Chapter 11. The Level & Structure of Interest Rates Loanable funds market Risk Structure of Interest Rates Loanable funds market Risk Structure of Interest Rates

I. Loanable Funds Market determine equilibrium interest rate overall level of interest rates  but still many different interest rates determine equilibrium interest rate overall level of interest rates  but still many different interest rates

Demand for LF behavior of issuers & borrowers interest rate is cost of borrowing  it is the price of loanable funds demand is downward sloping behavior of issuers & borrowers interest rate is cost of borrowing  it is the price of loanable funds demand is downward sloping

LF i D LF

what shifts demand? tax rules  favorable tax treatment for interest payments increase demand  mortgage interest deductible  bond interest deductible for issuer tax rules  favorable tax treatment for interest payments increase demand  mortgage interest deductible  bond interest deductible for issuer

expected profitability  increases will encourage investment & borrowing -- increase demand  increases w/ economic expansion, decreases w/ recession expected profitability  increases will encourage investment & borrowing -- increase demand  increases w/ economic expansion, decreases w/ recession

government borrowing  deficits increase demand  surpluses decrease demand government borrowing  deficits increase demand  surpluses decrease demand

Supply of LF behavior of savers, lenders, bond buyers interest rate is reward for saving  postpone present consumption supply curve is upward sloping behavior of savers, lenders, bond buyers interest rate is reward for saving  postpone present consumption supply curve is upward sloping

LF i S LF D LF

what shifts supply? tax rules  favorable treatment of interest income  pensions tax exempt interest tax rules  favorable treatment of interest income  pensions tax exempt interest

income & wealth  increases will increase amount and % of saving rate of time preference  people more/less willing to postpone consumption income & wealth  increases will increase amount and % of saving rate of time preference  people more/less willing to postpone consumption

FOMC policy  if Fed buys Treasuries, increase supply of LF FOMC policy  if Fed buys Treasuries, increase supply of LF

ExampleExample Fed sell Treasuries  decrease S LF Federal gov’t runs a deficit  increase D LF Fed sell Treasuries  decrease S LF Federal gov’t runs a deficit  increase D LF

LF i S LF D LF interest rate rises

What is i? benchmark interest rate or base interest rate minimum rate acceptable to lenders  all other rates compared to benchmark  Treasury yield -- default-free, highly liquid benchmark interest rate or base interest rate minimum rate acceptable to lenders  all other rates compared to benchmark  Treasury yield -- default-free, highly liquid

III. Risk Structure of Interest Rates different interest rates on assets with same maturity why?  assets have different characteristics different interest rates on assets with same maturity why?  assets have different characteristics

measurementmeasurement difference between two interest rates  spread measured in  percentage points  basis points  1 percentage pt. = 100 basis pts. difference between two interest rates  spread measured in  percentage points  basis points  1 percentage pt. = 100 basis pts.

example 1 3 mo. Tbill.95% 3 mo. Commercial paper 1.02 % spread.07 percentage pts. 7 basis pts. 3 mo. Tbill.95% 3 mo. Commercial paper 1.02 % spread.07 percentage pts. 7 basis pts.

example 2 10 yr Tnote3.85% 10 BAA corporate5.02% spread  1.07 percentage pts.  107 basis pts. 10 yr Tnote3.85% 10 BAA corporate5.02% spread  1.07 percentage pts.  107 basis pts.

3/5/20043/5/ mo Tbill.95% 3 mo Commerical Paper1.02% 10 yr. Tnote3.85% 10 yr. AAA corporate4.31% 10 yr. BAA corporate5.02% 10 yr. AAA muni3.47% 30 yr. mortgage 5.36% 3 mo Tbill.95% 3 mo Commerical Paper1.02% 10 yr. Tnote3.85% 10 yr. AAA corporate4.31% 10 yr. BAA corporate5.02% 10 yr. AAA muni3.47% 30 yr. mortgage 5.36%

PatternsPatterns Baa always the highest yield Municipal’s always the lowest (1940) Baa > AAA > U.S. > municipal  size of the spread varies Baa always the highest yield Municipal’s always the lowest (1940) Baa > AAA > U.S. > municipal  size of the spread varies

Risk premium base interest rate + risk premium = interest rate on corporate debt base interest rate + risk premium = interest rate on corporate debt

size of risk premium issuer default/credit risk liquidity maturity (chapter 12) options tax treatment issuer default/credit risk liquidity maturity (chapter 12) options tax treatment

IssuerIssuer spreads exist among different issuers but usually a function of other factors spreads exist among different issuers but usually a function of other factors

