WHY BONDS WITH THE SAME TERM OF MATURITY HAVE DIFFERENT INTEREST
RATES?
The relationship among these interest rates is called the risk structure of
interest rates.
1) Default Risk
P2 r2
P1 r1 P1
r1 P2 r2
D2 D1c
D1 D2c
From graph:
Increase in default risk the corporation suffer losses, the expected
return on corporate bonds decrease. So that, the demand for corporate
bonds decrease. The equilibrium price of corporate bond falls from P1 to P2
and interest rate on corporate bonds increase from r 1 to r2. At the same
time the demand for treasury bonds rises from D1 to D2. The equilibrium
price increase from P1 to P2 and the interest rates for treasury bonds
decrease from r1 to r2.
The risk premium on corporate bond has risen from zero to r2c r2. So, we
can conclude that a bond with default risk will always have a positive risk
premium.
2) Liquidity
The more liquid an asset is, the more desirable it is. Treasury bonds are the
most liquid of all long term bonds because they are so widely traded that
they are the easiest to sell quickly and the cost of selling is low. Corporate
bonds are not liquid because fewer bonds for any one corporation are
traded, thus it can be costly to sell this bonds.
If corporate bond become less liquid than TB, its demand will fall. The TB
becomes relatively liquid in comparison with the CB. The demand curve for
TB shift to the right. From the graph, it shows that the price of the less
liquid asset falls and interest rates rise, while the price of the more liquid
asset rises and the interest rates falls.
The result is the spread between the interest rates on the two bonds has
risen.
3) Income tax
Pb r Pb r
Sc St
P1 r1
P2 r2 P2
r2 P1 r1
D1 D2m
D2 D1m
From graph:
If the municipal bond is given tax-free status, it raises their after tax
expected return relative to TB and makes MB more desirable. Demand for
MB increase. The result is equilibrium price increase and the interest rate
falls. TB become less desirable. Demand falls. The result is equilibrium
price fall and the interest rate increased.
As a conclusion, if tax free is given, we are willing to hold the riskier and
less liquid asset even though it has lower interest rates.
TERM STRUCTURE OF INTEREST RATE
Another factor that can influence interest rate on bonds is its term of
maturity.
Yield Curve ------- is a plot of the yields on bonds with differing terms to
maturity but the risk, liquidity and tax are considered the same.
When yield curve slop upward, the long term interest rates are above
the short term interest rate.
When yield curves are flat, short term and long term interest rates are
the same.
When yield curves are downward sloping, long term interest rates are
below short term interest rates.
Yield ( % )
upward sloping
flat
downward sloping
yearsto maturity
The theory of the term structure must also explain the following facts:
It states that the interest rates on a long term bond will equal an
average of short term interest rates that people expect to occur over
the life of the long term bond.
Findings:
When the yield curve is upward sloping, the short-term interest rates
are expected to rise in the future. The long term rate is currently
above the short term rate, the average of future short-term rates is
expected to be higher than the current one.
It states that the interest rates on a long term bond will equal an
average of short term interest rates expected to occur over the life
of the long term bond plus a liquidity premium.
Assumption:
} liquidity premium
expectation theory
yrs to maturity