The Risk and Term Structure

of Interest Rates

Financial Markets
Week 5

Copyright © 2019 Pearson Education, Ltd.

Preview

• In this chapter, we examine the sources and causes

of fluctuations in interest rates relative to one
another and look at a number of theories that
explain these fluctuations.
Learning Objectives

• Identify and explain three factors explaining the

risk structure of interest rates.

• List and explain the three theories of why interest

rates vary across maturities.
Risk Structure of Interest Rates
(1 of 3)

• Bonds with the same maturity have different interest

rates due to:
– Default risk
– Liquidity
– Tax considerations
Figure 1 Long-Term Bond Yields,
1919–2017

Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal R
eserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2
Risk Structure of Interest Rates
(2 of 3)

• Default risk: probability that the issuer of the bond

is unable or unwilling to make interest payments or
pay off the face value

– U.S. Treasury bonds are considered default free

(government can raise taxes).
– Risk premium: the spread between the interest
rates on bonds with default risk and the interest
rates on (same maturity) Treasury bonds
Figure 2 Response to an Increase in
Default Risk on Corporate Bonds
Table 1 Bond Ratings by Moody’s,
Standard and Poor’s, and Fitch (1 of 2)

Moody’s Rating Agency S&P Fitch Definitions

Aaa AAA AAA Prime Maximum Safety
Aa1 AA+ AA+ High Grade High Quality
Aa2 AA AA Blank
Aa3 AA– AA– Blank
A1 A+ A+ Upper Medium Grade
A2 A A Blank
A3 A– A– Blank
Baa1 BBB+ BBB+ Lower Medium Grade
Baa2 BBB BBB Blank
Baa3 BBB– BBB– Blank
Ba1 BB+ BB+ Noninvestment Grade
Table 1 Bond Ratings by Moody’s,
Standard and Poor’s, and Fitch ( 2of 2)

Moody’s Rating Agency S&P Fitch Definitions

Ba2 BB BB Speculative
Ba3 BB– BB– Blank
B1 B+ B+ Highly Speculative
B2 B B Blank
B3 B– B– Blank
Caa1 CCC+ CCC Substantial Risk
Caa2 CCC — In Poor Standing
Caa3 CCC– — Blank
Ca — — Extremely Speculative
C — — May Be in Default
— — D Default

https://youtu.be/Kj2W_EqKzuw
The Global Financial Crisis and the
Baa–Treasury Spread

• Starting in August 2007, the collapse of the subprime

mortgage market led to large losses among financial
institutions. As a consequence, many investors began
to doubt the financial health of corporations with low
credit ratings such as Baa and even the reliability of
the ratings themselves. The perceived increase in
default risk for Baa bonds made them less desirable
at any given price.
Risk Structure of Interest Rates
(3 of 3)

• Liquidity: the relative ease with which an asset can

be converted into cash
– Cost of selling a bond
– Number of buyers/sellers in a bond market

• Income tax considerations

– Interest payments on municipal bonds are exempt
from federal income taxes.
Figure 3 Interest Rates on
Municipal and Treasury Bonds
Effects of the Obama Tax
Increase on Bond Interest Rates

• In 2013, Congress approved legislation favored by

the Obama administration to increase the income tax
rate on high-income taxpayers from 35% to 39%.
Consistent with supply and demand analysis, the
increase in income tax rates for wealthy people
helped to lower the interest rates on municipal
bonds relative to the interest rate on Treasury bonds.
Term Structure of Interest Rates
(1 of 4)

• Bonds with identical risk, liquidity, and tax

characteristics may have different interest rates
because the time remaining to maturity is different
Term Structure of Interest Rates
(2 of 4)

• Yield curve: a plot of the yield on bonds with

differing terms to maturity but the same risk, liquidity,
and tax considerations
– Upward-sloping: long-term rates are above
short-term rates
– Flat: short- and long-term rates are the same
– Inverted: long-term rates are below short-term
rates
Term Structure of Interest Rates
(3 of 4)

• The theory of the term structure of interest rates

must explain the following facts:

1. Interest rates on bonds of different maturities move

together over time.
2. When short-term interest rates are low, yield curves
are more likely to have an upward slope; when
short-term rates are high, yield curves are more
likely to slope downward and be inverted.
3. Yield curves almost always slope upward.
Term Structure of Interest Rates
(4 of 4)

• Three theories to explain the three facts:

1. Expectations theory explains the first two facts but

not the third.

