2014 Pearson Education Inc LEARNING OBJECTIVES After studying

LEARNING OBJECTIVES After studying this chapter, you should be able to: 5. 1 Explain why bonds with the same maturity can have different interest rates. 5. 2 Explain why bonds with different maturities can have different interest rates. © 2014 Pearson Education, Inc.

Searching for Yield • In the aftermath of the Great Recession, many investors responded to low interest rates by searching for ways to earn more income from their savings. • To earn significantly higher interest rates, investors need to purchase longterm bonds or those with relatively high default risk. • As a result, there was great demand for junk bonds, causing interest rates on these bonds to reach record lows. • In this chapter, we study the relationships among different interest rates. © 2014 Pearson Education, Inc.

Key Issue and Question Issue: During the financial crisis, the bond rating agencies were criticized for having given high ratings to securities that proved to be very risky. Question: Should the government more closely regulate the credit rating agencies? © 2014 Pearson Education, Inc. 4 of 50

5. 1 Learning Objective Explain why bonds with the same maturity can have different

The Risk Structure of Interest Rates Why might bonds that have the same maturities have different interest rates? • Risk • Liquidity • Information costs • Taxation The risk structure of interest rates is the relationship among interest rates on bonds that have different characteristics but the same maturity. The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 6 of 50

Default Risk Default risk (or credit risk) is the risk that the bond issuer will fail to make payments of interest or principal. Measuring Default Risk • The default risk premium on a bond is the difference between the interest rate on the bond and the interest rate on a Treasury bond with the same maturity. • Many investors rely on credit rating agencies to provide them with information on the creditworthiness of corporations and governments. A bond rating is a single statistic that summarizes a rating agency’s view of the issuer’s likely ability to make the required payments on its bonds. The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 7 of 50

The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 8 of 50

Changes in Default Risk and in the Default Risk Premium Determining Default Risk Premium in Yields The initial default risk premium is the difference in yields associated with the prices P 1 T and P 1 C. Figure 5. 1 (1 of 2) The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 9 of 50

Changes in Default Risk and in the Default Risk Premium Determining Default Risk Premium in Yields As the default risk on corporate bonds increases, the demand for corporate bonds shifts to the left in panel (a), and the demand for Treasury bonds shifts to the right in panel (b). Figure 5. 1 (2 of 2) The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 10 of 50

Changes in Default Risk and in the Default Risk Premium Rising Default Premiums during Recessions The default premium typically rises during a recession. The increase in the default premium was much larger in the 2007 -2009 recession than the 2001 recession. Figure 5. 2 The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 11 of 50

Making the Connection Do Credit Rating Agencies Have a Conflict of Interest? • John Moody began modern bond ratings with Moody’s Analyses of Railroad Investments in 1909. • By the late 1970 s, recession, inflation, and government regulations expanded the work of credit rating agencies. • When credit rating agencies began charging firms and governments—rather than investors—for their services, a conflict of interest emerged. • Credit rating agencies came under increased scrutiny during the financial crisis. • In 2010, Congress passed the Dodd-Frank Act that affected the regulations of credit rating agencies, and created a new office within the Securities and Exchange Commission (SEC) to oversee credit rating agencies. The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 12 of 50

Liquidity and Information Costs • Investors care about liquidity, so they are willing to accept a lower interest rate on more liquid investments. • Spending time and money acquiring information on a bond reduces the bond’s expected return. • A change in a bond’s liquidity or the cost of acquiring information about the bond affects its demand. • During the financial crisis of 2007– 2009, homeowners defaulted on many of the mortgages contained in mortgage-back bonds. Investors also had difficulty finding information about the types of mortgages in them. The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 13 of 50

Tax Treatment • Investors care about the return they receive left after paying their taxes. How the Tax Treatment of Bonds Differs Municipal bonds are bonds issued by state and local governments. The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 14 of 50

How the Tax Treatment of Bonds Differs • Recall the two types of income from owning bonds: (1) interest income from coupons – taxed at the same rates as wage and salary income. (2) capital gains or losses from price changes on the bonds – taxed at a lower rate than interest rate, and taxed only if they are realized, i. e. , a bold sold at a higher price than paid for. The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 15 of 50

The Effect of Tax Changes on Interest Rates The Effect of Changes in Taxes on Bond Prices If the federal income tax rate increases, the demand curve for tax-exempt municipal bonds shifts to the right in panel (a), and the demand curve for Treasury bonds shifts to the left in panel (b). Figure 5. 3 © 2014 Pearson Education, Inc. 16 of 50

Solved Problem 5. 1 How Would a VAT Affect Interest Rates? Suppose the federal government replaces the federal income tax with a value-add tax (VAT), which is collected at each stage of production. Explain the effect of this policy change on the interest rates on municipal bonds, corporate bonds, and Treasury bonds. Draw three graphs, one for each market, to illustrate your answer. The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 17 of 50

Solved Problem 5. 1 How Would a VAT Affect Interest Rates? Solving the Problem Step 1 Review the chapter material. Step 2 Analyze the effect of the tax policy change on the interest rate on municipal bonds. The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 18 of 50

