+

CH3
Structure of Interest Rates
3 Structure of Interest Rates
Chapter Objectives

■ describe how characteristics of debt securities

cause their yields to vary
■ demonstrate how to estimate the appropriate
yield for any particular debt security
■ explain the theories behind the term structure of
interest rates (relationship between the term to
maturity and the yield of securities)

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2
Why Debt Security Yields Vary

The yields on debt securities are affected:

Credit (default) risk
Liquidity
Tax status
Term to maturity

3 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Why Debt Security Yields Vary

1. Credit (Default) Risk – securities with a higher

degree of default risk offer higher yields.
a. Rating Agencies - Rating agencies charge the issuers of
debt securities a fee for assessing default risk. (Exhibit
3.1).
b. Accuracy of Credit Ratings - The ratings issued by the
agencies are useful indicators of default risk but they are
opinions, not guarantees.
c. Oversight of Credit Rating Agencies - The Financial
Reform Act of 2010 established an Office of Credit Ratings
within the Securities and Exchange Commission in order to
regulate credit rating agencies. Rating agencies must
establish internal controls.

4 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
+
Default risk Affecting Security Yields

 Benchmark—risk-free rate for given maturity

 Defaultrisk premium = risky security yield –
treasury security yield of same maturity
 Defaultrisk premium = market expected
default loss rate
 Rating agencies set default risk ratings
 Anticipated or actual ratings changes impact
security prices and yields
Exhibit 3.1 Rating Classification by Rating Agencies

6 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
+ 7

Liquidity Affecting Security Yields

 TheLiquidity of a security affects the

yield/price of the security
A liquid investment is easily converted to
cash at minimum transactions cost
 Investors
pay more (lower yield) for liquid
investment
 Liquidityis associated with short-term, low
default risk, marketable securities
+ 8

Tax Affecting Security Yields

 Tax status of income or gain on security impacts the security

yield

 Investor concerned with after-tax return or yield

 Investors require higher yields For higher taxed securities

Why Debt Securities Yields Vary

Computing the Equivalent Before-Tax Yield:

 at   bt (1  T )
 at = after-tax yield
 bt = before-tax yield

= Investor’s marginal tax rate

T
Computing the Equivalent Before-Tax Yield:

 at
 bt 
(1  T )
9 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 3.2 After-Tax Yields Based on Various Tax Rates
and Before-Tax Yields

10 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
+
Maturity Affecting Security Yields

 Term to maturity
 Interest rates typically vary by maturity.
 The term structure of interest rates defines the relationship
between maturity and yield.
 The Yield Curve is the plot of current interest yields versus time
to maturity.
 Exhibit 3.3 Example of Relationship between Maturity
and Yield of Treasury Securities (as of May 2011)

12 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
+
Yield Curve Shapes

Normal Level or Flat Inverted

 Explaining Actual Yield Differentials

1. Small yield differentials can be relevant

2. The yield differential is the difference
between the yield offered on a security and
the yield on the risk-free rate.
3. They are sometimes measured in basis points
where 1bp = 0.01%

14 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Yield Differentials on Money Market Securities

1. Yields on commercial paper and negotiable

CDs are only slightly higher than T-bill rates
to compensate for lower liquidity and higher
default risk.
2. Market forces cause the yields on all
securities to move in the same direction.
3. Treasury bonds have the lowest yield
because of their low default risk and high
liquidity.

15 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 3.4 Yield Differentials of Corporate Bonds

16 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Estimating the Appropriate Yield

Yn = Rf,n + DP + LP + TA
where:

Yn = yield of an n-day debt security

Rf,n = yield of an n-day Treasury (risk-free) security

DP = default premium to compensate for credit risk

LP = liquidity premium to compensate for less

liquidity

TA = adjustment due to difference in tax status

17 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 A Closer Look at the Term Structure

1. Pure Expectations Theory: Term structure

reflected in the shape of the yield curve is
determined solely by the expectations of interest
rates.
a. An expected increase in rates leads to an
upward sloping yield curve (Exhibit 3.5)
b. An expected decrease in rates leads to a
downward sloping yield curve.
c. Long-term rates are average of current short-
term and expected future short-term rates
d. Yield curve slope reflects market expectations
of future interest rates

18 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 A Closer Look at the Term Structure

Algebraic Presentation:

(1 t i2 ) 2  (1 t i1 )(1 t 1 F1 )

i  known annualized interest rate of a two - year security at time t

t 2

i  known annualized interest rate of a one - year security at time t

t 1

t 1 F1  one - year interest rate that is anticipate d as of time t  1

19 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
+ 20

Pure Expectations Theory

Explaining Shape of Yield Curve
Downward-
Upward- Sloping
Sloping Yield Curve
Yield Curve

