Chapter 11. The Level & Structure of Interest Rates

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

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

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

5. i DLF LF

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

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

8. government borrowing • deficits increase demand • surpluses decrease demand

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

10. i SLF DLF LF

11. what shifts supply? • tax rules • favorable treatment of interest income • pensions tax exempt interest

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

13. FOMC policy • if Fed buys Treasuries, increase supply of LF

14. Example • Fed sell Treasuries • decrease SLF • Federal gov’t runs a deficit • increase DLF

15. i SLF interest rate rises DLF LF

16. 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

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

18. measurement • difference between two interest rates • spread • measured in • percentage points • basis points • 1 percentage pt. = 100 basis pts.

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

20. example 2 • 10 yr Tnote 3.85% • 10 BAA corporate 5.02% • spread • 1.07 percentage pts. • 107 basis pts.

21. 3/5/2004 • 3 mo Tbill .95% • 3 mo Commerical Paper 1.02% • 10 yr. Tnote 3.85% • 10 yr. AAA corporate 4.31% • 10 yr. BAA corporate 5.02% • 10 yr. AAA muni 3.47% • 30 yr. mortgage 5.36%

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

24. Risk premium • base interest rate + risk premium = interest rate on corporate debt

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

26. Issuer • spreads exist among different issuers • but usually a function of other factors

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

28. 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

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

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

31. default risk & yield • investors are risk averse higher default risk lower credit rating higher yield

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

33. default risk is not constant! • varies over the business cycle • higher in recessions • lower in expansions • Baa vs. Treasury bond yield • 12/99 191 basis pts. • 2/03 307 basis pts. • 3/04 107 basis pts.

34. Bond ratings (p. 400) S&P Moody’s Investment grade High Yield

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

36. 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

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

38. 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

39. 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

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

41. Tax treatment • depends on the issuer • municipal • Treasury • corporate

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

43. Treasury bond interest • exempt from state income tax Corporate bond interest • fully taxable

44. more favorable tax treatment lower before-tax yield

45. tax treatment explains muni yields Treasury yields Corp yields < <

46. 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%

47. 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

48. 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%

49. 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