CHAPTER 4: THE STRUCTURE OF INTEREST RATE

4.1.The Term Structure of Interest Rates

The term structure of interest rates is the relationship between interest rates or

bond yields and different terms or maturities. When graphed, the term structure of

interest rates is known as a yield curve, and it plays a central role in an economy. The

term structure reflects expectations of market participants about future changes in

interest rates and their assessment of monetary policy conditions. (Investopedia, 2003)

The term structure of interest rates shows the various yields that are currently being

offered on bonds of different maturities. It enables investors to quickly compare the yields

offered on short-term, medium-term and long-term bonds.

The term structure of interest rates takes three primary shapes:

1.If short-term yields are lower than long-term yields, the curve slopes upwards and the

curve is called a positive (or "normal") yield curve.

A normal yield curve indicates that investors require a higher rate of return for taking

the added risk of lending money for a longer period of time. Many economists also believe

that a steep positive curve indicates investors expect higher future inflation (and thus higher
interest rates), and that a sharply inverted yield curve means investors expect lower inflation

(and interest rates) in the future. A flat curve generally indicates investors are unsure about

future economic growth.

Because the yield curve is generally indicative of future interest rates, which are indicative of

an economy's expansion or contraction, yield curves and changes in yield curves can convey

much information. Changes in the shape of the yield curve also affect a portfolio's return in

that they make some bonds more or less valuable relative to other bonds. These concepts

are part of what motivates analysts to study yield curves carefully.

2. If short-term yields are higher than long-term yields, the curve slopes downwards

and the curve is called a negative (or "inverted") yield curve.

An inverted yield curve indicates that investors require a higher rate of return for taking

the added risk of lending money for a shorter period of time. Many economists also believe

that a steep positive curve indicates investors expect higher future inflation (and thus higher

interest rates), and that a sharply inverted yield curve means investors expect

lower inflation (and interest rates) in the future.

A flattening yield curve generally indicates investors are unsure about future economic
growth.
 3. Flat yield curve. A flat term structure of interest rates exists when there is little or no

variation between short and long-term yield rates

A flat yield curve indicates that there is no immediate benefit to investing in long-term

securities over short-term securities since the yield on either is essentially the same.

Many economists also believe that a steep positive curve means that investors expect

strong future economic growth with higher future inflation (and thus higher interest rates), and

that a sharply inverted curve means that investors expect sluggish economic growth with

lower future inflation (and thus lower interest rates). A flat curve generally indicates that

investors are unsure about future economic growth and inflation.

There are three central theories that attempt to explain why yield curves are shaped the way

they are.

1. The "expectations theory" says that expectations of increasing short-term interest

rates are what create a normal curve (and vice versa).

2. The "liquidity preference hypothesis" says that investors always prefer the higher

liquidity of short-term debt and therefore any deviance from a normal curve will only prove to

be a temporary phenomenon.
 3. The "segmented market hypothesis" says that different investors adhere to

specific maturitysegments. This means that the term structure of interest rates is a reflection

of prevailing investment policies.

Changes in the shape of the term structure of interest rates can also have an impact on

portfolio returns by making some bonds relatively more or less valuable compared to other

bonds. These concepts are part of what motivate analysts and investors to study the term

structure of interest rates carefully.

4.2 Default Risk

 Default risk is the chance that the bond issuer will not make the

required coupon payments or principal repayment to its bondholders.

 Many things can influence an issuer's default risk and in varying degrees.

Examples include poor or falling cash flow from operations (which is often

needed to make the interest and principal payments), rising interest rates (if

the bonds are floating-rate notes, rising interest rates increase the required

interest payments), or changes in the nature of the marketplace that would

adversely affect the issuer (such as a change in technology, an increase in

competitors, or regulatory changes). The default risk associated with foreign

bonds also includes the home country's sociopolitical situation and the stability

and regulatory activity of its government.

 Default risk is the chance that a company or individual will be unable to make

the required payments on their debt obligation. Lenders and investors are
 exposed to default risk in virtually all forms of credit extensions. A higher level of

risk leads to a higher required return, and in turn, a higher interest rate.

 Default risk is the chance that companies or individuals won’t be able to make required

debt payments.

 A free cash flow figure that is near zero or negative indicates that the company may be

having trouble generating the cash necessary to deliver on promised payments, and

this could indicate higher default risk.

 Default risk can be gauged using standard measurement tools, including FICO scores

for consumer credit, and credit ratings by the likes of S&P and Moody’s for corporate

and government debt issues.

