2. After studying this chapter, you should be able to:
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
5.1
Explain why bonds with the same maturity can have different interest rates.
5.2
Explain why bonds with different maturities can have different interest rates.

3. Searching for Yield
In the aftermath of the Great Recession, many investors responded to low interest rates by searching for ways to earn more income from their savings.
To earn significantly higher interest rates, investors need to purchase long-term bonds or those with relatively high default risk.
As a result, there was great demand for junk bonds, causing interest rates on these bonds to reach record lows.
In this chapter, we study the relationships among different interest rates.

4. Key Issue and Question
Issue: During the financial crisis, the bond rating agencies were criticized for having given high ratings to securities that proved to be very risky.
Question: Should the government more closely regulate the credit rating agencies?

5. 5.1
Learning Objective
Explain why bonds with the same maturity can have different interest rates.

6. The Risk Structure of Interest Rates
Why might bonds that have the same maturities have different interest rates?
Risk
Liquidity
Information costs
Taxation
The risk structure of interest rates is the relationship among interest rates on bonds that have different characteristics but the same maturity.
The Risk Structure of Interest Rates

7. Default Risk
Default risk (or credit risk) is the risk that the bond issuer will fail to make payments of interest or principal.
Measuring Default Risk
The default risk premium on a bond is the difference between the interest rate on the bond and the interest rate on a Treasury bond with the same maturity.
Many investors rely on credit rating agencies to provide them with information on the creditworthiness of corporations and governments.
Note: Bonds with higher risk will have a higher interest rate.
Teaching Tips: At the height of the financial crisis in the fall of 2008, the default risk premium for bonds of companies rated Baa by Moody’s surpassed 6%, higher than any time since the 1930s. Have students discuss how this can be used as a measure of the severity of the financial crisis (i.e., difficulty of investment-grade corporations in obtaining credit).
A bond rating is a single statistic that summarizes a rating agency’s view of the issuer’s likely ability to make the required payments on its bonds.
The Risk Structure of Interest Rates

8. The Risk Structure of Interest Rates
Teaching Tips: At the height of the financial crisis in the fall of 2008, the default risk premium for bonds of companies rated Baa by Moody’s surpassed 6%, higher than any time since the 1930s. Have students discuss how this can be used as a measure of the severity of the financial crisis (i.e., difficulty of investment-grade corporations in obtaining credit).
The Risk Structure of Interest Rates
[To Jim: should the Teaching Tips appear on both slides 7 & 8?]

9. Changes in Default Risk and in the Default Risk Premium
Figure 5.1 (1 of 2)
Determining Default Risk Premium in Yields
Investors require extra return to compensate them for a high level of risk on the Baa corporate bond. In other words, the corporate bond’s default risk premium must be very high.
The initial default risk premium is the difference in yields associated with the prices P1T and P1C.
The Risk Structure of Interest Rates

10. Changes in Default Risk and in the Default Risk Premium
Figure 5.1 (2 of 2)
Determining Default Risk Premium in Yields
As the default risk on corporate bonds increases, the demand for corporate bonds shifts to the left in panel (a), and the demand for Treasury bonds shifts to the right in panel (b).
The Risk Structure of Interest Rates

11. Changes in Default Risk and in the Default Risk Premium
The corporate bond rate is for Baa-rated bonds. The Treasury bond rate is for 10-year Treasury notes. During recessions, the default risk on corporate bonds typically increases, which can cause a flight to quality.
Figure 5.2
Rising Default Premiums during Recessions
The default premium typically rises during a recession. The increase in the default premium was much larger in the recession than the 2001 recession.
The Risk Structure of Interest Rates

