Chapter 3

Structure of Interest Rates

1
Chapter Outline
■ Characteristics of debt securities that
cause their yields to vary
■ Explaining actual yield differentials
■ Estimating the appropriate yield
■ A closer look at the term structure
■ International structure of interest rates

2
Characteristics of Debt Securities
■ Credit (default) risk
◻ Securities with a higher degree of risk have to offer
higher yields to be chosen
◻ Credit risk is especially relevant for longer-term
securities
◻ Investors must consider the creditworthiness of the
security issuer
■ Can use bond ratings of rating agencies
■ The higher the rating, the lower the perceived credit risk
■ Ratings can change over time as economic conditions
change
■ Ratings for different bond issues by the same issuer can vary

3
Characteristics of Debt Securities
(cont’d)
■ Credit (default) risk (cont’d)
◻ Rating agencies
■ Moody’s Investor Service and Standard and Poor’s
Corporation are the most popular
■ Agencies use different methods to assess the
creditworthiness of firms and state governments
◻ A particular bond issue could have different ratings from each
agency, but differences are usually small
■ Financial institutions may be required to invest only in
investment-grade bonds rated Baa or better by Moody’s
and BBB or better by Standard and Poor’s

4
Characteristics of Debt Securities
(cont’d)
Ratings Assigned by:
Description of Security Moody’s Standard and Poor’s
Highest quality Aaa AAA
High quality Aa AA
High-medium quality A A
Medium quality Baa BBB
Medium-low quality Ba BB
Low quality (speculative) B B
Poor quality Caa CCC
Very poor quality Ca CC
Lowest quality (in default) C DDD, D
5
Characteristics of Debt Securities
(cont’d)
■ Credit (default) risk (cont’d)
◻ Shifts in credit risk premiums
■ The risk premium corresponding to a particular
bond rating can chance over time
◻ Accuracy of credit ratings
■ In general, credit ratings have served as
reasonable indicators of the likelihood of default
■ Credit rating agencies do not always detect
financial problems of firms

6
Characteristics of Debt Securities
(cont’d)
■ Liquidity
◻ Liquid securities can be easily converted to
cash without a loss in value
■ Short-maturity securities with an active secondary
market are liquid
◻ Securities with lower liquidity have to offer a
higher yield to be preferred

7
Characteristics of Debt Securities
(cont’d)
■ Tax status
◻ Investors are more concerned with after-tax income
than before-tax income
■ Taxable securities have to offer a higher before-tax yield to
be preferred
◻ The after-tax yield is equal to:

8
Characteristics of Debt Securities
(cont’d)
■ Tax status
◻ Computing the equivalent before-tax yield
■ The before-tax yield necessary to match the after-tax yield
on a tax-exempt security is:

■ State taxes should be considered along with federal taxes

9
Computing the Equivalent
Before-Tax Yield
Assume a firm in the 30 percent tax bracket is
aware of a tax-exempt security that pays a yield
of 9 percent. To match this after-tax yield,
taxable securities (with similar maturity and
:risk) must offer a before-tax yield of

10
Characteristics of Debt Securities
(cont’d)
■ Term to maturity
◻ The term structure of interest rates defines the relationship
between maturity and annualized yield
■ Special provisions
◻ A call feature allows the issuer of bonds to buy the bonds
back before maturity
■ The yield on callable bonds should be higher than on noncallable
bonds
◻ A convertibility clause allows investors to convert the bond
into a specified number of common stock shares
■ The yield on convertible bonds is lower than on nonconvertible
bonds

11
Explaining Actual Yield Differentials
■ Yield differentials are often measured in basis
points
◻ 100 basis points equal 1 percent
■ Yield differentials of money market securities
◻ Commercial paper rates are higher than T-bill rates
◻ Eurodollar deposit rates are higher than yields on
other money market securities
◻ Market forces cause the yields of all securities to
move in the same direction

12
Explaining Actual Yield Differentials
(cont’d)
■ Yield differentials of capital market securities
◻ Municipal bonds have the lowest before-tax yield
■ After-tax yield is higher than that of Treasury bonds
◻ Treasury bonds have the lowest yield
■ No default risk
■ Very liquid
◻ Investors prefer municipal or corporate bonds over
Treasury bonds only if the after-tax yield compensates
for default risk and lower liquidity

