© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 7 The Risk and Term Structure of Interest Rates

7-2 Risk & Term Structure: The Big Questions 1. Why do different bonds have different yields? 2. What information is there in the relative yield of different bonds?

7-3 Risk & Term Structure: Roadmap Ratings and the risk structure –Bonds –Commercial Paper Differences in tax status The term structure Information content

7-4 Bond Ratings Bond Ratings - Moody’s and Standard and Poor’s Ratings Groups Investment Grade Non-Investment –Speculative Grade –Highly Speculative

7-5 Bond Ratings: Junk or High-Yield Bonds Speculative grade –below Moody’s Baa –below S&P BBB Fallen angels: Originally investment grade, but issuer did poorly. Original-issue: Little known about the issuers

7-6 Bond Ratings: Changes Ratings downgrade Borrower encounters problems Ratings upgrade Prospects of repayment improve.

7-7 Bond Ratings: Investment Grade

7-8 Bond Ratings: Speculative Grades

7-9 Commercial Paper: What is it? Short-term (less than 270 days) bond Unsecured. Issued on a discount basis Only most creditworthy borrowers can issue it.

7-10 Commercial Paper: Ratings

7-11 Bond Ratings and Risk: Impact of Ratings on Yields Risk  Bond Demand  Bond Price  Bond Yield 

7-12 Bond Ratings and Risk: Impact of Ratings on Yields Bond Yield = U.S. Treasury Yield + Default Risk Premium (Default risk premium sometimes called risk spread or the spread over Treasuries.)

7-13 When GM and Ford bonds were downgraded, auto loan rates were the same. Auto loans are bundled together in pools – these are asset-backed securities. Even though GM and Ford were doing poorly, the probability that car buyers would repay was unaffected.

7-14 Bond Ratings and Risk: Risk Structure of Interest Rates

7-15 Your credit rating is your credit score Credit score based on paying on time Credit score  interest rate on loans Worse score  higher interest rate

7-16 Tax Status and Bond Prices Coupon Payments on Municipal Bonds are exempt from Federal Tax Payments. Interest income from bonds issued by one government are not taxed by another government

7-17 Tax Status and Bond Prices Tax-Exempt Bond Yield = (Taxable Bond Yield) x (1- Tax Rate).

7-18 Things to keep in mind: What is the tax status of the bonds? Only the IRS taxes interest on U.S. Treasury bonds Municipal bonds are worth holding if your tax rate is high enough Never hold tax-exempt bonds in a retirement account Watch when tax rates change, the best bond for you may change, too

7-19 Term Structure of Interest Rates: Preliminaries Definition of the Term Structure: The relationship among bonds with the same risk characteristics but different maturities is called the term structure of interest rates. Yield Curve: A plot of the term structure, with the yield to maturity on the vertical axis and the time to maturity on the horizontal axis.

7-20 Term Structure of Interest Rates

7-21 Term Structure of Interest Rates: Yield Curve The U.S. Treasury Yield Curve: October 12, 2006.

7-22 Term Structure of Interest Rates: Facts to Explain 1.Interest Rates of different maturities tend to move together 2.Yields on short-term bond are more volatile than yields on long-term bonds 3.Long-term yields tend to be higher than short-term yields.

7-23 Term Structure of Interest Rates: Expectations Hypothesis Assumption: Bonds of different maturities are perfect substitutes for each other. Implies: Investor w/ a two-year horizon indifferent between: 1. A 2 yr bond for 2 yrs 2. A 1 yr bond and a second 1yr bond in 1 yr.

7-24 Term Structure of Interest Rates: Expectations Hypothesis 1. Total return from 2 year bonds over 2 years 2. Return from 1 yr bond and then another 1 yr bond

7-25 Term Structure of Interest Rates: Expectations Hypothesis If one and two year bonds are perfect substitutes, then: or Long-term interest rate = average of expected future short-term interest rates

7-26 Term Structure of Interest Rates: Expectations Hypothesis

7-27 Term Structure of Interest Rates: Expectations Hypothesis General formula:

7-28 Term Structure of Interest Rates: Expectations Hypothesis

7-29 Term Structure of Interest Rates: Expectations Hypothesis Explains: 1.Interest Rates of different maturities tend to move together 2.Yields on short-term bond are more volatile than yields on long-term bonds BUT NOT 3. Long-term yields tend to be higher than short-term yields.

7-30 Term Structure of Interest Rates: Liquidity Premium Theory The yield curve’s upward slope is explained by the fact that long-term bonds are riskier than short-term bonds. Bondholders face both inflation and interest-rate risk. The longer the term of the bond, the greater both types of risk.

7-31 Term Structure of Interest Rates: Liquidity Premium Theory Explaining the fact that the yield curve normally slopes up: –Bondholders face both inflation and interest-rate risk. –The longer the term of the bond, the greater both types of risk. –The bigger the risk, the higher the risk premium

7-32 Term Structure of Interest Rates: Liquidity Premium Theory General Formula:

7-33 Read the title Read the label on the horizontal axis Read the label on the vertical axis

7-34 Information Content of Interest Rates: Risk Structure When the economy starts to slow, it puts a strain on private firms. A slower economy means a higher default probability Increased default risk is different across firms Firms already doing poorly, do even worse

7-35 Information Content of Interest Rates: Risk Structure Lower initial grade of a bond, the worse they do in a downturn The risk spread is an excellent measure of activity

7-36 During financial crises, people take cover. They sell risky investments & buy safe ones. This is a flight to quality This is what happened in 1998

7-37 Information Content of Interest Rates: Risk Structure

7-38 Information Content of Interest Rates: Term Structure When the yield curve slopes down, it is called inverted An inverted yield curve is a very valuable forecasting tool It signals an economic downturn

7-39 Information Content of Interest Rates: Term Structure

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 7 End of Chapter