Structure of Interest Rates ▪ Accuracy of Credit Ratings — The ratings issued by the

agencies are opinions, not guarantees. Bonds that are assigned

Chapter Objectives a low credit rating experience default more frequently than
▪ Describe how characteristics of debt securities cause their bonds assigned a high credit rating, which suggests that the
yields to vary. rating can be a useful indicator of credit risk. However, credit
▪ Demonstrate how to estimate the appropriate yield for any rating agencies do not always detect firms’ financial problems.
particular debt security.
▪ Explain the theories behind the term structure of interest ▪ Oversight of Credit Rating Agencies — The Financial
rates (relationship between the term to maturity and the yield Reform Act of 2010 established an Office of Credit Ratings
of securities). within the Securities and Exchange Commission in order to
regulate credit rating agencies. Rating agencies must establish
Why Debt Security Yields Vary internal controls.
The yields on debt securities are affected:
▪ Credit (default) risk Exhibit 3.1 Rating Classification by Rating Agencies
▪ Liquidity DESCRIPTION OF RATINGS RATINGS
▪ Tax status SECURIT Y ASSIGNED BY: ASSIGNED BY:
▪ Term to maturity MOODY ’S STANDARD &
POOR’S
Credit (default) Risk
▪ Investors must consider the creditworthiness of the security Highest quality Aaa AAA
issuer. High quality Aa AA
▪ All else being equal, securities with a higher degree of default High–medium quality A A
risk must offer higher yields. Medium quality Baa BBB
▪ Especially relevant for longer term securities. Medium–low quality Ba BB
Low quality (speculative) B B
Use of Ratings Agencies to Assess Credit Risk
▪ Rating Agencies — Investors can personally assess the Poor quality Caa CCC
creditworthiness of corporations that issue bonds, but they Very poor quality Ca CC
may prefer to rely on bond ratings provided by rating Lowest quality (in default) C DDD, D
agencies.(Exhibit 3.1).

▪ Credit Ratings and Risk Premiums over Time — Rating

agencies can change bond ratings over time in response to
changes in the issuing firm’s financial condition.

Liquidity
▪ The lower a security’s liquidity, the higher the yield preferred
by an investor.
▪ Debt securities with a short-term maturity or an active
secondary market have greater liquidity.

Tax Status (Exhibit 3.2)

▪ Investors are more concerned with after-tax income.
▪ Taxable securities must offer a higher before-tax yield.
▪ The formulae for expected yields after-tax is calculated as
follows:
Yat = Ybt (1 − T) Term to Maturity
▪ Maturity dates will differ between debt securities.
Yat = after-tax yield ▪ The term structure of interest rates defines the relationship
Ybt = before-tax yield between possible terms to maturity and the annualized yield
T = investor’s marginal tax rate for a debt security at a specific moment in time while holding
other factors constant.
Exhibit 3.2 After-Tax Yields Based on Various Tax Rates and
Before-Tax Yields Modeling the Yield to be Offered on a Debt Security
BEFORE- BEFORE- BEFORE- BEFORE- BEFORE- When a company wants to issue debt, it needs to consider
TAX YIELD TAX TAX TAX TAX all the characteristics just described so that it can
TAX RATE YIELD 2% YIELD 4% YIELD 6% YIELD 8% determine the appropriate yield to offer that will entice
10% 1.80% 3.60% 5.40% 7.20% investors to buy its debt securities. The following model
15 1.70 3.40 5.10 6.80 incorporates the key characteristics for determining the
25 1.50 3.00 4.50 6.00 appropriate yield to be offered on a debt security:
28 1.44 2.88 4.32 5.76
35 1.30 2.60 3.90 5.20 Yn = Rf,n + DP + LP + TA

•Computing the Equivalent Before-Tax Yield: where:

Yn = yield of an n-day debt security
Rf,n = yield of an n-day Treasury (risk-free) security
DP = default premium to compensate for credit risk
LP = liquidity premium to compensate for less liquidity
TA = adjustment due to difference in tax status
A Closer Look at the Term Structure

Pure Expectations Theory

▪ According to pure expectations theory, the term structure of
interest rates is determined solely by expectations of interest
rates.
o Impact of an Expected Increase in Interest Rates
(Exhibit 3.3)
o Impact of an Expected Decline in Interest Rates
(Exhibit 3.3)
o Algebraic Presentation — If the term structure of
interest rates is solely influenced by expectations of
future interest rates, the following relationships hold:

