Content

• Introduction
Lecture 4
The Risk and Term
Structure
of Interest Rates
1 2
• The risk structure of interest rates
• Default risk
• Ratings
• Ratings and interest rates
• Liquidity
• Differences in tax status and municipal bonds
• The term structure of interest rates
• Yield curves
• Expectations theory
• Segmented markets theory
• Liquidity premium theory

Readings
• Mishkin (2021), The Economics of
Money, Banking, and Financial Markets,
13th edition, Pearson, Chapter 6.
• Cecchetti and Schoenholtz (2012),
Money, Banking, and Financial Markets,
4th edition, McGraw-Hill, Chapter 7.
3 percentage points or basis points
Introduction
• In the previous lecture, we examined the
determination of just one interest rate. Yet there
are enormous numbers of bonds on which the
interest rates can and do differ
• Not all interest rates are created equal! We have
many interest rates at one time. But interest rates
do move together over time
• Why do interest rates differ?
• Risk structure: bonds/debt with same
maturity but different characteristics
• Term structure: bond with same
characteristics but different maturities
• Difference between two interest rates is called
spread, which is normally measured in
4
 Introduction Introduction

5 6

Risk Structure of Interest Rates Risk Structure of Interest Rates

Bonds with the same maturity have Default risk: probability that the issuer of the
different interest rates due to: bond is unable or unwilling to make interest
payments or pay off the face value
– Default risk
– Liquidity Default risk of a bond depends on (i) the
creditworthiness of the issuer, and (ii) the
– Tax considerations
structure of the bond
– U.S. Treasury bonds are considered default
free (government can raise taxes).
– Risk premium: the spread between the
interest rates on bonds with default risk
and the interest rates on (same maturity)
7 8
Treasury bonds

Ratings
• Independent companies (rating agencies) have
arisen to evaluate the creditworthiness of potential
borrowers
• The best known bond rating services are Moody’s,
Standard & Poor’s, Fitch
• They monitor the status of individual bond issuers
and assess the likelihood a lender will be repaid by
the bond issuer
• A high rating suggests that a bond issuer will have
little problem meeting a bond’s payment obligations
• Firms or governments with an exceptionally strong
financial position carry the highest ratings and are
able to issue the highest-rated bonds, Triple A
• E.g., the U.S. Government, ExxonMobil, Microsoft
Figure 2 Response to an Increase in Default
Risk on Corporate Bonds
9 10
Ratings
• The top four categories are considered investment-
grade bonds
• Speculative grade bonds are bonds issued by
companies and countries that may have difficulty
meeting their bond payments but are not at risk of
immediate default
• Highly speculative bonds include debts that are in
serious risk of default
• Both speculative grades are often referred to as junk
bonds or high-yield bonds
11 12
 TABLE 1 Bond Ratings by Moody’s, Standard
Ratings and Poor’s, and Fitch

• The distinction between investment-grade and

speculative, noninvestment-grade bonds is important
 A number of regulated institutional investors are
not allowed to invest in bonds rated below Baa on
Moody’s scale or BBB on Standard and Poor’s scale
• Bond ratings may change over time. Material changes
in a firm’s or government’s financial conditions
precipitate changes in its debt ratings
 Ratings downgrade - lower an issuer’s bond rating.
 Ratings upgrade - upgrade an issuer’s bond rating

13 14

The Impact of Ratings on Yields

Bond ratings are designed to reflect default
risk.
The lower the rating
– The higher the risk of default.
– The lower its price and the higher its yield.
To understand quantitative ratings, it is easier
to compare them to a benchmark.

