Lecture Note Four: Bond Yields and

Interest Rate Structure

FINA3323 Fixed Income Securities

HKU Business School
University of Hong Kong

Dr. Huiyan Qiu

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 Outline
Benchmark interest rate and bond yields
Factors affecting bond yields
Yield curve and theoretical spot rate curve
Spot rates and forward rates
Term structure of interest rate: shape and theories

Reference: Fabozzi’s chapter 5, Tuckman’s chapter 2

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 Where have we been?
The price of bond is the present value of all future cash
flows. We used the following bond pricing function (1)
to determine the bond price, (2) to examine the yield to
maturity, and (3) to study the bond price volatility.

Note: the discount rate used here is the bond yield.

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 Where are we going?
We want to understand bonds better by asking

• Why do different bonds have different yields? What affect

the bond yield?

• How to get the theoretical spot rate from Treasury

securities? What is forward rate?

• What is the term structure of interest rate? How to explain

different interest rate structure?

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 Benchmark Yields
The minimum yield that investors demand for investing
in a fixed income security is referred to as the base yield
or benchmark yield.
Securities offering benchmark yield are referred to as
benchmark securities.
• Should be liquid and actively traded with no credit risk.
• Should have active repo market as well as active future
market.

Benchmark yield and bond yield 4-5

 Benchmark Securities
U.S. Treasury securities are often considered as the
benchmark securities.
• The securities are backed by the full faith and credit of the
U.S. government.
• Treasury securities are the key interest rates in the U.S.
economy as well as in international capital.
Since Hong Kong dollar is linked to the US dollar,
domestic interest rates in Hong Kong are primarily
influenced by interest rates in the U.S.

Benchmark yield and bond yield 4-6

 Interest Rates

3-month LIBOR

Fed Fund Rate 3-month HIBOR

Benchmark yield and bond yield 4-7

 U.S. Treasury Security Yields
Maturity Yield
Figure: the
average of daily US 3-month 1.5488
Treasury yield
curve rates from 6-month 1.5378
January 1 to 2-year 1.4298
February 28, 2020.
3-year 1.4178
Source:
US Department of Trea 5-year 1.4490
sury, Resource Center
10-year 1.6373

30-year 2.0995
 Benchmark Interest Rate
With the development of swap market, the interest rate
swap market in most countries outside US is
increasingly used as an interest rate benchmark despite
of the existence of a liquid government bond market.
• Interest rate in government bond market may not be
representative of the true interest rate (technical or
regulatory factor; limited maturities)
• Differences in the credit risk for each country makes it
difficult to compare government yields across countries.

Benchmark yield and bond yield 4-9

 Bond Yield Spreads
For riskier security, risk-averse investors demand higher
yield than benchmark yield.
Yield spread = bond yield – benchmark yield
The yield spread reflects the compensation that the
market is offering for bearing the risks associated with
the non-benchmark bond.
Yield spread can be defined between two bonds. It
reflects the difference in risks associated with the two
bonds.
Yield spread = yield on bond A – yield on bond B
Benchmark yield and bond yield 4-10
 Bond Yield Spreads
Some market participants measure the risk premium on a
relative basis by taking the ratio.

Benchmark yield and bond yield 4-11

 Bond Yield Spreads
The factors that affect the yield spread include:
• Credit risk
• Inclusion of options
• Liquidity
• Tax status
• Term to maturity

Factors affecting bond yields 4-12

 Yield Spread: Credit Risk
Credit risk, mainly default risk, refers to the risk that the
issuer of a bond may be unable to make timely principal
and/or interest payments.
Most market participants rely primarily on commercial
rating companies to assess the default risk of an issuer.
• S&P/Fitch rating system: AAA, AA, A, BBB, BB, B, and
CCC
• Moody’s ratings: Aaa, Aa, A, Baa, Ba, B, and Caa

Factors affecting bond yields 4-13

 Yield Spread: Credit Risk
Bonds with ratings of BBB (or Baa) and above are
considered to be “investment grade”
The spread between Treasury securities and non-
Treasury securities that are identical in all respects
except for quality is referred to as a credit spread.
Examples of credit spreads are provided on the next
slide.
• As can be seen, for a given maturity, the higher the credit
rating is, the smaller the credit spread.