2. Segmented markets theory explains the third fact

but not the first two.

3. Liquidity premium theory combines the two theories

to explain all three facts.
Figure 4 Movements over Time of Interest
Rates on U.S. Government Bonds with
Different Maturities

Sources: Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/

Expectations Theory (1 of 7)

• The interest rate on a long-term bond will equal an

average of the short-term interest rates that people
expect to occur over the life of the long-term bond.

• Buyers of bonds do not prefer bonds of one maturity

over another; they will not hold any quantity of a
bond if its expected return is less than that of
another bond with a different maturity.

• Bond holders consider bonds with different

maturities to be perfect substitutes.
Expectations Theory (2 of 7)

An example:

• Let the current rate on one-year bond be 6%.

• You expect the interest rate on a one-year bond to
be 8% next year.
• Then the expected return for buying two one-year
bonds averages (6% + 8%)/2 = 7%.
• The interest rate on a two-year bond must be 7% for
you to be willing to purchase it.
Expectations Theory (3 of 7)

For an investment of $1
it = today's interest rate on a one-period bond
ite+1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond
Expectations Theory (4 of 7)

Expected return over the two periods from investing $1 in the

two-period bond and holding it for the two periods
(1 + i2t )(1 + i2t ) − 1
= 1 + 2i2t + (i2t ) 2 − 1
= 2i2t + (i2t ) 2
Since (i2t ) 2 is very small
the expected return for holding the two-period bond for two periods is
2i2t
Expectations Theory (5 of 7)

If two one-period bonds are bought with the $1 investment

(1 + it )(1 + ite+1 ) − 1
1 + it + ite+1 + it (ite+1 ) − 1
it + ite+1 + it (ite+1 )
it (ite+1 ) is extremely small
Simplifying we get
it + ite+1
Expectations Theory (6 of 7)

Both bonds will be held only if the expected returns are equal
2i2t = it + ite+1
it + ite+1
i2t =
2
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
it + ite+1 + ite+ 2 + ... + ite+ ( n −1)
int =
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond
Expectations Theory (7 of 7)

• Expectations theory explains:

– Why the term structure of interest rates changes
at different times.
– Why interest rates on bonds with different
maturities move together over time (fact 1).
– Why yield curves tend to slope up when short-
term rates are low and slope down when short-
term rates are high (fact 2).

• Cannot explain why yield curves usually slope

upward (fact 3)
Segmented Markets Theory

• Bonds of different maturities are not substitutes at all.

• The interest rate for each bond with a different

maturity is determined by the demand for and supply
of that bond.

• Investors have preferences for bonds of one maturity

over another.

• If investors generally prefer bonds with shorter

maturities that have less interest-rate risk, then this
explains why yield curves usually slope upward (fact 3).
Liquidity Premium & Preferred
Habitat Theories (1 of 2)

• 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 liquidity
premium that responds to supply and demand
conditions for that bond.

• Bonds of different maturities are partial (not perfect)

substitutes.
Liquidity Premium Theory

it + it+1
e
+ it+2
e
+ ...+ it+(
e

int = n−1)
+ lnt
n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity
Preferred Habitat Theory

• Investors have a preference for bonds of one maturity

over another.

• They will be willing to buy bonds of different

maturities only if they earn a somewhat higher
expected return.

• Investors are likely to prefer short-term bonds over

longer-term bonds.
Figure 5 The Relationship Between the
Liquidity Premium (Preferred Habitat) and
Expectations Theory
Liquidity Premium & Preferred
Habitat Theories (2 of 2)

• Interest rates on different maturity bonds move together

over time; explained by the first term in the equation

• Yield curves tend to slope upward when short-term rates

are low and to be inverted when short-term rates are
high; explained by the liquidity premium term in the first
case and by a low expected average in the second case

• Yield curves typically slope upward; explained by a larger

liquidity premium as the term to maturity lengthens
Figure 6 Yield Curves and the Market’s Expectations
of Future Short-Term Interest Rates According to the
Liquidity Premium (Preferred Habitat) Theory
Figure 7 Yield Curves for U.S.
Government Bonds
Thank You