12. Do Credit Rating Agencies Have a Conflict of Interest?
Making the Connection
Do Credit Rating Agencies Have a Conflict of Interest?
John Moody began modern bond ratings with Moody’s Analyses of Railroad Investments in 1909.
By the late 1970s, recession, inflation, and government regulations expanded the work of credit rating agencies.
When credit rating agencies began charging firms and governments—rather than investors—for their services, a conflict of interest emerged.
Credit rating agencies came under increased scrutiny during the financial crisis.
In 2010, Congress passed the Dodd-Frank Act that affected the regulations of credit rating agencies, and created a new office within the Securities and Exchange Commission (SEC) to oversee credit rating agencies.
The Risk Structure of Interest Rates

13. Liquidity and Information Costs
Investors care about liquidity, so they are willing to accept a lower interest rate on more liquid investments.
Spending time and money acquiring information on a bond reduces the bond’s expected return.
A change in a bond’s liquidity or the cost of acquiring information about the bond affects its demand.
During the financial crisis of 2007–2009, homeowners defaulted on many of the mortgages contained in mortgage-back bonds. Investors also had difficulty finding information about the types of mortgages in them.
The Risk Structure of Interest Rates

14. Tax Treatment
Investors care about the return they receive left after paying their taxes.
How the Tax Treatment of Bonds Differs
Municipal bonds are bonds issued by state and local governments.
GE bond: FV = $1,000; coupon = 8%; t = 40%. Then tax = $80 – 80(1 – 0.04) = $32. Coupon after tax: $80 - $32 = $48. Return after tax: $48/$1,000 = 4.8%.
Treasury FV = $1,000; coupon = 8%; t = 25%. Then tax = $80 – 80(1 – 0.025) = $20. Coupon after tax: $80 - $20 = $60. Return after tax: $60/$1,000 = 6.0%.
The Risk Structure of Interest Rates

15. How the Tax Treatment of Bonds Differs
Recall the two types of income from owning bonds:
(1) interest income from coupons – taxed at the same rates as wage and salary income.
(2) capital gains or losses from price changes on the bonds – taxed at a lower rate than interest rate, and taxed only if they are realized, i.e., a bold sold at a higher price than paid for.
The Risk Structure of Interest Rates

16. The Effect of Tax Changes on Interest Rates
Figure 5.3
The Effect of Changes in Taxes on Bond Prices
If the federal income tax rate increases, the demand curve for tax-exempt municipal bonds shifts to the right in panel (a), and the demand curve for Treasury bonds shifts to the left in panel (b).

17. How Would a VAT Affect Interest Rates?
Solved Problem 5.1
How Would a VAT Affect Interest Rates?
Suppose the federal government replaces the federal income tax with a value-add tax (VAT), which is collected at each stage of production.
Explain the effect of this policy change on the interest rates on municipal bonds, corporate bonds, and Treasury bonds. Draw three graphs, one for each market, to illustrate your answer.
The Risk Structure of Interest Rates

18. How Would a VAT Affect Interest Rates? Solving the Problem
Solved Problem 5.1
How Would a VAT Affect Interest Rates?
Solving the Problem
Step 1 Review the chapter material.
Step 2 Analyze the effect of the tax policy change on the interest rate on municipal bonds.
The Risk Structure of Interest Rates

19. How Would a VAT Affect Interest Rates? Solving the Problem (continued)
Solved Problem 5.1
How Would a VAT Affect Interest Rates?
Solving the Problem (continued)
Step 3 Analyze the effect of the tax policy change on the interest rate on corporate bonds.
Step 4 Analyze the effect of the tax policy change on the interest rate on Treasury bonds.
Step 5 Summarize your findings.
The policy change would increase the interest rate on municipal bonds and lower the interest rates on corporate bonds and Treasury bonds.
The Risk Structure of Interest Rates

20. The Risk Structure of Interest Rates

21. Should You Invest in Junk Bonds?
Making the Connection
In Your Interest
Should You Invest in Junk Bonds?
Junk bonds are corporate bonds with lower than investment grade rating (e.g., Ba or below from Moody’s).
In the late 1970s, Michael Milken advocated investing in junk bonds as historical data show that a diversified portfolio of junk bonds brought to increases in returns more than offset their default risk.
In 2012, increased demand for junk bonds pushed down their yields to levels that financial advisors doubted that their yields were high enough to compensate investors for their high default risk.
The Risk Structure of Interest Rates

