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Chapter 7. Risk and Term Structure of Interest Rates

Chapter 7. Risk and Term Structure of Interest Rates. Risk Structure Term Structure. Not all interest rates are created equal!. many interest rates at one time But interest rates do move together over time. Interest rate structure. Why do yields differ? Risk structure

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Chapter 7. Risk and Term Structure of Interest Rates

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  1. Chapter 7. Risk and Term Structure of Interest Rates • Risk Structure • Term Structure

  2. Not all interest rates are created equal! • many interest rates at one time • But interest rates do move together over time

  3. Interest rate structure • Why do yields differ? • Risk structure • bonds/debt with same maturity but different characteristics • Term structure • Bond with same characteristics but different maturities

  4. Interest rates: a snapshot 1/07 1/08 • 3 mo Tbill 4.98% 2.75% • 3 mo Com Paper 5.17% 3.25% • 10 yr. Tnote 4.76% 3.74% • 10 yr. AAA corp 5.4% 5.33% • 10 yr. BAA corp 6.34% 6.54% • 30 yr. mortgage 6.22% 5.76%

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

  6. example 1 • 3 mo. Tbill 2.75% • 3 mo. Commercial paper 3.25% • spread • 0.5 percentage pts. • 50 basis pts.

  7. example 2 • 10 yr Tnote 3.74% • 10 BAA corporate 6.54% • spread • 2.8 percentage pts. • 280 basis pts.

  8. I. Risk Structure of Interest Rates • debt with same maturity, but different characteristics • default risk • tax treatment

  9. Patterns • Baa > AAA > U.S. Treasury • size of the spread varies

  10. A. Default Risk • risk of not receiving timely payment of principal and interest • depends on • creditworthiness of issuer • structure of bond

  11. 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

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

  13. Bond ratings • bond issuer pays rating agency • Moody’s, S&P, Fitch • p. 151 or p. 149 • high credit rating • = low default risk • bond ratings may change over time • Downgrades or upgrades

  14. Investment grade Moodys’ S&P • Aaa AAA • Aa (Aa1, Aa2, Aa3) AA (AA+, AA, AA-) • A A • Baa BBB

  15. Noninvestment, speculative • Ba BB • B B Highly Speculative (High-yield, “Junk”) • Caa CCC • Ca CC • C C • D (in default)

  16. examples • AAA • GE, Toyota, Berkshire Hathaway, Pfizer • AA • Wells Fargo, Merck, Merrill Lynch, Gillette, NYC GO bonds, Rochester, Syracuse, Onondaga Co. • A • Caterpillar, Boeing, Dow Chemical, Coca Cola, California GO bonds, • BBB • DaimlerChrysler, Union Pacific, Mattel, Home Depot

  17. BB • GM, Sears • B • Ford, Clear Channel, Univision • CCC • Revlon, Sirius, Pep Boys, JoAnn, ToysRUs • CC • Primus • C • Wolverine Tube

  18. Defaults • Most likely in industrial sector • Defaults over past 10 years: • Zenith Delta, Northwest • Enron Delphi • Daewoo • Purina Mills

  19. Municipal defaults • NYC 1975, Cleveland 1978 • Largest: Washington Power SS • Over $2 billion • (failed nuclear plants in 1970s) • The Cicero Commons (2003) • Wilkes-Barre, PA (2002)

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

  21. If Treasuries are the benchmark Bond yield = Treasury yield + default premium

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

  23. default risk is not constant! • varies over the business cycle • higher in recessions • lower in expansions • Tnote vs. BAA yield • 1/07 158 basis pts. (6.34% vs. 4.76%) • 1/08 280 basis pts. (6.54% vs. 3.74%)

  24. B. Tax treatment Q. why do municipal bonds have lower yields than Tbonds? • muni’s less liquid • muni’s not default-free A. tax treatment

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

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

  27. example: federal taxes • bond where F=$10,000 • coupon rate = 10% • annual coupon pmts = $1000

  28. municipal bond • before taxes: • $1000 in interest pmts. • after taxes: • $1000 in interest pmts

  29. Corporate bond • before taxes: • $1000 interest pmts. • after taxes • (25% marginal rate) • $1000(1-.25) = $750 interest pmts.

  30. So, after taxes • muni has 10% coupon rate • corp has 7.5% coupon rate • After tax yield = i(1- tax rate) • muni can offer a lower yield and still be competitive

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

  32. impact of tax rates • higher tax brackets derive more benefit from muni’s • changing tax rates will affect the corporate-municipal yield spread

  33. II. Term structure of interest rates • bonds with the same characteristics, but different maturities

  34. focus on Treasury yields • same default risk, tax treatment • many choices of maturity -- 4 weeks to 10 years

  35. Treasury yields over time

  36. relationship between yield & maturity is NOT constant • sometimes short-term yields are highest, • Most of the time, long-term yields are highest

  37. A. Yield curve • plot of maturity vs. yield • slope of curve indicates relationship between maturity and yield • The living yield curve

  38. yield maturity upward sloping • yields rise w/ maturity (common)

  39. yield maturity downward sloping (inverted) • yield falls w/ maturity (rare)

  40. yield maturity flat • yield varies little with maturity

  41. 3 facts about the yield curve • based on historical data on U.S. Treasury yields 1. interest rates on bonds of different maturities generally move together

  42. 2. ST bond yields are more volatile than LT bond yields 3. The yield curve usually slopes up.

  43. Understanding the yield curve • what causes the 3 facts? • what does the shape of the yield curve tell us? • must understand why/how maturity affects yield

  44. 2 theories of term structure • assumptions about investor preference • implications for maturity and yield • check implications against 3 facts about yield curve

  45. B. The Expectations Theory • Assume: bond buyers do not have any preference about maturity i.e. bonds of different maturities are perfect substitutes

  46. if assumption is true, then investors care only about expected return • for example, • if expect better return from short-term bonds, only hold short-term bonds

  47. but investors hold both short-term an long-term bonds • so, • must EXPECT similar return: long-term yields = average of the expected future short-term yields

  48. example • 5 year time horizon • investors indifferent between (1) holding 5-year bond (2) holding 1year bonds, 5 yrs. in a row as long as expected return is same

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