Chapter 7

The Risk and Term Structure of Interest Rates

McGraw-Hill/Irwin

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Bond Ratings and Risk

Bond Ratings Moodys and Standard and Poors Ratings Groups Investment Grade Non-Investment Speculative Grade Highly Speculative
7-2

Bond Ratings and Risk

Commercial Paper Ratings Moodys and Standard and Poors Rating Groups Investment Speculative Default
7-3

Bond Ratings and Risk

7-4

Bond Ratings and Risk

Increased Risk reduces Bond Demand. The resulting shift to the left causes a decline in equilibrium price and an increase in the bond yield. Risk spread (premium) Bond Yield = U.S. Treasury Yield + Default Risk Premium

7-5

Bond Ratings and Risk

Long-Term Bond Interest Rates and Ratings

7-6

Bond Ratings and Risk

Short-Term Interest Rates and Risk

7-7

Tax Status and Bond Prices

Coupon Payments on Municipal Bonds are exempt from Federal Tax Payments. Tax-Exempt Bond Yield = (Taxable Bond Yield) x (1- Tax Rate).

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Term Structure of Interest Rates

The relationship among bonds with the same risk characteristics but different maturities is called the term structure of interest rates.

A plot of the term structure, with the yield to maturity on the vertical axis and the time to maturity on the horizontal axis, is called the yield curve.
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Term Structure of Interest Rates

Web Link: US Treasury

Bloomberg.com

7-10

Term Structure of Interest Rates

Term Structure of Treasury Interest Rates

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Term Structure of Interest Rates

Term Structure Facts

Interest Rates of different maturities tend to move together Yields on short-term bond are more volatile than yields on long-term bonds
Long-term yields tend to be higher than short-term yields.
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Term Structure of Interest Rates

Expectations Hypothesis
Bonds of different maturities are perfect substitutes for each other.

An investor with a two-year horizon.

Buy a 2 year bond or Buy a one year bond and another one year bond in one year.

7-13

Term Structure of Interest Rates

Total return from 2 year bonds over 2 years

(1 i2y )(1 i2y )

Return from one year bond and then another one year bond

(1 i1y )(1 i )
e 1y
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Term Structure of Interest Rates

If one and two year bonds are perfect substitutes, then:

(1 i 2y )(1 i 2y ) (1 i1y )(1 i )

e 1y
Or

i 2y

i1y i 2

e 1y

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Term Structure of Interest Rates

Or in general terms

int

i1t i

e 1t 1

e 1t 2

.... i

e 1t n 1

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Term Structure of Interest Rates

Expectations Theory can not explain why long-term rates are usually above short term rates.

7-17

Term Structure of Interest Rates

Liquidity Premium Theory

The yield curves upward slope is explained by the fact that long-term bonds are riskier than short-term bonds. Bondholders face both inflation and interest-rate risk. The longer the term of the bond, the greater both types of risk.
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Term Structure of Interest Rates

Liquidity Premium Theory

int rp n

i1t i

e 1t 1

e 1t 2

.... i

e 1t n 1

n
7-19

Information Content of Interest Rates

Direction of future rates Implied forward rate Direction of risk premium

7-20

Forward Rates

Forward Rate is an implied nonobservable short term rate.

7-21

Forward Rate Example

Year Spot Rate 1 5% 2 6% 3 7% 4 6% f2 = (1.06)2/ (1.05) 1 = 7.0% Strategy 1: Invest $1 in a 2 yr. zero coupon: $1 x (1.06)2 = $1.1236 Strategy 2: Invest $1 in 1yr zero coupon receiving 5% 1st yr. and 7.0% 2nd yr. = $ 1.1236 = (1.05)(1.07)
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Forward Rate Example

Year Spot Rate 1 5% 2 6% 3 7% 4 6% f2 = (1.06)2/ (1.05) 1 = 7.0% f3 = (1.07)3/ (1.06)2 1 = 9.03% f2 = (1.06)4/ (1.07)3 1 = 3.06%

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Information Content of Interest Rates

7-24

Chapter 7

End of Chapter

McGraw-Hill/Irwin

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.