 Expected higher interest  Expected lower interest

rate levels rate levels
 Expansivemonetary  Tightmonetary
policy(Reason behind) policy(Reason behind)
 Expanding economy  Recession soon?
 A Closer Look at the Term Structure

2. Liquidity Premium Theory: Investors prefer

short-term liquid securities but will be willing to
invest in long-term securities if compensated
with a premium for lower liquidity.
a. Explains upward-sloping yield curve

Estimation of Forward Rates Based on

Liquidity Premium
(1 + ti2)2 = (1 + ti1)(1 + t+1r1) + LP2

where LP2 is the liquidity premium on the 2 year security

21 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 3.6 Impact of Liquidity Premium on the Yield
Curve under Three Different Scenarios

22 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 A Closer Look at the Term Structure

3. Segmented Markets Theory: Investors choose

securities with maturities that satisfy their
forecasted cash needs.
Limitations of the theory:
Some borrowers and savers have the flexibility to choose
among various maturities
Implications: Preferred Habitat Theory (A more
flexible perspective)
Although investors and borrowers may normally
concentrate on a particular maturity market, certain
events may cause them to wander from their “natural” or
preferred market.

23 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Research on the Term Structure Theories

1. Interest rate expectations have a strong influence

on the term structure of interest rates.
2. However, the forward rate derived from a yield
curve does not accurately predict future interest
rates, and this suggests that other factors may be
relevant.
3. General Research Implications - Although the
results differ, there is evidence that expectations,
liquidity premium, and segmented markets
theories all have some validity.

24 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Integrating the Theories of the Term Structure

1. If we assume the following conditions:

a. Investors and borrowers currently expect interest
rates to rise.
b. Most borrowers need long-term funds, while most
investors have only short-term funds to invest.
c. Investors prefer more liquidity to less.
2. Then all three conditions place upward
pressure on long-term yields relative to short
term yields leading to upward sloping yield
curve. (Exhibit 3.7)

25 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 3.7 Effect of Conditions in Example of Yield
Curve

26 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Use of the Term Structure

1. Forecasting Interest Rates

a. The shape of the yield curve can be used to
assess the general expectations of investors and
borrowers about future interest rates.
b. The curve’s shape should provide a reasonable
indication (especially once the liquidity
premium effect is accounted for) of the market’s
expectations about future interest rates.
2. Forecasting Recessions - Some analysts
believe that flat or inverted yield curves
indicate a recession in the near future.

27 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Use of the Term Structure

3. Making Investment Decisions - If the yield

curve is upward sloping, some investors may
attempt to benefit from the higher yields on
longer-term securities even though they
have funds to invest for only a short period of
time.
4. Making Decisions about Financing - Firms
can estimate the rates to be paid on bonds
with different maturities. This may enable
them to determine the maturity of the bonds
they issue.

28 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Use of the Term Structure

1. Why the Slope of the Yield Curve Changes -

Conditions may cause short-term yields to change in
a manner that differs from the change in long-term
yields. (Exhibit 3.8)
2. How the Yield Curve Has Changed over Time -
Yield curves at various dates are illustrated in
Exhibit 3.9.
3. International Structure of Interest Rates - The
yield curve’s shape at any given time also varies
among countries. Exhibit 3.10 plots the yield curve
for six different countries in January 2009.

29 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 3.8 Potential Impact of Treasury Shift from
Long-Term to Short-Term Financing

30 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 3.9 Yield Curves at Various Points in Time

31 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 3.10 Yield Curves among Foreign
Countries (as of May 2011)

32 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SUMMARY

 Quoted yields of debt securities at any given time

may vary for the following reasons. First, securities
with higher credit (default) risk must offer a higher
yield. Second, securities that are less liquid must
offer a higher yield. Third, taxable securities must
offer a higher before-tax yield than do tax-exempt
securities. Fourth, securities with longer maturities
offer a different yield (not consistently higher or
lower) than securities with shorter maturities.
 The appropriate yield for any particular debt
security can be estimated by first determining the
risk-free yield that is currently offered by a Treasury
security with a similar maturity. Then adjustments
are made that account for credit risk, liquidity, tax
status, and other provisions.
33 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SUMMARY

 The pure expectations theory suggests that the

shape of the yield curve is dictated by interest rate
expectations. The liquidity premium theory suggests
that securities with shorter maturities have greater
liquidity and therefore should not have to offer as
high a yield as securities with longer terms to
maturity. The segmented markets theory suggests
that investors and borrowers have different needs
that cause the demand and supply conditions to vary
across different maturities. Consolidating the
theories suggests that the term structure of interest
rates depends on interest rate expectations, investor
preferences for liquidity, and the unique needs of
investors and borrowers in each maturity market.

34 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.