Understanding Default Risk

Default risk can change as a result of broader economic changes or changes in a

company's financial situation. Economic recession can impact the revenues and earnings of

many companies, influencing their ability to make interest payments on debt and, ultimately,

repay the debt itself. Companies may face factors such as increased competition and

lower pricing power, resulting in a similar financial impact. Entities need to generate sufficient

net income and cash flow to mitigate default risk. In the event of a default, investors may lose

out on periodic interest payments and their investment in the bond. A default could result in a

100% loss on investment.

Special Considerations
 Lenders generally examine a company's financial statements and employ several financial

ratios to determine the likelihood of debt repayment.

Free cash flow is the cash that is generated after the company reinvests in itself and is

calculated by subtracting capital expenditures from operating cash flow. Free cash flow is

used for things such as debt and dividend payments. A free cash flow figure that is near

zero or negative indicates that the company may be having trouble generating the cash

necessary to deliver on promised payments. This could indicate a higher default risk.

Types of Default Risk

The credit scores established by the rating agencies can be grouped into two categories:

1. Investment Grade

2. Non- Investment grade ( or junk)

Investment-grade debt is considered to have low default risk and is generally more sought-

after by investors. Conversely, non-investment grade debt offers higher yields than safer

bonds, but it also comes with a significantly higher chance of default.

While the grading scales used by the rating agencies are slightly different, most debt is

graded similarly. Any bond issue given a AAA, AA, A, or BBB rating by S&P is considered

investment grade. Anything rated BB and below is considered non-investment gra de.

4.3 Tax Treatment

Federal tax.
 The semiannual interest payments on TIPS are taxable to a holder of securities when

received. This is consistent with the tax treatment of other Treasury securities. If the holder is

a corporation or other institutional investor, the interest payments will be taxable when

received or accrued, in accordance with the holders’ method of accounting.

Investors will also be taxed on inflation adjustments to the principal in the year in which

the adjustments occur, even though the principal adjustments would not actually be received

from Treasury until maturity (a situation that is sometimes described as taxing “phantom

income”). Conversely, a decrease in the inflation-indexed principal amount (due to deflation)

will first reduce the interest income attributable to the semiannual interest payments for the

year of the adjustment; and if the amount of the decrease exceeds the income attributable to

the semiannual interest payments, the excess will generally be an ordinary deduction to the

extent that interest from the security was previously included in income. Any remaining

decrease will be carried forward to reduce interest income on the inflation-protected security

in future years. A taxpayer will generally recognize a capital loss if the taxpayer sells or

exchanges the inflation-protected security, or if the security matures, before the taxpayer has

used all that decrease.

If a Treasury Inflation Protected Security is purchased at a discount you should consult

your tax advisor.

State tax.

Like all securities issued by the U.S. Treasury, TIPS are exempt from taxation by a

state or a political subdivision of a state, except for state estate or inheritance taxes and other

exceptions provided by law.

4.3 Marketability
Marketability refers to the ability of an investor to sell a security quickly, at a low transaction

cost, and at its fair market value.

 The lower these costs are, the greater a security’s marketability.

 The interest rate, or yield, on a security varies inversely with its degree of marketability.

The difference in interest rates or yields between a marketable security and a less

marketable security is known as the marketability risk premium

 U.S. Treasury bills have the largest and most active secondary market and are

considered to be the most marketable of all securities.

 The increase in corporate liquidity over the past ten years, together with higher levels

of interest rates and growing sophistication among corporate treasurers and bank

portfolio managers, have contributed to the increasing importance of various money-

market instruments.

 The relative position of the Treasury bill has declined, and bank time certificates of

deposits, short-term issues of municipalities, and commercial paper have assumed

greater importance.

 The fundamental reason for the attractiveness of alternatives to Treasury bills is, of

course, the additional yield that the investor can obtain in the substitute instruments.

 The differential yield spread over Treasury bills can be explained substantially by two

factors—the difference in marketability and the existence of some default risk on the

alternative securities.

4.4 The Call Privilege

A call provision or call privilege is a stipulation on the contract for a bond—or other fixed-

income instruments—that allows the issuer to repurchase and retire the debt security

Call provision triggering events include the underlying asset reaching a preset price and a

specified anniversary or other date being reached. The bond indenture will detail the events

that can trigger the calling of the investment. An indenture is a legal contract between the

issuer and the bondholder.

If the bond is called, investors are paid any accrued interest defined within the provision up to

the date of recall. The investor will also receive the return of their invested principal. Also,

some debt securities have a freely-callable provision. This option allows them to be called at

any time.

A Brief Overview of Bonds

Companies issue bonds to raise capital for financing their operations, such as purchasing

equipment or launching a new product or service. They may also float a new issue to retire

older callable bonds if the current market interest rate is more favorable When an investor

buys a bond—also known as debt security—they are lending the business funds, much like a

bank lends money.