22. 5.2
Learning Objective
Explain why bonds with different maturities can have different interest rates.
Teaching Tips: In Fall 2012, some commentators expressed fear of rapidly increasing inflation in the next few years. Meanwhile, interest rates on long-term bonds, such as the five-year and ten-year Treasury bonds, were about 0.6% and 1.6%, respectively. Have students discuss what this implies about the bond market’s view of future inflation. Are low interest rates on long-term bonds consistent with expectations of rapidly increasing inflation?
[To Jim: in the Notes, is it “bond markets’ or market’s?]

23. The Term Structure of Interest Rates
The term structure of interest rates is the relationship among the interest rates on bonds that are otherwise similar but that have different maturities.
The Treasury yield curve shows the relationship among the interest rates on Treasury bonds with different maturities.
An upward-sloping yield curve occurs when short-term rates are lower than long-term rates.
Infrequently, a downward-sloping yield curve occurs when short-term interest rates are higher than long-term interest rates.
The Term Structure of Interest Rates

24. The Treasury Yield Curve
Figure 5.4
The Treasury Yield Curve
This figure shows the Treasury yield curves for June 15, 2007, and September 21, 2012.
The Term Structure of Interest Rates

25. The Term Structure of Interest Rates
Note: Figure 5.5 also shows that interest rates on bonds of different maturities tend to move together.
Figure 5.5
The Interest Rates on 3-Month Treasury Bills and 10-Year Treasury Notes, January 1970–August 2012
The figure shows that most of the time since 1970, the interest rates on 3-month Treasury bills have been lower than the interest rates on 10-year Treasury notes.
The Term Structure of Interest Rates

26. Negative Interest Rates on Treasury Bills?
Making the Connection
Negative Interest Rates on Treasury Bills?
Can the nominal interest rate ever be negative?
A negative nominal interest rate means that the lender is actually paying the borrower interest in return for borrowing the lender’s money.
During the Great Depression and the financial crisis of 2007–2009, investors were willing to accept negative interest rates on the Treasury bills.
Because interest rates on other short-term investments (e.g., bank CD), were also very low, investors were giving up relatively little to temporarily park their funds in default-risk free Treasury bills.
In the summer of 2012, fears that the governments of Greece and Spain might default on their debt also led to negative interest rates for short-term government bonds issued by France and Germany.
The Term Structure of Interest Rates

27. Explaining the Term Structure
Any explanation of the term structure should be able to account for three facts:
1. Interest rates on long-term bonds are usually higher than interest rates on short-term bonds.
2. Interest rates on short-term bonds are occasionally higher than interest rates on long-term bonds.
3. Interest rates on bonds of all maturities tend to rise and fall together.
Economists have advanced three theories to explain these facts:
expectations theory
segmented markets theory
liquidity premium theory or preferred habitat theory
The Term Structure of Interest Rates

28. The Expectations Theory of the Term Structure
Expectations theory holds that the interest rate on a long-term bond is an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond.
Two key assumptions:
1. Investors have the same investment objectives.
2. For a given holding period, investors view bonds of different maturities as being perfect substitutes for one another.
The Term Structure of Interest Rates

29. The Expectations Theory Applied in a Simple Example
You invest $1,000 for two years and are considering one of two strategies:
The buy-and-hold strategy.
You buy a two-year bond and hold it until maturity.
After two years, the $1,000 investment will have grown to $1,000(1 + i2t)(1 + i2t).
The rollover strategy.
You buy a one-year bond today and hold it until it matures in one year. At that time, you buy a second one-year bond, and you hold it until it matures at the end of the second year.
After two years, you will expect your $1,000 investment to have grown to $1,000(1 + i1t) (1 + ie it+1).
With the rollover strategy, you must form an expectation of what the interest rate on the one-year bond will be.
We will assume that this is a two-year discount bond. This simplification allows us to avoid having to deal with coupon payments, although the result would not change if we added that complication.
The Term Structure of Interest Rates