15 16
The Impact of Ratings on Yields
U.S. Treasury issues are the closet to risk-free
and are commonly referred to as benchmark
bonds.
Yields on other bonds are measured in terms
of the spread over Treasuries.
Bond yield is the sum of two parts:
= U.S. Treasury yield + Default risk premium
17
The Impact of Ratings on Yields
7-19
19
The Impact of Ratings on Yields
If bond ratings properly reflect risk, then the
lower the rating if the issuer, the higher the
default-risk premium.
When Treasury yields move, all other yields
move with them.
We can see this from the next figure showing a
plot of the risk structure of interest rates.
18
The Impact of Ratings on Yields
Changes in the U.S. Treasury yields account for
most of the movement in the Aaa and Baa
bond yields.
From 1979-2009, the 10-year U.S. Treasury
bond yield has averaged almost a full
percentage point below the average yield on
Aaa bonds and two percentage points below
the average yield on Baa bonds.
20
The Impact of Ratings on Yields
A two-percentage point increase in the yield,
from 5 to 7 percent, lowers the value of the
promise of $100 in 10 years by $10.56, or 17
percent.
Clearly ratings are crucial to corporations’
ability to raise financing.
– A lower rate increases the costs of funds.
Investors clearly must be compensated for
assuming risk.
21
Sovereign Defaults
23
Companies aren’t the only ones with credit
ratings: you have one too.
There are companies keeping track of your
financial information.
All this information is combined into a credit
score, which you should care about.
The better your credit score, the lower the
interest rate you will pay on debt.
22
Sovereign Defaults
24
Hedging with Credit Default Swaps
• CDS are financial instruments used for swapping the
risk of debt default. A credit event occurs when
there is a substantial, identifiable loss.
• The buyer of a credit default swap pays a premium
for effectively insuring against a debt default. The
buyer receives a lump sum payment if the debt
instrument is defaulted. Swaps pay the buyer face
value should a borrower fail to adhere to its debt
agreements. The buyer of a credit swap receives
credit protection, whereas the seller of the swap
guarantees the credit worthiness of the product. By
doing this, the risk of default is transferred from the
holder of the fixed income security to the seller of
the swap.
25
Risk Structure of Interest Rates
Liquidity: the relative ease with which an asset
can be converted into cash
– Cost of selling a bond
– Number of buyers/sellers in a bond market
What happens to the risk premium if corporate bonds
become less liquid?
The spread between the interest rates on the two bond
types will rise. Therefore, the differences between interest
rates on corporate bonds and Treasury bonds (that is,
the risk premiums) reflect not only the corporate bond’s
default risk but its liquidity too. This is why a risk
premium is more accurately a risk and liquidity premium,
but convention dictates that it be called a risk premium 27
Hedging with Credit Default Swaps
• CDS are quoted in basis points. A basis point
equals $1,000 annually on a swap protecting $10
million of debt.
• Credit events applicable to governments are failure
to pay on the debt or restructuring of the debt.
Generally speaking, a restructuring involves reduced
payments or payments that are spread over time
without compensation.
• CDS spreads can be interpreted as a measure of the
perceived risk that a government will restructure or
default on its debt.
26
Risk Structure of Interest Rates
• Municipal bonds have lower interest rates
than T-bonds
• Municipal bonds are not risk-free
– Cleveland defaulted in early 1970s
– New York defaulted in late 1970s
– Orange County, California defaulted in 1994
• Is there a contradiction?
Income tax considerations
– Interest payments on municipal bonds are exempt
from federal income taxes.
28
Figure 3 Interest Rates on Municipal
and Treasury Bonds
Term Structure of Interest Rates
Bonds with identical risk, liquidity, and tax
characteristics may have different interest rates
because the time remaining to maturity is
different

29 30

Figure 4 Movements over Time of Interest Rates on

U.S. Government Bonds with Different Maturities Term Structure of Interest Rates
Yield curve: a plot of
the yield on bonds with
differing terms to
maturity but the same
risk, liquidity and tax
considerations
– Upward-sloping: long-
term rates are above
short-term rates
– Flat: short- and long-
term rates are the
same
– Inverted: long-term
rates are below short-
term rates
31 32
Facts that the Theory of the Term Structure of Intere
st Rates Must Explain
1. Interest rates on bonds of different
maturities move together over time
2. When short-term interest rates are low,
yield curves are more likely to have an
upward slope; when short-term rates are
high, yield curves are more likely to slope
downward and be inverted
3. Yield curves almost always slope upward
33
Expectations Theory
The interest rate on a long-term bond will
equal an average of the short-term interest
rates that people expect to occur over the life
of the long-term bond
Buyers of bonds do not prefer bonds of one
maturity over another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a
different maturity
Bond holders consider bonds with different
maturities to be perfect substitutes
35
Three Theories to Explain the Three Facts
1. Expectations theory explains the first two
facts but not the third
2. Segmented markets theory explains fact
three but not the first two
3. Liquidity premium theory combines the
two theories to explain all three facts
34
Expectations Theory: Example
Let the current rate on one-year bond be 6%.
You expect the interest rate on a one-year
bond to be 8% next year.
Then the expected return for buying two one-
year bonds averages (6% + 8%)/2 = 7%.
The interest rate on a two-year bond must be
7% for you to be willing to purchase it.
36
Expectations Theory Expectations Theory

