Chapter 7
The Risk and Term
Structure of Interest
Rates
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
Risk & Term Structure:
The Big Questions
1. Why do different bonds have different
yields?
2. What information is there in the relative
yield of different bonds?
7-2
Risk & Term Structure:
Roadmap
• Ratings and the risk structure
– Bonds
– Commercial Paper
• Differences in tax status
• The term structure
• Information content
7-3
Bond Ratings
Bond Ratings Moody’s and Standard and Poor’s
Ratings Groups
• Investment Grade
• Non-Investment
– Speculative Grade
– Highly Speculative
7-4
Bond Ratings:
Junk or High-Yield Bonds
• Speculative grade
– below Moody’s Baa
– below S&P BBB
• Fallen angels:
Originally investment grade, but issuer did poorly.
• Original-issue:
Little known about the issuers
7-5
Bond Ratings:
Changes
• Ratings downgrade
Borrower encounters problems
• Ratings upgrade
Prospects of repayment improve.
7-6
Bond Ratings:
Investment Grade
7-7
Bond Ratings:
Speculative Grades
7-8
Commercial Paper:
What is it?
•
•
•
•
Short-term (less than 270 days) bond
Unsecured.
Issued on a discount basis
Only most creditworthy borrowers can
issue it.
7-9
Commercial Paper:
Ratings
7-10
Bond Ratings and Risk:
Impact of Ratings on Yields
• Risk 
Bond Demand
Bond Price 
Bond Yield 
7-11
Bond Ratings and Risk:
Impact of Ratings on Yields
Bond Yield = U.S. Treasury Yield
+ Default Risk Premium
(Default risk premium sometimes called risk spread
or the spread over Treasuries.)
7-12
• When GM and Ford bonds were
downgraded, auto loan rates were the same.
• Auto loans are bundled together in pools –
these are asset-backed securities.
• Even though GM and Ford were doing
poorly, the probability that car buyers would
repay was unaffected.
7-13
Bond Ratings and Risk:
Risk Structure of Interest Rates
7-14
•
•
•
•
Your credit rating is your credit score
Credit score based on paying on time
Credit score  interest rate on loans
Worse score  higher interest rate
7-15
Tax Status and Bond Prices
•
Coupon Payments on Municipal Bonds are
exempt from Federal Tax Payments.
•
Interest income from bonds issued by one
government are not taxed by another
government
7-16
Tax Status and Bond Prices
Tax-Exempt Bond Yield
= (Taxable Bond Yield) x (1- Tax Rate).
7-17
Things to keep in mind:
• What is the tax status of the bonds?
• Only the IRS taxes interest on U.S. Treasury bonds
• Municipal bonds are worth holding if your tax rate is
high enough
• Never hold tax-exempt bonds in a retirement
account
• Watch when tax rates change, the best bond for you
may change, too
7-18
Term Structure of Interest Rates:
Preliminaries
Definition of the Term Structure:
The relationship among bonds with the same
risk characteristics but different maturities is
called the term structure of interest rates.
Yield Curve:
A plot of the term structure, with the yield to
maturity on the vertical axis and the time to
maturity on the horizontal axis.
7-19
Term Structure of Interest Rates
7-20
Term Structure of Interest Rates:
Yield Curve
The U.S. Treasury Yield
Curve: October 12, 2006.
7-21
Term Structure of Interest Rates:
Facts to Explain
1. Interest Rates of different maturities tend to
move together
2. Yields on short-term bond are more volatile
than yields on long-term bonds
3. Long-term yields tend to be higher than
short-term yields.
7-22
Term Structure of Interest Rates:
Expectations Hypothesis
Assumption:
Bonds of different maturities are perfect
substitutes for each other.
Implies:
Investor w/ a two-year horizon indifferent
between:
1. A 2 yr bond for 2 yrs
2. A 1 yr bond and a second 1yr bond in 1 yr.
7-23
Term Structure of Interest Rates:
Expectations Hypothesis
1. Total return from 2 year bonds over 2 years
(1  i 2t )(1  i 2t )
2. Return from 1 yr bond and then another 1 yr bond
(1  i1t )(1  i
e
1t 1
)
7-24
Term Structure of Interest Rates:
Expectations Hypothesis
If one and two year bonds are perfect substitutes, then:
(1  i 2t )(1  i 2t )  (1  i1t )(1 1te 1 )
or
i1t  i
i 2t 
2
e
1t 1
Long-term interest rate
= average of expected future short-term interest rates
7-25
Term Structure of Interest Rates:
Expectations Hypothesis
7-26
Term Structure of Interest Rates:
Expectations Hypothesis
General formula:
int 
i1t  i
e
1t 1
i
e
1t  2
 ....  i
e
1t  n 1
n
7-27
Term Structure of Interest Rates:
Expectations Hypothesis
7-28
Term Structure of Interest Rates:
Expectations Hypothesis
Explains:
1.
Interest Rates of different maturities tend to move
together
2.
Yields on short-term bond are more volatile than
yields on long-term bonds
BUT NOT
3. Long-term yields tend to be higher than short-term
yields.
7-29
Term Structure of Interest Rates:
Liquidity Premium Theory
The yield curve’s 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.
7-30
Term Structure of Interest Rates:
Liquidity Premium Theory
Explaining the fact that the yield curve
normally slopes up:
– Bondholders face both inflation and
interest-rate risk.
– The longer the term of the bond, the
greater both types of risk.
– The bigger the risk, the higher the risk
premium
7-31
Term Structure of Interest Rates:
Liquidity Premium Theory
General Formula:
int  rp n 
i1t  i
e
1t 1
i
e
1t  2
 ....  i
e
1t  n 1
n
7-32
• Read the title
• Read the label on
the horizontal axis
• Read the label on
the vertical axis
7-33
Information Content of Interest Rates:
Risk Structure
• When the economy starts to slow, it puts a
strain on private firms.
• A slower economy means a higher default
probability
• Increased default risk is different across firms
• Firms already doing poorly, do even worse
7-34
Information Content of Interest Rates:
Risk Structure
• Lower initial grade of a bond,
the worse they do in a downturn
• The risk spread is an excellent
measure of activity
7-35
• During financial crises, people take cover.
• They sell risky investments & buy safe ones.
• This is a flight to quality
• This is what happened in 1998
7-36
Information Content of Interest Rates:
Risk Structure
7-37
Information Content of Interest Rates:
Term Structure
• When the yield curve slopes down,
it is called inverted
• An inverted yield curve
is a very valuable forecasting tool
• It signals an economic downturn
7-38
Information Content of Interest Rates:
Term Structure
7-39
Chapter 7
End of Chapter
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008