SCENARIO STRUCTURE OF EXPECTATIONS ABOUT THE

YIELD CURVE FUTURE INTEREST RATE
1. t+1 r1 > ti1 Upward slope Higher than today’s rate
2. t+1 r1 = ti1 Flat Same as today’s rate
3. t+1 r1 < ti1 Downward slope Lower than today’s rate

Exhibit 3.3 How Interest Rate Expectations Affect the Yield

Curve

According to pure expectations theory, a one-year investment

followed by a two-year investment should offer the same
annualized yield over the three-year horizon as a three year
security that could be purchased today. This relation is expressed
as follows:

(1 + t i3 ) = (1 + t i1 )(1 + t +1 i2 )
3 2
Liquidity Premium Theory(Exhibit 3.4)
▪ The preference for the more liquid short-term securities
places upward pressure on the slope of a yield curve. Liquidity
may be a more critical factor to investors at some times than
at others, and the liquidity premium will accordingly change
over time.
▪ The model that explains these movements is called liquidity
premium theory
Exhibit 3.4 Impact of Liquidity Premium on the Yield Curve
under Three Different Scenarios
Estimation of the Forward Rate Based on a Liquidity
Premium — When expectations theory is combined with
liquidity theory, the yield on a security will not necessarily be
equal to the yield from consecutive investments in shorter-term
securities over the same investment horizon.
(1 + t +1 i 2 ) = (1 + t +1 i1 )(1 + t +1 r1 ) + LP2
2
Here,
LP2 denotes the liquidity premium on a two-year security.
The relationship between the liquidity premium and term to
maturity can be expressed as follows:
0 < LP1 < LP2 < LP3 < … LP20
Segmented Markets Theory: Investors choose securities with
maturities that satisfy their forecasted cash needs.
▪ Limitation of the Theory:
o Some borrowers and savers have the flexibility to
choose among various maturities.
▪ Implications: Preferred Habitat Theory
o Although investors and borrowers may normally
concentrate on a particular maturity market, certain
events may cause them to wander from their “natural”
or preferred market.
Integrating the Term Structure Theories
▪ Evidence suggests that expectations theory, liquidity
premium theory, and segmented markets theory all have
some validity.
▪ To understand how all three theories can simultaneously
affect the yield curve, first assume the following conditions:
o Investors and borrowers who select security
maturities based on anticipated interest rate
movements currently expect interest rates to rise.
o Most borrowers are in need of long-term funds,
whereas most investors have only short-term funds to
invest.
o Investors prefer more liquidity to less.
▪ Then all three conditions place upward pressure on long-term
yields relative to short term yields leading to upward sloping
yield curve. (Exhibit 3.5)
Exhibit 3.5 Effect of Conditions in Example of Yield Curve
 longer-term securities even though they have funds to
invest for only a short period of time.
o Firms can estimate the rates to be paid on bonds with
different maturities. This may enable them to
determine the maturity of the bonds they issue.

How the Yield Curve Has Changed over Time

▪ The yield curve is usually upward sloping, but a slight
downward slope has sometimes been evident. The yield
curves for the last few years have been very low, reflecting a
low annualized interest rate at any possible time to maturity.

Exhibit 3.6 Impact of Liquidity Premium on the Yield Curve

under Three Different Scenarios

Integrating the Theories of the Term Structure

Use of the Term Structure

▪ Forecasting Interest Rates
o The shape of the yield curve can be used to assess the
general expectations of investors and borrowers
about future interest rates.
o The curve’s shape should provide a reasonable
indication (especially once the liquidity premium
effect is accounted for) of the market’s expectations
about future interest rates.
▪ Forecasting Recessions — Some analysts believe that flat or Source: Federal Reserve.
inverted yield curves indicate a recession in the near future
International Structure of Interest Rates
▪ Making Investment and Decisions — ▪ Factors that affect the shape of the yield curve can vary among
o If the yield curve is upward sloping, some investors countries, and the yield curve’s shape at any given time also
may attempt to benefit from the higher yields on varies among countries.
▪ Interest rate movements across countries tend to be
positively correlated as a result of internationally integrated
financial markets. Actual interest rates may vary significantly
across countries at a given point in time.