STRUCTURE OF INTEREST RATES 1

The yields on debt securities are affected: Credit (default) risk Liquidity Tax status Term to maturity 2

Credit (Default) Risk – securities with a higher degree of default risk offer higher yields. a.Rating Agencies - Rating agencies charge the issuers of debt securities a fee for assessing default risk. (Exhibit 3.1). b.Accuracy of Credit Ratings - The ratings issued by the agencies are useful indicators of default risk but they are opinions, not guarantees. c.Oversight of Credit Rating Agencies - The Financial Reform Act of 2010 established an Office of Credit Ratings within the Securities and Exchange Commission in order to regulate credit rating agencies. Rating agencies must establish internal controls. 3

Default Risk (chance of not getting your $ back at maturity)  Financial strength of the issuer  Business strengths of the issuer  Industry outlook  Term to maturity  Credit Agency Rating Liquidity (how easy is it to buy or sell at intrinsic values?)  Size of the issue (float)  General market conditions  Characteristics of the secondary market in bonds 4

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Computing the Equivalent Before-Tax Yield: = after-tax yield = before-tax yield = Investor’s marginal tax rate Computing the Equivalent Before-Tax Yield: 6

Y n = R f,n + DP + LP + TA where: Y n =yield of an n-day debt security R f,n =yield of an n-day Treasury (risk-free) security DP=default premium to compensate for credit risk LP=liquidity premium to compensate for less liquidity TA=adjustment due to difference in tax status 7

Pure Expectations Theory  Investor / borrower expectations and preferred maturities  Computing the forward rate (see page 54) Liquidity Premium Theory  S-T securities typically more marketable that L-T  Increase in marketability, ceteris paribus, should result in lower YTM Segmented Markets Theory  Investor preferences for certain maturities investment horizon  Nature of assets and liabilities (matching principle) 8

Algebraic Presentation: 9

Comprehensive Explanation for Term Structure and Shape of the Yield Curve  The yield curve has much to do with investor expectations about the economy.  Lenders prefer less risk and more liquidity.  Borrowers prefer longer terms.  Implications of flat and inverted yield curves 10

11 Nov 14, 2000

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Briefly describe the implications of the following theories;  Pure Expectations Theory  Liquidity Premium Theory  Segmented Markets Theory What factors do we consider when investing in bonds? Why is the normal shape of the Yield Curve upward sloping to the right? What do we mean by a before-tax equivalent yield and why is it important? What factors influence interest rates? What is a forward rate and Why is it important? How do economic conditions affect the risk premium? Q&A: 1, 5, 6, 8, 17 Interpreting: a, b, c. 13