Bond Ratings and Risk Raters Moody’s, Standard and Poor’s, Fitch Ratings Investment Grade Non-Investment – Speculative Grade Highly Speculative
Bond Yield = U.S. Treasury Yield + Default Risk Premium
Long-Term Bond Interest Rates and Ratings
Short-Term Interest Rates and Risk
Tax Status and Bond Prices Coupon Payments on Municipal Bonds are exempt from Federal Taxes Tax-Exempt Bond Yield = (Taxable Bond Yield) x (1- Tax Rate) State and local governments can raise funds at a lower interest rates because of the tax exempt status of their bonds
Term Structure of Interest Rates : Term Structure : the relationship among bonds with the same risk characteristics but different terms to maturity 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
Web Link: US Treasury Bloomberg.com
Term Structure “Facts” Interest Rates of different maturities tend to move together Yields on short-term bond are more volatile than yields on long-term bonds Long-term yields tend to be higher than short-term yields.
Expectations Hypothesis Bonds of different maturities are perfect substitutes for each other. – –You end up with the same future value whether you buy a long-term bond and carry it to maturity or whether you buy a short-term bond now and turn the proceeds over for new short- term bonds when the old bonds mature An investor with a two-year horizon can: – –Buy a 2 year bond now or – –Buy a one year bond now and another one year bond in one year, when the first bond matures
Total return from 2 year bonds over 2 years Return from one year bond and then another one year bond
If bonds of different maturities are perfect substitutes for each other, both options are equally good: Or
According to the expectations theory:
BUT … Expectations Theory can not explain why long-term rates are usually above short term 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.
Liquidity Premium Theory: There is a risk premium on long-term bonds … the longer the term, n, the greater the risk premium, rp n
Risk premia increase when the economy enters recessions