For an investment of $1 Expected return over the two periods from investing $1 in the
it = today's interest rate on a one-period bond two-period bond and holding it for the two periods
ite1 = interest rate on a one-period bond expected for next period (1 + i2t )(1 + i2t )  1
i2t = today's interest rate on the two-period bond  1  2i2t  (i2t ) 2  1
 2i2t  (i2t ) 2
Since (i2t ) 2 is very small
the expected return for holding the two-period bond for two periods is
2i2t

37 38

Expectations Theory Expectations Theory

Both bonds will be held only if the expected returns are equal
If two one-period bonds are bought with the $1 investment
2i2t  it  ite1
(1  it )(1  i )  1
e
t 1
it  ite1
i2t 
1  it  ie
t 1  it (i )  1
e
t 1 2
it  ie
 it (ite1 ) The two-period rate must equal the average of the two one-period rates
t 1
For bonds with longer maturities
it (ite1 ) is extremely small
it  ite1  ite 2  ...  ite ( n 1)
Simplifying we get int 
n
it  ite1 The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond

39 40
Expectations Theory
• Explains why the term structure of interest rates
changes at different times
• Explains why interest rates on bonds with different
maturities move together over time (fact 1)
• Explains why yield curves tend to slope up when
short-term rates are low and slope down when
short-term rates are high (fact 2)
• Cannot explain why yield curves usually slope
upward (fact 3)
41
Segmented Markets Theory
• Bonds of different maturities are not
substitutes at all
• The interest rate for each bond with a
different maturity is determined by the
demand for and supply of that bond
• Investors have preferences for bonds of one
maturity over another
• If investors generally prefer bonds with
shorter maturities that have less interest-rate
risk, then this explains why yield curves
usually slope upward (fact 3)
42

Liquidity Premium &

Liquidity Premium Theory
Preferred Habitat Theories
• The interest rate on a long-term bond will
equal an average of short-term interest rates
expected to occur over the life of the long- it  it1
e
 it2
e
 ... it(
e

term bond plus a liquidity premium that int   lnt n1)

n
responds to supply and demand conditions where lnt is the liquidity premium for the n-period bond at time t
for that bond
lnt is always positive
• Bonds of different maturities are partial (not Rises with the term to maturity
perfect) substitutes

43 44
 Figure 5 The Relationship Between the Liquidity
Preferred Habitat Theory Premium (Preferred Habitat) and Expectations Theory

• Investors have a preference for bonds of one

maturity over another
• They will be willing to buy bonds of different
maturities only if they earn a somewhat
higher expected return
• Investors are likely to prefer short-term
bonds over longer-term bonds

45 46

Figure 6 Yield Curves and the Market’s Expectations of

Liquidity Premium and Preferred Habitat Theories Future Short-Term Interest Rates According to the Liquidity Premium
(Preferred Habitat) Theory

• Interest rates on different maturity bonds move

together over time; explained by the first term
in the equation
• Yield curves tend to slope upward when short-
term rates are low and to be inverted when
short-term rates are high; explained by the
liquidity premium term in the first case and by
a low expected average in the second case
• Yield curves typically slope upward; explained
by a larger liquidity premium as the term to
maturity lengthens

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Figure 7 Yield Curves for U.S. Government Bonds

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02/2012 50
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Practical exercise
(to be completed in your own time)
3. Investment companies attempt to explain to investors
the nature of the risk the investor incurs when buying
shares in their mutual funds. For example, Vanguard
(a U.S. company) carefully explains interest rate risk
and offers alternative funds with different interest rate
risks. Go to
http://flagship.vanguard.com/VGApp/hnw/FundsStocks
Overview.
a. Select the bond fund you would recommend to an
investor who has very low tolerance for risk and a
short investment horizon. Justify your answer.
b. Select the bond fund you would recommend to an
investor who has very high tolerance for risk and a
long investment horizon. Justify your answer.
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Practical exercise
(to be completed in your own time)
Other Readings
1. Go to www.bloomberg.com and click on Market
Data and then Rates & Bonds to find information
about the yield curve in Australia, Brazil, Germany,
Hong Kong, Japan, the United Kingdom, and the
United States. What does each of these yield curves
tell us about the public’s expectations of future
movements of short-term interest rates?
2. Go to
http://www.standardandpoors.com/ratings/en/ap/.
Find a country or corporation whose debt rating
has recently changed and explain why S&P made
the change.
Junk bonds:
http://www.econlib.org/library/Enc/JunkBonds.html
The Yield Curve as a Leading Indicator:
http://www.newyorkfed.org/research/capital_markets/yc
faq.html
NY Times, Risk Management:
http://www.nytimes.com/2009/01/04/magazine/04risk-
t.html?_r=1&em
Understanding ratings:
http://www.understandingratings.com/

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