Factors affecting bond yields 4-14

 Yield Spread: Credit Risk
Corporate Bond Yields and Risk Premium Measures Relative
to Treasury Yields on February 26, 2011

Factors affecting bond yields 4-15

 Yield Spread: Inclusion of Options
Some bonds include a provision that gives either the
bondholder and/or the issuer an option to take some
action against the other party.
The presence of an embedded option has an effect on the
spread of an issue.
• Callable bonds: investors demand higher yield on
callable bonds, especially when rates are expected to fall
in the future.
• Convertible bonds: investors will accept a lower yield
for convertible bonds because investor return include
expected return on equity participation.
Factors affecting bond yields 4-16
 Yield Spread: Liquidity
The liquidity of a security affects the yield/price of the
security.
A liquid investment can be easily converted to cash at
minimum transactions cost. Investors pay more for
liquid investment (lower yield).
Liquidity is often associated with short-term, low default
risk, marketable securities.
Measures of liquidity include bid-ask spread, turnover
ratio…

Factors affecting bond yields 4-17

 Yield Spread: Tax Status
Tax status of income or gain on security impacts the
security yield.
Investors are concerned with after-tax return or yield.
Thus, investors require higher yield for higher taxed
securities.
• Because of the tax-exempt feature of municipal bonds, the
yield on municipal bonds is less than securities with the
same maturity.
• Example: given 20% tax rate, the fully taxable pre-tax
equivalent corporate bond for a 11.2% municipal bond is
11.2%/(1-0.2)=14%.
Factors affecting bond yields 4-18
 Yield Spread: TTM
The term to maturity is the time remaining on a bond’s
life.
Interest rate typically vary by maturity.
The term structure of interest rates defines the
relationship between maturity and yield.
The graphical depiction of the relation between the yield
on bonds of the same credit quality but different
maturities is often referred to as yield curve.

Factors affecting bond yields 4-19

 Yield Curve
Investors have typically constructed yield curves from
observations of prices and yields in the Treasury market
for two reasons:
• First, Treasury securities are free of default risk, and
differences in credit worthiness do not affect yields.
Therefore, these instruments are directly comparable.
• Second, as the largest and most active bond market, the
Treasury market offers the fewest problems of illiquidity
or infrequent trading.

Yield curve and spot rate curve 4-20

 Treasury Yield Curve

Source: US Department of Treasury, Resource Center

Yield curve and spot rate curve 4-21
 Yield Curve Shapes

Yield curve and spot rate curve 4-22

 Bond Valuation
The bond pricing formula assumes that one interest rate
should be used to discount all the bond’s cash flows.
Non-flat term structure of interest rate implies that each
cash flow should be discounted at a unique rate
appropriate for the time period in which the cash flow
will be received.
The correct way to think about bonds is that they are
packages of zero-coupon instruments.
• The value of the bond should equal the value of all the
component zero-coupon instruments.

Yield curve and spot rate curve 4-23

 Zero-Coupon Instruments
To determine the value of each zero-coupon instrument,
it is necessary to know the yield on a zero-coupon
Treasury with that same maturity
• This yield is the spot rate, and the graphical depiction of
the relationship between the spot rate and maturity is
called the spot rate curve.
It is not possible to construct a spot rate curve solely
from observations of market activity on Treasury
securities because there are no zero-coupon Treasury
debt issues with a maturity greater than one year.

Yield curve and spot rate curve 4-24

 The Theoretical Spot Rate Curve
Using yields of the actually traded Treasury debt
securities, we can theoretically derive the spot rate
curve. This curve is called a theoretical spot rate
curve.
Candidates for inclusion are
• On-the-run Treasury issues
• On-the-run Treasury issues and selected off-the-run
Treasury issues
• All Treasury coupon securities and bills
• Treasury coupon strips
Yield curve and spot rate curve 4-25
 Different Methodologies
The methodology used to calculate the theoretical spot
rate curve depends on the securities used.
• If Treasury coupon strips are used
• The observed yields are the spot rates
• If on-the-run Treasury issues (with or without selected
off-the-run issues) are used
• A methodology called bootstrapping is used
• If all Treasury coupon securities and bills are used
• Statistical methodologies must be employed (such as
exponential spline fitting)

