The Risk and Term Structure of Interest Rates

1. The Risk and Term Structure of Interest Rates Chapter 5

2. The Term Structure of Rates and the Yield Curve • Term Structure • Relationship among yields of different maturities of the same type of security. • Yield Curve • Graphical relationship between yield and maturity.

3. Empirical Facts • Interest rates on bonds of different maturities move together over time. • When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term interest rates are high, yield curves are more likely to slope downward and be inverted. • Yield curves almost always slope upward.

4. Different Theories of the Shape of the Yield Curve • Supply and Demand • Determined by relative supply/demand of different maturities • Deals with each maturity by itself and ignores the interrelationships between different maturities of the same security

5. Expectations Hypothesis • The shape of the yield curve is determined by the investors’ expectations of future interest rate movements. • The interest rate on the long-term bond will equal an average of short-term interest rates that people expect to occur over the life of the long-term bond. • If the one-year interest rate over the next five years is expected to be 5, 6, 7, 8, 9 percent, • then the interest rate on the two-year bond would be 5.5%. • While for the five-year bond it would be 7%. • Investors are indifferent between short and long-term securities.

6. Liquidity Premium Modification • Investors know from experience that short-term securities provide greater marketability and have smaller price fluctuations than do long-term securities. • The liquidity premium is that premium demanded for holding long-term securities. • Therefore, a two-year security would have to yield more than the average of the two one-year securities as a reward for bearing more risk.

7. The Preferred Habitat Approach • The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a term (liquidity) premium that responds to supply and demand conditions for that bond. • If investors prefer the habitat of short-term bonds over long-term bonds, they might be willing to hold short-term bonds even though they have a lower expected return. This means that investors would have to be paid a positive term premium to be willing to hold a long-term bond.

8. Real-World Observations • When interest rates are high relative to past rates, investors expect them to decline and the price of bonds to rise in the future resulting in big capital gains • Investors would then favor long-term securities, which drives up price and lowers yield—downward sloping yield curve

9. Real-World Observations • If interest rates are low relative to past—results in an upward sloping curve • Historically, over the business cycle short-term rates fluctuate more than longer-term rates • Yield curves tend to be upward sloping more often, suggesting the liquidity premium is the dominate theory

10. Summary of Term Structure Theory • Expectations theory forms the foundation of the slope of the curve • Liquidity premium theory makes a long-term permanent modification that suggests an upward sloping curve • Over short periods, relative supplies of securities have an impact on yields, altering the shape of the curve

11. Government Bonds • Reading the WSJ. • Current coupon or on the run issue.

12. Marketability • Recently issued government bonds (current coupon—“on the run”) are more marketable than older issues (“off the run”) • Because these newly issued bonds are highly marketable, they carry somewhat lower yields to maturity as compared to older issues 

13. Default Risk • Other than US Federal government securities, bonds carry a risk of default • Risk on municipal bonds used to be considered very low • However, experience of New York City (1975), Cleveland (1978) and Orange Country, California (1995) suggest these bonds are becoming riskier • Corporate bonds generally have a higher default risk than municipal bonds • Investors will expect higher return to compensate for increased default risk

14. Default Risk • Standard and Poor’s and Moody’s Investors Service rate the default risk on bonds which serve as a guide to investors • The introduction of risk in the yield curve will cause the curve to shift since another variable other than “maturity” has changed • The higher the perceived risk, the greater the upward shift of the curve for that particular security

15. Risk and Tax Structure of Rates • Investors are concerned about the after tax return on bonds • Although municipal bonds are riskier than federal government bonds, tax exempt status of municipal bonds will generally result in a lower yield (downward shift of the curve)