37
Treasury yields over time
38
  • relationship between yield maturity is NOT
    constant
  • sometimes short-term yields are highest,
  • Most of the time, long-term yields are highest

39
A. Yield curve
  • plot of maturity vs. yield
  • slope of curve indicates relationship between
    maturity and yield
  • The living yield curve

40
upward sloping
  • yields rise w/ maturity (common)

41
downward sloping (inverted)
  • yield falls w/ maturity (rare)

42
flat
  • yield varies little with maturity

43
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

44
  • 2. ST bond yields are more volatile than LT bond
    yields
  • 3. The yield curve usually slopes up.

45
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

46
2 theories of term structure
  • assumptions about investor preference
  • implications for maturity and yield
  • check implications against 3 facts about yield
    curve

47
B. The Expectations Theory
  • Assume
  • bond buyers do not have any preference about
    maturity
  • i.e.
  • bonds of different maturities are perfect
    substitutes

48
  • 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

49
  • but investors hold both short-term an long-term
    bonds
  • so,
  • must EXPECT similar return
  • long-term yields
  • average of the expected
  • future short-term yields

50
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

51
  • expected one-year interest rates
  • 5, 6, 7, 8, 9
  • over next 5 years
  • so 5-year bond must yield (approx)

52
yield curve
  • if ST rates are expected to rise,
  • yield curve slopes up

53
under exp. theory,
  • slope of yield curve tells us direction of
    expected future short-term rates

54
ST rates expected to fall
55
ST rates expected to stay the same
56
ST rates expected to rise, then fall
57
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)

58
  • 2. ST rates are more volatile
  • YES.
  • If LT rates are an average of ST rates, then they
    will be less volatile

59
  • 3. yield curve usually slopes up
  • NO.
  • Under expectations theory,
  • this means we would expect interest rates to
    rise most of the time
  • BUT we dont
  • (rates have trended down for 20 yrs.)

60
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

61
B. Liquidity Premium Theory
  • assume
  • bonds of different maturities are imperfect
    substitutes,
  • and investors PREFER ST bonds
  • Less inflation risk, less interest rate risk

62
  • so if true,
  • investors hold ST bonds
  • UNLESS
  • LT bonds offer higher yield as incentive
  • higher yield liquidity premium

63
  • so,
  • LT yield average exp. ST yields
  • liquidity premium

64
example
  • 5 years
  • 1 yr. bond yields
  • 5, 6, 7, 8, 9
  • AND 5yr. bond has 1 liquidity prem.

65
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

66
  • 3. yield curve usually slopes up
  • YES.
  • IF LT bond yields have a liquidity premium,
  • then usually LT yields gt ST yields
  • or yield curve slopes up.

67
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.

68
yield curve
small liquidity premium
  • if liquidity premium is small,
  • then ST rates are expected to rise

69
yield curve
large liquidity premium
  • if liquidity premium is larger,
  • then ST rates are expected to stay the same

70
C. What does the yield curve tell us?
  • expected future ST rates?
  • expected inflation?
  • business cycle?

71
  • slope of yield curve is useful in predicting
    recessions
  • slight upward slope
  • normal GDP growth
  • steep upward slope
  • recovery from recession

72
  • flat curve
  • uncertainty
  • could mean recession,
  • or slow growth
  • inverted curve
  • exp. lower interest rates
  • followed by slowdown or
  • recession
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