1. CHAPTER 3 Structure of Interest Rates © 2003 South-Western/Thomson Learning

2. Chapter Objectives n Learn why individual interest rates differ or why security prices vary or change n Analyze theories explaining why rates vary by term or maturity, called the term structure of interest rates

3. Factors Affecting Security Yields n Risk-averse investors demand higher yields For added riskiness n Risk is associated with variability Of returns n Increased riskiness generates lower security prices or higher investor required rates of return

4. Factors Affecting Security Yields n Security yields and prices are affected by levels and changes in: l Default risk (also called Credit Risk) l Liquidity l Tax status l Term to maturity l Special contract provisions such as embedded options

5. Factors Affecting Security Yields n Benchmark—risk-free treasury securities for given maturity n Default risk premium = risky security yield – treasury security yield of same maturity n Default risk premium = market expected default loss rate n Rating agencies set default risk ratings n Anticipated or actual ratings changes impact security prices and yields

6. Factors Affecting Security Yields n The Liquidity of a security affects the yield/price of the security n A liquid investment is easily converted to cash At minimum transactions cost n Investors pay more (lower yield) for liquid investment n Liquidity is associated with short-term, low default risk, marketable securities

7. Factors Affecting Security Yields n Tax status of income or gain on security impacts the security yield n Investor concerned with after-tax return or yield n Investors require higher yields For higher taxed securities

8. Factors Affecting Security Yields Y at = Y bt (1 – T) Where: Y at = after-tax yield Y bt = before-tax yield T = investor’s marginal tax rate

9. Factors Affecting Security Yields n Example: a taxable security that offers a before-tax yield of 14 percent. The investor’s tax rate is 20 percent. Calculate the after-tax yield. Y at = 14%(1 – 0.2) = 11.2% n The fully taxable pre-tax equivalent corporate bond for a 11.2% municipal bond is: Y bt = 11.2%/(1 –.2) = 14%

10. Factors Affecting Security Yields n Term to maturity l Interest rates typically vary by maturity. l The term structure of interest rates defines the relationship between maturity and yield. u The Yield Curve is the plot of current interest yields versus time to maturity.

11. Yield Curve An upward-sloping yield curve indicates that Treasury Securities with longer maturities offer higher annual yields Yield % Time to Maturity

12. Yield Curve Shapes NormalLevel or Flat Inverted

13. Factors Affecting Security Yields n Special Provisions l Call Feature: enables borrower to buy back the bonds before maturity at a specified price u Call features are exercised when interest rates have declined u Investors demand higher yield on callable bonds, especially when rates are expected to fall in the future

14. Factors Affecting Security Yields n Special provisions l Convertible bonds u Convertibility feature allows investors to convert the bond into a specified number of common stock shares u Investors will accept a lower yield for convertible bonds because investor returns include expected return on equity participation

15. Estimating the Appropriate Yield n The appropriate yield to be offered on a debt security is based on the risk-free rate for the corresponding maturity plus adjustments to capture various security characteristics Y n = R f,n + DP + LP + TA + CALLP + COND

16. Estimating the Appropriate Yield Y n = R f,n + DP + LP + TA + CALLP + COND Where: Y n = yield of an n-day security R f,n = yield on an n-day Treasury (risk-free) security DP= default premium (credit risk) LP= liquidity premium TA= adjustment for tax status CALLP= call feature premium COND= convertibility discount

17. The Term Structure of Interest Rates l Pure Expectations Theory l Liquidity Premium Theory l Segmented Markets Theory Theories Explaining Shape of Yield Curve

18. The Term Structure of Interest Rates n Pure Expectations Theory l Long-term rates are average of current short-term and expected future short-term rates l Yield curve slope reflects market expectations of future interest rates l Investors select maturity based on expectations

19. The Term Structure of Interest Rates n Pure Expectations Theory l Assumes investor has no maturity preferences and transaction costs are low l Long-term rates are averages of current short rates and expected short rates u Forward rate: market’s forecast of the future interest rate

20. The Term Structure of Interest Rates n Expected higher interest rate levels n Expansive monetary policy n Expanding economy n Expected lower interest rate levels n Tight monetary policy n Recession soon? Upward- Sloping Yield Curve Downward- Sloping Yield Curve

21. The Term Structure of Interest Rates n Liquidity Premium Theory l Investors prefer short-term, more liquid, securities l Long-term securities and associated risks are desirable only with increased yields l Explains upward-sloping yield curve l When combined with the expectations theory, yield curves could still be used to interpret interest rate expectations

22. The Term Structure of Interest Rates n Segmented Markets Theory l Theory explaining segmented, broken yield curves l Assumes investors have maturity preference boundaries, e.g., short-term vs. long-term maturities l Explains why rates and prices vary significantly between certain maturities

23. The Term Structure of Interest Rates n Uses of the term structure l Forecast interest rates u The market provides a consensus forecast of expected future interest rates u Expectations theory dominates the shape of the yield curve l Forecast recessions u Flat or inverted yield curves have been a good predictor of recessions. See Exhibit 3.14. l Investment and financing decisions u Lenders/borrowers attempt to time investment/financing based on expectations shown by the yield curve u Riding the yield curve u Timing of bond issuance

24. Exhibit 3.14 Yield Curve as a Signal for Recessions 7 6 5 4 3 2 1 0 –1 –2 –3 –4 1955196019651970197519801985199019952000 *The general shape of the yield curve is measured as the differential between annualized 10-year and three-month interest rates. Recessionary periods are shaded. Year 2001 Interest Rate Differential (10-Year Rate Minus Three-Month Rate)

25. Treasury Debt Management and the Yield Curve n U.S. Treasury attempts to finance federal debt at the lowest overall cost n Treasury uses a mixture of Bills, Notes, and Bonds to finance periodic deficits and refinance outstanding securities n Treasury focuses on short-term issuance, phasing out 30-year bonds n Treasury 10-year bond now the standard issue n Leave the long-term issuance to private issuers

26. Historic Review of the Term Structure n Yield curves levels and shapes at various times indicate: l Inflation expectations l Level of economic activity or phase of business cycle l Monetary policy at the time n Usually high positive slope in short-term l Represents demand for liquidity l Short-term securities desired; higher prices; lower rates l Short-term securities provide liquidity with maturity

27. Exhibit 3.17 Yield Curves at Various Points in Time 051015202530 17 16 15 14 13 12 11 10 9 8 7 6 5 2 3 4 February 17, 1982 January 2, 1985 October 22, 1996 September 18, 2001 August 2, 1989 October 15, 2000 Annualized Treasury Security Yields Number of Years to Maturity

28. Exhibit 3.18 Change in Term Premium Over Time 0 5 10 15 20 Percentages Year 1996199519941999199820012000199719931992199119901989198819871986198519841983198219811980 30-year T-Bond Yield Three-month T-Bill Rate

29. International Structure of Interest Rates n Capital flows to the highest expected after-tax, real (inflation and other risk-adjusted), foreign exchange adjusted rates of return

30. International Structure of Interest Rates n Yield differences between countries are related to: l Expected changes in forex rates l Varied expected real rates of return l Varied expected inflation rates l Varied country and business risk l Varied central bank monetary policy