Default risk/ credit risk risk of not receiving timely payment of principal and interest depends on  creditworthiness of issuer  structure of bond risk of not receiving timely payment of principal and interest depends on  creditworthiness of issuer  structure of bond

U.S. government debt zero default risk backed by “full faith and credit” of U.S. government why?  power to tax largest economy  power to issue stable currency zero default risk backed by “full faith and credit” of U.S. government why?  power to tax largest economy  power to issue stable currency

Other issuers private foreign municipal all have some default risk rated for default risk private foreign municipal all have some default risk rated for default risk

Bond ratings bond issuer pays rating agency  Moody’s, S&P high credit rating  low default risk bond ratings may change over time bond issuer pays rating agency  Moody’s, S&P high credit rating  low default risk bond ratings may change over time

default risk & yield investors are risk averse higher default risk lower credit rating higher yield

so default risk explains Treasury yields AAA Corp yields BAA Corp yields <<

default risk is not constant! varies over the business cycle  higher in recessions  lower in expansions Baa vs. Treasury bond yield  12/ basis pts.  2/ basis pts.  3/ basis pts. varies over the business cycle  higher in recessions  lower in expansions Baa vs. Treasury bond yield  12/ basis pts.  2/ basis pts.  3/ basis pts.

Bond ratings (p. 400) AAA AA A Aaa Aa A BBB BB B Baa Ba B CCC CC C Caa Ca C Moody’s S&P Investment grade High Yield

B. Liquidity how quickly/cheaply can bond be sold for cash? higher liquidity lower yield

liquidity is not rated Treasuries most liquid depends on size of issuer related to default risk  bonds in default very illiquid  higher-rated bonds tend to be more liquid Treasuries most liquid depends on size of issuer related to default risk  bonds in default very illiquid  higher-rated bonds tend to be more liquid

Embedded Options special rights granted to holder or issuer of bond affect on yield spread depends on option  beneficial to issuer?  beneficial to holder? special rights granted to holder or issuer of bond affect on yield spread depends on option  beneficial to issuer?  beneficial to holder?

options for issuer increase yield relative to option-free bond call provision  issuer has right to pay off bond early  issuer often calls bonds when interest rate falls increase yield relative to option-free bond call provision  issuer has right to pay off bond early  issuer often calls bonds when interest rate falls

options for holder decrease yield relative to an option- free bond put provision  holder has right to sell back bond early  holder more likely to exercise right at higher interest rates decrease yield relative to an option- free bond put provision  holder has right to sell back bond early  holder more likely to exercise right at higher interest rates

issuer options  must offer higher yield to get special rights holder options  must accept lower yield in exchange for special rights issuer options  must offer higher yield to get special rights holder options  must accept lower yield in exchange for special rights

Tax treatment depends on the issuer  municipal  Treasury  corporate depends on the issuer  municipal  Treasury  corporate

municipal bond interest exempt from federal income tax possibly exempt from state income tax  if issuer & bondholder are in same state exempt from federal income tax possibly exempt from state income tax  if issuer & bondholder are in same state

Treasury bond interest exempt from state income tax Corporate bond interest fully taxable

more favorable tax treatment lower before-tax yield

tax treatment explains Treasury yields muni yields Corp yields < <

example 1 10 yr. municipal Baa bond, 6% 10 yr. corporate Baa bond, 8% tax rate 28% after tax yield? muni = 6% corporate = 8%(1-.28) = 5.76% 10 yr. municipal Baa bond, 6% 10 yr. corporate Baa bond, 8% tax rate 28% after tax yield? muni = 6% corporate = 8%(1-.28) = 5.76%

example 2 10 yr. municipal Baa bond, 6% tax rate 28% what corporate yield would make investors indifferent? corp. yield (1-.28) = 6% corp. yield = 8.33% equivalent taxable yield 10 yr. municipal Baa bond, 6% tax rate 28% what corporate yield would make investors indifferent? corp. yield (1-.28) = 6% corp. yield = 8.33% equivalent taxable yield

example 3 10 yr. municipal Baa bond, 6% 10 yr. corporate Baa bond, 8% what tax rate makes investor indifferent? 8% (1- t) = 6% t = 25% 10 yr. municipal Baa bond, 6% 10 yr. corporate Baa bond, 8% what tax rate makes investor indifferent? 8% (1- t) = 6% t = 25%

impact of tax rates higher tax brackets derive more benefit from muni’s changing tax rates will affect the corporate-municipal yield spread IRS rulings could make muni debt taxable higher tax brackets derive more benefit from muni’s changing tax rates will affect the corporate-municipal yield spread IRS rulings could make muni debt taxable