13
Estimating the Appropriate Yield
■ The yield on a debt security is based on the
risk-free rate with adjustments to capture
various characteristics:

■ Maturity is controlled for by matching the

maturity of the risk-free security to that of the
security of concern

14
Computing the Appropriate Yield
A company wants to issue 180-day commercial paper.
Six-month T-bills currently have a yield of 7 percent.
Assume that a default risk premium of 0.8 percent, a
liquidity premium of 0.1 percent, and a 0.2 percent tax
adjustment are necessary to sell the commercial paper
to investors. What is the appropriate yield the company
?should offer on its commercial paper

15
A Closer Look at the Term Structure

■ Pure expectations theory

◻ Pure expectations theory suggests that the
shape of the yield curve is determined solely
by expectations of future interest rates
◻ Assuming an initially flat yield curve:
■ The yield curve will become upward sloping if
interest rates are expected to rise
■ The yield curve will become downward sloping if
interest rates are expected to decline

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Sudden Expectation of Higher
Interest Rates
Market for short-term risk-free debt Market for long-term risk-free debt

S1 S2 S2 S1

i1 i2

D1 D2
i2 i1
D2 D1

17
Sudden Expectation of Higher
Interest Rates (cont’d)
Yield Curve

YC2

YC1

18
Sudden Expectation of Lower
Interest Rates
Market for long-term risk-free debt Market for short-term risk-free debt

S1 S2 S2 S1

i1 i2

D1 D2
i2 i1
D2 D1

19
Sudden Expectation of Lower
Interest Rates (cont’d)
Yield Curve

YC1
YC2

20
A Closer Look at the Term Structure
(cont’d)
■ Pure expectations theory (cont’d)
◻ Algebraic presentation
■ The relationship between interest rates on two-year and
one-year securities is:

■ The one-year interest rate in one year (the forward rate)

can then be estimated:

21
Computing the Forward Rate
Assume that the annualized two-year interest rate today is
8 percent. Furthermore, one-year securities currently
offer an interest rate of 5 percent. What is an estimate
?of the forward rate

22
A Closer Look at the Term Structure
(cont’d)
■ Pure expectations theory (cont’d)
◻ Algebraic presentation (cont’d)
■ The one-year interest rate in two years (the forward
rate) can also be estimated:

23
Computing the One-Year Interest
Rate Two Years from Now
Continuing with the previous example, assume that
three-year securities currently offer an interest rate of
10 percent. What is an estimate of the one-year interest
?rate that will prevail two years from now

24
A Closer Look at the Term Structure
(cont’d)
■ Pure expectations theory (cont’d)
◻ Algebraic presentation (cont’d)
■ Future annualized interest rates for periods other than
one year can also be computed using the yield curve
■ A one-year investment followed by a two-year
investment should offer the same yield as a three-year
security:

25
Computing the Two-Year Interest
Rate One Year from Now
Continuing with the previous example, what is an
estimate of the two-year interest rate that will prevail
?in one year

26
A Closer Look at the Term Structure
(cont’d)
■ Pure expectations theory (cont’d)
◻ The theory assumes that forward rates are
unbiased estimators of future interest rates
◻ If forward rates are biased, investors should
attempt to capitalize on the discrepancy

27
A Closer Look at the Term Structure
(cont’d)
■ Liquidity premium theory
◻ According to the liquidity premium theory, the
yield curve changes as the liquidity premium
changes over time due to investor preferences
■ Investors who prefer short-term securities will hold
long-term securities only if compensated with a premium
■ Short-term securities are typically more liquid than
long-term securities
◻ The preference for short-term securities places
upward pressure on the slope of the yield curve

28
A Closer Look at the Term Structure
(cont’d)
■ Liquidity premium theory (cont’d)
◻ Estimation of the forward rate based on a liquidity
premium
■ The yield on a security will not necessarily be equal to
the yield from consecutive investments in shorter-term
securities:

■ The relationship between the liquidity premium and the

term to maturity is:

29
A Closer Look at the Term Structure
(cont’d)
■ Liquidity premium theory (cont’d)
◻ Estimation of the forward rate based on a liquidity premium
(cont’d)
■ The one-year forward rate can be derived as:

