Lecture Notes The Risk Structure of Interest Rates: (Chapter 8)

Lecture Notes The Risk Structure of Interest Rates: (Chapter 8) Program MM Universitas Pelita Harapan

In this session, we will discuss how some other factors influence interest rates:  marketability, liquidity  default risk,  call privileges,  taxation of security income,  prepayment risk,  convertibility. Scope

Marketability – Can an asset be sold quickly? Marketability is positively related to the size and reputation of the institution issuing the securities and to the number of similar securities outstanding. However, marketability is negatively related to yield. Liquidity – A liquid financial asset is readily marketable. Moreover, its price tends to be stable over time and it is reversible. Popular measures of liquidity include the bid-ask spread, trading volume, frequency of trades, and average trade size. Marketability and Liquidity

Default risk – The risk that a borrower will not make all the promised payments at the agreed-upon times. Promised yield on a risky asset = risk-free interest rate + default risk premium The promised yield on a risky debt security is the yield to maturity that will be earned by the investor if the borrower makes all promised payments when they are due. Default Risk and Interest Rates

Default Risk and Interest Rates

Expected yield on a risky asset = Spiyi pi = probability that the ith possible yield, yi, occurs Anticipated default loss on a risky asset = promised yield – expected yield Factors Influencing Default Risk Premiums Credit ratings by rating companies such as Moody’s and Standard & Poor’s Highly-rated securities are perceived as having negligible default risk. Default Risk and Interest Rates

Default Risk and Interest Rates Bond-Rating Categories

Default Risk and Interest Rates The Behavior of Interest Rates

Default Risk and Interest Rates Market Yield

Fluctuations (cycles) in business activity The yield spread between Aaa- and Baa-rated securities increases during economic recessions. For corporate securities, the period of time the firm has been in operation, variability in company earnings, and the amount of leverage employed Default Risk and Interest Rates Factors Influencing Default Risk Premiums

Inflation and Default Risk Premiums Default risk premiums tend to be higher and more volatile when inflation is high and volatile. Greater uncertainty about inflation tends to produce a “flight to quality” in the financial markets, and investors simply become more cautious about buying default-risk-exposed financial instruments. Default Risk and Interest Rates

Yield Curves for Risky Securities There is some evidence that the yield curves on high-default-risk instruments often have a downward (negative) slope or may have a significant bow or hump in them as maturity increases. Each required payment that is successfully made seems to lower the risk that subsequent payments will be missed. Default Risk and Interest Rates

The Volatile History of Junk Bonds Junk bonds are long-term debt securities whose full repayment is judged to be significantly less certain than that for bonds rated investment quality. Default Risk and Interest Rates

The Junk-Bond Spread and the Economy Junk bond spread = junk bond yields – Aaa corporate bond yields A rise in the junk bond spread indicates a growing fear among bond market investors that marginal-quality corporate borrowers are more likely to default on their debts (i.e. a weakening economy). Default Risk and Interest Rates

Credit derivatives are financial contracts that seek to protect lenders against default risk by shifting that risk to someone else willing to accept it for a fee. In a credit swap, two or more lenders agree to exchange a portion of their expected payments. A credit option may enable the lender to be reimbursed if a credit asset begins to lose value. New Ways of Dealing with Default Risk: Credit Derivatives

New Ways of Dealing with Default Risk: Credit Derivatives

A call privilege on a bond contract grants the borrower the option to retire all or a portion of a bond issue by buying back the securities in advance of maturity at a specified call price. A bond may be callable immediately, or the privilege may be deferred for a specified period of time. Call Privileges and Call Risk

The yield on called financial assets can be calculated by equating the security’s price (P) with the present value of all its future cash flows (I): Call Privileges and Call Risk n = the number of periods until maturity k = the time period in which the security is called, k < n I = future cash flow C = call price i = the interest rate the call price is reinvested at h = holding period yield

Advantages and Disadvantages The call option is an advantage to the security issuer because it grants greater financial flexibility and the potential for reducing future interest costs. However, it is a disadvantage to the security buyer. The holding-period yield may decline if the security is called, and the potential for capital gains is limited. Call Privileges and Call Risk

The Call Premium & Interest Rate Expectations Issuers of callable securities must pay a call premium in the form of a higher interest rate. The call premium is higher if the market expects interest rates to fall (such that the call risk is higher), the call deferment period is shorter, and the call price is lower. Call Privileges and Call Risk

Prepayment risk is the risk that the purchaser may receive higher-than-expected repayments of principal early in the life of loan-backed securities. Prepayment risk is especially valid for the investors in securities that are backed by home mortgage loans, as many home loans will be retired early due to loan refinancing and home-owner turnover. Loan-back securities – Secondary mortgage Facility (SMF) In Indonesia, a new SMF company just established last year and is yet to operate. Prepayment Risk and the Yields on Loan-Backed Securities

Prepayment Risk and the Yields on Loan-Backed Securities

Since prepayments may lower the investor’s return, loan-backed securities with greater prepayment risks are priced lower. One of the most popular devices today to reduce prepayment risk is to divide the loan-backed security issue into classes or tranches. Each tranche promises a different rate of return based on a different maturity and risk profile. Prepayment Risk and the Yields on Loan-Backed Securities

Taxes imposed by the government can have a profound effect on the returns earned by investors on financial assets. Thus, governments can use their taxing power to encourage the investment in certain financial assets, thereby redirecting the flow of savings and investment toward areas of critical social need. Tax-exempt securities represent a subsidy to induce investors . The exemption privilege shifts the burden of taxation from buyers of bonds to other taxpayers Taxation of Returns on Financial Assets

In particular, governments may vary the income brackets and tax rates tie the applicable tax rates to the length of time that securities were held grant certain amounts of tax exemptions for various categories enable the deduction of capital losses (up to specified limits) change the permissible annual contributions to educational or retirement accounts Taxation of Returns on Financial Assets

After-tax yield = (1– t) Before-tax yield where t is the investor’s marginal tax rate An investor will be indifferent between taxable and tax-exempt securities when Tax-exempt yield = (1– t) Taxable yield To make valid comparisons between taxable and tax-exempt issues, the taxed investor should convert all expected yields to an after-tax basis. Taxation of Returns on Financial Assets

Convertible(or hybrid)securities are special issues of corporate bonds or preferred stock that can be exchanged for a specific number of shares of the issuing firm’s common stock. Convertibles offer the investor the prospect of a stable interest or dividend income, as well as capital gains on common stock on conversion. Hence, investors are generally willing to pay a premium for convertibles. Convertible Securities

For the corporate bond issuer, the advantages of convertible bonds is a significantly lower interest cost and being able to avoid issuing more common stock. Interest on convertible bonds is often a tax-deductible expense in many countries too. Note that the issuer may call in the securities early, forcing conversion. Convertible Securities

Lecture Notes The Risk Structure of Interest Rates: (Chapter 8)