30. The Expectations Theory Applied in a Simple Example
The expectations theory assumes that the returns from the two strategies must be the same.
Arbitrage should result in the returns from the two strategies being the same:
This means:
For an n-year bond, the interest rate is:
The Term Structure of Interest Rates

31. Interpreting the Term Structure Using the Expectations Theory
The Term Structure of Interest Rates

32. Interpreting the Term Structure Using the Expectations Theory
The expectations theory implies:
An upward-sloping yield curve is the result of investors expecting future short-term rates to be higher than the current short-term rate.
A flat yield curve is the result of investors expecting future short-term rates to be the same as the current short-term rate.
A downward-sloping yield curve is the result of investors expecting future short-term rates to be lower than the current short-term rate.
The Term Structure of Interest Rates

33. (c) fall relative to current levels.
Figure 5.6
Using the Yield Curve to Predict Interest Rates: The Expectations Theory
Under the expectations theory, the slope of the yield curve shows that future short-term interest rates are expected to:
(a) rise,
(b) remain the same, or
(c) fall relative to current levels.
The Term Structure of Interest Rates

34. Shortcomings of the Expectations Theory
The expectations theory explains an upward-sloping yield curve as the result of investors expecting future short-term rates to be higher than the current short-term rate.
But if the yield curve is typically upward sloping, investors must be expecting short-term rates to rise most of the time.
This explanation seems unlikely because short-term rates are about as likely to fall as to rise at any given time.
The Term Structure of Interest Rates

35. Can You Make Easy Money from the Term Structure?
Solved Problem 5.2A
In Your Interest
Can You Make Easy Money from the Term Structure?
The term interest carry trade refer to borrowing at a low short-term interest rate and using the borrowed funds to invest at a higher long-term interest rate.
a. Would you use an interest-carry-trade strategy for your personal investments? Identify the difficulties with this strategy for an individual investor.
b. If you were an investment adviser for an institutional investor, would you advise that investor to use an interest-carry-trade strategy? Identify the difficulties with this strategy for an institutional investor.
b. If the yield curve was inverted, or downward sloping, would an institutional investor still find an interest-carry-trade strategy to be possible? Briefly explain.
The Term Structure of Interest Rates

36. Can You Make Easy Money from the Term Structure? Solving the Problem
Solved Problem 5.2A
In Your Interest
Can You Make Easy Money from the Term Structure?
Solving the Problem
Step 1 Review the chapter material.
Step 2 Answer part (a) by explaining whether an individual investor can profitably engage in an interest carry trade.
The yield curve is typically upward sloping, so borrowing short term and investing the funds long term seems a good investment strategy.
But the average investor would have difficulty using this strategy because the gap between the rate at which she can borrow and the long-term bond rate is often too small or even negative.
Step 3 Consider the situation of an institutional investor to answer part (b).
Unlike individual investors, institutional investors can borrow at a low short-term rate and they face less default risk.
But interest rate carry trade would not bring potential profits because the expectations theory holds that the average of the expected short-term interest rates should be roughly equal to the equivalent long-term interest rates.
The Term Structure of Interest Rates

37. Can You Make Easy Money from the Term Structure?
Solved Problem 5.2A
In Your Interest
Can You Make Easy Money from the Term Structure?
Solving the Problem (continued)
Step 3 Answer part (b) by explaining whether the interest carry trade would still be possible if the yield curve were inverted.
If the yield curve were inverted, an institutional investor could borrow long term and invest the funds at the higher short-term rates.
In this case, the investor would be subject to reinvestment risk— the risk that the interest rate on new short-term investments will declined after the short-term investment mature.
The Term Structure of Interest Rates