Yield curve and spot rate curve 4-26

 Using Treasury Coupon Strips
STRIPS is short for “separate trading of registered
interest and principal securities”.
Treasury coupon strips are zero-coupon Treasury
securities. It seems logical to use the observed yield on
strips to construct an actual spot rate curve.
However, there are three problems with using the
observed rates on strips.
1. The liquidity of the strips market is not as great as that
of the Treasury coupon market
• Observed rates reflect a premium for liquidity
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 Problems with Using Treasury Coupon Strips

2. The tax treatment of strips is different from that of

Treasury coupon securities
• Accrued interest on strips is taxed even though no cash is
received by the investor
3. There are maturity sectors in which non-U.S. investors
find it advantageous to trade off yield for tax
advantages associated with a strip
• Certain foreign tax authorities grant favorable tax
treatment only when a strip is created from the principal
rather than the coupon

Yield curve and spot rate curve 4-28

 On-the-Run Treasury Issues
Selected Treasury Issues
• 3-month Treasury bill
• 6-month Treasury bill
• 1-year Treasury bill
• 2-year Treasury note
• 3-year Treasury note
• 5-year Treasury note
• 10-year Treasury note
• 30-year Treasury bond

Yield curve and spot rate curve 4-29

 Step One
Collect the par coupon yields on the current on-the-run
Treasuries.
Use linear interpolation to fill in the missing maturities
to create the par yield curve.
• If the yield on the par coupon curve is given at two
maturity points, the per period yield difference is
calculated as

Yield curve and spot rate curve 4-30

 Linear Interpolation – Example
The par yields for the 2-year and 5-year on-the-run
issues are 6.0% and 6.6% respectively.
There are six semiannual periods between these two
maturity points. Calculate
• 2.5-year yield = 6.00% + 0.10% = 6.10%
• 3.0-year yield = 6.10% + 0.10% = 6.20%
• 3.5-year yield = 6.20% + 0.10% = 6.30%
• 4.0-year yield = 6.30% + 0.10% = 6.40%
• 4.5-year yield = 6.40% + 0.10% = 6.50%

Yield curve and spot rate curve 4-31

 Step Two
Next step is to use the bootstrapping method to find the
theoretical spot rate curve.
Example: following are four hypothetical Treasuries
with par yield.

A Treasury bill is a zero-coupon instrument

• Its annualized yield is equal to the spot rate
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 Bootstrapping
Let R0,t denote the annualized spot rate for period t. R0,1
= 5.25% and R0,2 = 5.50%.
Now consider the 1.5-year Treasury coupon bond. Use
$100 as the par value, then

Solving for R0,3 gives R0,3 = 5.76%

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 Bootstrapping (cont’d)
Consider the 2-year Treasury coupon bond. Use $100 as
the par value, then

Solving for R0,4 gives R0,4 = 6.02%

The process may now be repeated to find the rest of the
theoretical spot rates up to 30 years maturity.

Yield curve and spot rate curve 4-34

Problems with Using Just the On-the-Run Issues

There is a large gap between some of the maturity

points, which may result in misleading yields for those
maturity points when estimated using the linear
interpolation method.
Yields for the on-the-run issues may be misleading
because most offer favorable financing opportunities in
the repo market, so the true yield would be greater than
the quoted (observed) yield.
To mitigate this problem, some dealers and vendors use
selected off-the-run Treasury issues.
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 Forward Rates
From the yield curve we can extrapolate the theoretical
spot rates. In addition, we can extrapolate the forward
rate.
A forward rate is an interest rate that is specified now
for a loan that will occur at a specified future date.
Let f0,i,n denote the forward interest rate observed at time
0 (the first subscript) that begins in i periods and ends in
n periods
• It is an interest rate that is implied by the rates prevailing
in the market today

Forward rate 4-36

 Forward Rates
Consider the following two choices
• Alternative 1: Invest $100 in a six-month instrument and
when it matures in six months, “roll over” the funds into
another six-month instrument
• Alternative 2: Invest $100 in a one-year instrument and
hold it to maturity
Which strategy is better?
It depends on the total (holding-period) return

Forward rate 4-37

 Forward Rates
Let r0,1 be the per-period yield on a 6-month instrument
Let r0,2 be the per-period yield on a 1-year instrument

Forward rate 4-38

 Forward Rates
Then, the return on
• Alternative 1 is $100(1 + r0,1)(1 + f0,1,2)
• Alternative 2 is $100(1 + r0,2)2
An investor will be indifferent between the two
alternatives when
$100(1 + r0,1)(1 + f0,1,2) = $100(1 + r0,2)2
In general, forward rate from period i to period n is
given by

Forward rate 4-39

 Forward Rates: Example
Given that the 1-year forward rate on a 1-year Treasury
bill is 4.32% and the 1-year spot rate is 3.8%, what is the
2-year spot rate?