In return, the company pays the bondholder an interest rate—known as the coupon rate—

over the life of the bond. The bondholder receives regular coupon payments. Some bonds

offer annual returns, while others may give semiannual, quarterly, or even monthly returns to

the investor. At maturity, the company pays back the original amount invested called the

principal.

KEY TAKEAWAYS
 ▪ A call provision is a provision on a bond or other fixed-income instrument that

allows the issuer to repurchase and retire its bonds.

▪ The call provision can be triggered by a preset price and can have a specified

period in which the issuer can call the bond.

▪ Bonds with a call provision pay investors a higher interest rate than a

noncallable bond.

▪ A call provision helps companies to refinance their debt at a lower interest rate.

Call Provision Benefits for the Issuer

When a bond is called, it usually benefits the issuer more than it does the investor. Typically,

call provisions on bonds are exercised by the issuer when overall market interest rates have

fallen. In a falling-rate environment, the issuer can call back the debt and reissue it at a lower

coupon payment rate. In other words, the company can refinance its debt when interest rates

fall below the rate being paid on the callable bond.

If overall interest rates have not fallen, or market rates are climbing, the corporation has no

obligation to exercise the provision. Instead, the company continues to make interest

payments on the bond. Also, if interest rates have risen significantly, the issuer is benefiting

from the lower interest rate associated with the bond. Bondholders may sell the debt security

on the secondary market but will receive less than face value due to its payment of lower

coupon interest.

Call Provision Benefits and Risks for Investors

 An investor buying a bond creates a long-term source of interest income through regular

coupon payments. However, since the bond is callable—within the agreement's terms—the

investor will lose the long-term interest income if the provision is exercised. Although the

investor does not lose any of the principal originally invested, future interest payments

associated are no longer due.

Investors may also face reinvestment risk with callable bonds. Should the corporation call and

return the principal the investor must reinvest the funds in another bond. When the current

interest rates have fallen, they are unlikely to find another, equal investment paying the higher

rate of the older, called, debt.

Investors are aware of reinvestment risk and, as a result, demand higher coupon interest

rates for callable bonds than those without a call provision. The higher rates help compensate

investors for reinvestment risk. So, in a rate environment with falling market rates, the investor

must weigh if the higher rate paid offset the reinvestment risk if the bond is called.

Pros Cons

 Bonds with call provisions pay a higher  The exercise of the call provision

coupon interest rate than noncallable happens when rates fall, hitting

bonds. investors with reinvestment risk.

 The call provision allows companies to  In rising rate environments, the bond

refinance their debt when interest rates may pay a below-market interest rate.

fall.


4.5 Comovement of Interest rate

According to the expectations theory of the term structure, long-term interest rates are the

sum of a weighted average of expected short-term interest rates and a constant risk premium.

 A concept related to excess comovement is excess volatility of an asset price.

 Empirical evidence on international yield comovement is sparse and lacks consensus.

 The recent global financial crisis, euro area yields have ceased to comove with the

yields of the other international markets.

 The empirical evidence indicates the presence of excess comovement of ten-year

bond yields between all three countries. Excess comovement of long-term bond yields

has important implications for interest rate determination.

 First, it implies that deviations of long rates from the predictions of the expectations

theory of the term structure contain an international component.

 Second, excess comovement between Canadian, UK and US bond yields implies that

common movements in long rates in these countries need not signal shifts in market

participants' expectations of price inflation.

 Clearly, the present analysis must be extended to cover a broader cross-section of

countries before any conclusions regarding global interest rate movements can be

reached.

 Nevertheless, the present results suggest that an international component of time

variation in term premia may be an important factor in interest rate determination at the

long end of the term structure.

Reference:

 https://www.investopedia.com/terms/t/termstructure.asp

 https://investinganswers.com/dictionary/t/term-structure-interest-rates

 https://investinganswers.com/dictionary/n/normal-yield-curve

 https://investinganswers.com/dictionary/i/inverted-yield-curve

 https://investinganswers.com/dictionary/f/flat-yield-curve

 https://investinginbonds.com/learnmore.asp?catid=9&subcatid=51&id=255

 https://www.investopedia.com/terms/c/callprovision.asp

Video Lecture:

 yield curve: https://www.youtube.com/watch?v=5L_zQGPNXOk

 inverted curve: https://www.youtube.com/watch?v=gor5PwPb8ac

 default risk: https://www.youtube.com/watch?v=DVe3TMUDSDw

News Article:
  https://www.bloomberg.com/news/articles/2019-05-08/new-zealand-cuts-interest-

rates-to-historic-low-currency-drops

Case Study:

 https://pdfs.semanticscholar.org/0509/a293db784cc9fb598d370d658aac7caa81b4.pdf