38. The Segmented Markets Theory of the Term Structure
Segmented markets theory holds that the interest rate on a bond of a particular maturity is determined only by the demand and supply of bonds of that maturity.
Two related observations:
1. Investors in the bond market do not all have the same objectives.
2. Investors do not see bonds of different maturities as being perfect substitutes for each other.
Segmented markets means that investors in the market for bonds of one maturity do not participate in markets for bonds of other maturities.
The Term Structure of Interest Rates

39. The Segmented Markets Theory of the Term Structure
Compared to short-term bonds, long-term bonds are subject to greater interest-rate risk, and they are often less liquid.
The yield curve is typically upward sloping because more investors are in the market for short-term bonds, causing their prices to be higher and their interest rates lower than long-term bonds.
But the segmented markets theory cannot explain a downward-sloping yield curve, or why interest rates of all maturities tend to rise and fall together.
The Term Structure of Interest Rates

40. The Liquidity Premium Theory
Liquidity premium theory (or preferred habitat theory) holds that the interest rate on a long-term bond is an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond, plus a term premium.
Term premium is the additional interest investors require in order to be willing to buy a long-term bond rather than a comparable sequence of short-term bonds.
The Term Structure of Interest Rates

41. The Liquidity Premium Theory
This theory adds a term premium to the expectations theory’s equation:
where is the term premium on a two-year bond.
The interest rate on an n-period bond is equal to:
The Term Structure of Interest Rates

42. Solved Problem 5.2B
Using the Liquidity Premium Theory to Calculate Expected Interest Rates
Given the data and the liquidity premium theory, what did investors expect the interest rate to be on the one-year Treasury bill two years from that time if the term premium on a two-year Treasury note was 0.20% and the term premium on a three-year Treasury note was 0.40%?
The Term Structure of Interest Rates

43. Solved Problem 5.2B
Using the Liquidity Premium Theory to Calculate Expected Interest Rates
Solving the Problem
Step 1 Review the chapter material.
Step 2 Use the liquidity premium equation that links the interest rate on a long-term bond to the interest rates on short-term bonds to calculate the interest rate that investors expected on the one-year Treasury bill in one year.
Step 3 Answer the problem by using the result from step 2 to calculate the interest rate investors expected on the one-year Treasury bill in two years.
The Term Structure of Interest Rates

44. The Term Structure of Interest Rates

45. Can the Term Structure Predict Recessions?
Economists have found the yield curve to be useful for predicting recessions.
During every recession since 1953, the term spread between the yields on long-term and short-term Treasury securities narrowed significantly.
During recessions, interest rates typically fall, and short-term rates tend to fall more than long-term rates.
In this situation, the liquidity premium theory predicts that long-term rates should fall relative to short-term rates, making the yield curve inverted.
Teaching Tips: In Fall 2012, some commentators expressed fear of rapidly increasing inflation in the next few years. Meanwhile, interest rates on long-term bonds, such as the five-year and ten-year Treasury bonds, were about 0.6% and 1.6%, respectively. Have students discuss what this implies about the bond markets’ view of future inflation. Are low interest rates on long-term bonds consistent with expectations of rapidly increasing inflation?
The Term Structure of Interest Rates

46. Can the Term Structure Predict Recessions?
Figure 5.7
Interpreting the Yield
Curve
Models of the term structure help analysts use data on the Treasury yield curve to forecast the future path of the economy.
The Term Structure of Interest Rates

47. Answering the Key Question
At the beginning of this chapter, we asked the question:
“Should the government more closely regulate credit rating agencies?”
Like other policy questions, this question has no definitive answer.
During the financial crisis of 2007–2009, many bonds had much higher levels of default risk than the credit rating agencies had indicated.
Some observers argued that the rating agencies had a conflict of interest in being paid by the firms whose bond issues they rate.
Other observers argued that the ratings may have been accurate when given, but the creditworthiness of the bonds declined rapidly following the housing bust and the financial crisis.