■ A positive liquidity premium means that the forward rate

overestimates the market’s expectations of the future interest
rate
■ A flat yield curve means the market is expecting a slight
decrease in interest rates
■ A slight upward slope means no expected change in interest
rates

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Computing the Forward Rate
With A Liquidity Premium
Assume that one-year interest rates are currently 10
percent. Further assume that two year interest rates are
equal to 8 percent. The liquidity premium on a two-year
security is 0.7 percent. What is an estimate of the
?one-year forward rate

31
A Closer Look at the Term Structure
(cont’d)
■ Segmented market theory
◻ According to segmented markets theory,
investors and borrowers choose securities with
maturities that satisfy their forecasted cash needs
■ Pension funds and life insurance companies prefer
long-term investments
■ Commercial banks prefer short-term investments
◻ Shifting by investors or borrowers between
maturity markets only occurs if the timing of their
cash needs change

32
 Impact of Different Scenarios –
Segmented Markets Theory
Investors Have Mostly Investors Have Mostly
Short-Term Funds Long-Term Funds
Available; Borrowers Available; Borrowers
Want Long-Term Funds Want Short-Term Funds
Supply of short-term funds Upward pressure Downward pressure
provided by investors
Demand for short-term funds by Downward pressure Upward pressure
borrowers
Yield on new short-term Downward pressure Upward pressure
securities
Supply of long-term funds Downward pressure Upward pressure
provided by investors
Demand for long-term funds Upward pressure Downward pressure
issued by borrowers
Yield on long-term securities Upward pressure Downward pressure

Shape of yield curve Upward slope Downward slope33

A Closer Look at the Term Structure
(cont’d)
■ Segmented market theory (cont’d)
◻ Limitations of the theory
■ Some borrowers and savers have the flexibility to choose
among various maturity markets
◻ e.g., Corporations may initially obtain short term funds if
they expect long-term interest rates to decline
◻ If markets were segmented, an adjustment in the interest
rate in one market would have no impact on other markets,
but evidence shows this is not true

34
A Closer Look at the Term Structure
(cont’d)
■ Segmented market theory (cont’d)
◻ Implications
■ The preference for particular maturities can affect the
prices and yields of securities with different maturities
and therefore the shape of the yield curve
■ The preferred habitat theory is a more flexible
perspective
◻ Investors and borrowers may wander from their markets
given certain events

35
A Closer Look at the Term Structure
(cont’d)
■ Research on term structure theories
◻ Interest rate expectations have a strong influence on the
term structure
◻ The forward rate from the yield curve does not accurately
predict future interest rates
◻ Variation in the yield-maturity relationship cannot be
explained by interest rate expectations or liquidity
◻ General research implications
■ Some evidence for pure expectations, liquidity premium, and
segmented markets theory

36
A Closer Look at the Term Structure
(cont’d)
■ Uses of the term structure
◻ Forecast interest rates
■ Pure expectations and liquidity premium theories can be
used
◻ Forecast recessions
■ A flat or inverted yield curve may indicate a recession in
the near future since lower interest rates are expected

37
A Closer Look at the Term Structure
(cont’d)
■ Uses of the term structure (cont’d)
◻ Investment decisions
■ Riding the yield curve involves investment in
higher-yielding long-term securities with short-term funds
■ Financial institutions whose liability maturities are
different from their asset maturities monitor the yield
curve
◻ Financing decisions
■ Assessing prevailing rates on securities for various
maturities allows firms to estimate the rates to be paid on
bonds with different maturities

38
A Closer Look at the Term Structure
(cont’d)
■ Impact of debt management on term structure
◻ If the Treasury uses a relatively large proportion of long-term
debt, this places upward pressure on long-term yields
◻ If the Treasury uses short-term debt, long-term interest rates
may be relatively low
■ Historical review of the term structure
◻ Early 1980s: downward sloping yield curve
◻ 1982 to 2001: an upward sloping yield curve generally
persisted
◻ September 11, 2001: investors shifted funds into short-term
securities and the Fed provided funds to the banking system,
causing the yield curve to become steeper

39
International Structure of Interest
Rates
■ Yield curves vary among countries
■ Interest rate movements across countries
tend to be positively correlated
■ Interest rates may vary across countries at
any particular point in time
◻ Supply and demand conditions across
countries cause differences

40