Solution:

Solve for to get = 4.06%.

Forward rate 4-40

 Using Forward Rates
In general, one-period forward rates and a one-period
spot rate can be related to a t-period spot rate by

where
• r0,t = the (per-period) t-period spot rate
• f0,t–1,t = the one-period forward rate from time t – 1 to time t

Forward rate 4-41

 Term Structure of Interest Rate
Historically, the shape of term structure of interest rate is
not always increasing. There are three facts:
• Interest rates of different maturities tend to move together.
• Yields on short-term bonds are more volatile than yields
on long-term bonds.
• Long-term yields tend to be higher than short-term yields.
That is, the yield curve is upward-sloping most of time.

Term structure of interest rate 4-42

 Treasury Yield Curve

Source: US Department of Treasury, Resource Center

Term structure of interest rate 4-43

Treasury Yield Over Time

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 Term Structure Theories
There are several explanations/interpretations:
• Pure expectation theory
• Bonds of different maturities are perfect substitutes
• Liquidity preference theory
• Investors prefer short-term bonds
• Segmented markets theory
• Bonds of different maturities are not substitutes at all

Term structure of interest rate 4-45

 Pure Expectation Theory
Pure expectation theory assumes that bonds of different
maturities are perfect substitutes for each other.
This implies that investors have no maturity preferences
and are indifferent in the following two alternatives:
• Alternative 1: invest in 2-year bond for 2 years
• Alternative 2: invest in 1-year bond and a second 1-year
bond in 1 year.

Term structure of interest rate 4-46

 Pure Expectation Theory (cont’d)
The indifference means
(
where is the expected 1-year interest rate 1 year later.
From the relationship between forward rates and spot
rates, we have

That is, forward rate exclusively represents the expected

future rates.

Term structure of interest rate 4-47

 Pure Expectation Theory (cont’d)
From (, we also have .
Hence . In general,

This implies that long-term rates are average of current

short-term and expected future short-term rates.

Term structure of interest rate 4-48

 Pure Expectation Theory (cont’d)
Under the pure expectation theory, the shape of yield
curve tells us the direction of expected short-term rates.
• Expect short-term rates to rise  the average of short-
term rates will be bigger than the current short-term rates
 long-term rates are higher  upward sloping yield
curve
• Expect short-term rates to fall  downward sloping yield
curve
• Expect short-term rates to stay unchanged  flat yield
curve

Term structure of interest rate 4-49

 Pure Expectation Theory (cont’d)
Pure expectation theory explains
• Fact 1: Interest rates of different maturities tend to move
together.
• Fact 2: Yields on short-term bonds are more volatile than
yields on long-term bonds.
But not
• Fact 3: The yield curve is upward-sloping most of time.

Term structure of interest rate 4-50

 Liquidity Preference Theory
Liquidity preference theory assumes that
• investors prefer short-term bonds because of liquidity
concern.
Thus, long-term securities and associated risks are
desirable only with increased yields.
Liquidity preference theory is consistent with the
empirical result that yield tend to be upward sloping
more often than they are downward sloping.

Term structure of interest rate 4-51

 Market Segmentation Theory
Market segmentation theory assumes that
• investors have preferred habitats and do not shift from one
maturity to another
• and bonds of different maturities are not substitutes at all.
This implies separate markets for short-term and long-
term bonds.
The shape of yield curve can be upward sloping or
downward sloping. No information on the expected
future short-term rates.

Term structure of interest rate 4-52

 Use of Term Structure
The knowledge of the term structure of interest rate can
be used to
• Forecast future interest rates and determine future bond
prices.
• Forecast recessions. Flat or inverted yield curves have
been a good predictor of recessions.
• Make appropriate investment and financing decisions.
• Timing of investment and financing
• Long-term vs. short-term

Term structure of interest rate 4-53

End of the Notes!

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