Solved Problem 5. 1 How Would a VAT Affect Interest Rates? Solving the Problem (continued) Step 3 Analyze the effect of the tax policy change on the interest rate on corporate bonds. Step 4 Analyze the effect of the tax policy change on the interest rate on Treasury bonds. Step 5 Summarize your findings. The policy change would increase the interest rate on municipal bonds and lower the interest rates on corporate bonds and Treasury bonds. The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 19 of 50

The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 20 of 50

Making the Connection In Your Interest Should You Invest in Junk Bonds? • Junk bonds are corporate bonds with lower than investment grade rating (e. g. , Ba or below from Moody’s). • In the late 1970 s, Michael Milken advocated investing in junk bonds as historical data show that a diversified portfolio of junk bonds brought to increases in returns more than offset their default risk. • In 2012, increased demand for junk bonds pushed down their yields to levels that financial advisors doubted that their yields were high enough to compensate investors for their high default risk. The Risk Structure of Interest Rates © 2014 Pearson Education, Inc. 21 of 50

5. 2 Learning Objective Explain why bonds with different maturities can have different interest

The Term Structure of Interest Rates The term structure of interest rates is the relationship among the interest rates on bonds that are otherwise similar but that have different maturities. • The Treasury yield curve shows the relationship among the interest rates on Treasury bonds with different maturities. • An upward-sloping yield curve occurs when short-term rates are lower than long-term rates. • Infrequently, a downward-sloping yield curve occurs when short-term interest rates are higher than long-term interest rates. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 23 of 50

Figure 5. 4 The Treasury Yield Curve This figure shows the Treasury yield curves

Figure 5. 5 The Interest Rates on 3 -Month Treasury Bills and 10 -Year Treasury Notes, January 1970–August 2012 The figure shows that most of the time since 1970, the interest rates on 3 -month Treasury bills have been lower than the interest rates on 10 -year Treasury notes. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 25 of 50

Making the Connection Negative Interest Rates on Treasury Bills? • Can the nominal interest rate ever be negative? • A negative nominal interest rate means that the lender is actually paying the borrower interest in return for borrowing the lender’s money. • During the Great Depression and the financial crisis of 2007– 2009, investors were willing to accept negative interest rates on the Treasury bills. • Because interest rates on other short-term investments (e. g. , bank CD), were also very low, investors were giving up relatively little to temporarily park their funds in default-risk free Treasury bills. • In the summer of 2012, fears that the governments of Greece and Spain might default on their debt also led to negative interest rates for short-term government bonds issued by France and Germany. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 26 of 50

Explaining the Term Structure Any explanation of the term structure should be able to account for three facts: 1. Interest rates on long-term bonds are usually higher than interest rates on short-term bonds. 2. Interest rates on short-term bonds are occasionally higher than interest rates on long-term bonds. 3. Interest rates on bonds of all maturities tend to rise and fall together. Economists have advanced three theories to explain these facts: • expectations theory • segmented markets theory • liquidity premium theory or preferred habitat theory The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 27 of 50

The Expectations Theory of the Term Structure Expectations theory holds that the interest rate on a long-term bond is an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond. Two key assumptions: 1. Investors have the same investment objectives. 2. For a given holding period, investors view bonds of different maturities as being perfect substitutes for one another. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 28 of 50

The Expectations Theory Applied in a Simple Example You invest $1, 000 for two years and are considering one of two strategies: 1. The buy-and-hold strategy. You buy a two-year bond and hold it until maturity. After two years, the $1, 000 investment will have grown to $1, 000(1 + i 2 t). 2. The rollover strategy. You buy a one-year bond today and hold it until it matures in one year. At that time, you buy a second one-year bond, and you hold it until it matures at the end of the second year. After two years, you will expect your $1, 000 investment to have grown to $1, 000(1 + i 1 t) (1 + ie it+1). With the rollover strategy, you must form an expectation of what the interest rate on the one-year bond will be. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 29 of 50

The Expectations Theory Applied in a Simple Example The expectations theory assumes that the returns from the two strategies must be the same. Arbitrage should result in the returns from the two strategies being the same: This means: For an n-year bond, the interest rate is: The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 30 of 50

Interpreting the Term Structure Using the Expectations Theory The Term Structure of Interest Rates

Interpreting the Term Structure Using the Expectations Theory The expectations theory implies: • An upward-sloping yield curve is the result of investors expecting future short-term rates to be higher than the current short-term rate. • A flat yield curve is the result of investors expecting future short-term rates to be the same as the current short-term rate. • A downward-sloping yield curve is the result of investors expecting future short-term rates to be lower than the current short-term rate. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 32 of 50

Figure 5. 6 Using the Yield Curve to Predict Interest Rates: The Expectations Theory Under the expectations theory, the slope of the yield curve shows that future short-term interest rates are expected to: (a) rise, (b) remain the same, or (c) fall relative to current levels. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 33 of 50

Shortcomings of the Expectations Theory • The expectations theory explains an upward-sloping yield curve as the result of investors expecting future short-term rates to be higher than the current short-term rate. • But if the yield curve is typically upward sloping, investors must be expecting short-term rates to rise most of the time. • This explanation seems unlikely because short-term rates are about as likely to fall as to rise at any given time. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 34 of 50

Solved Problem 5. 2 A In Your Interest Can You Make Easy Money from the Term Structure? The term interest carry trade refer to borrowing at a low short-term interest rate and using the borrowed funds to invest at a higher long-term interest rate. a. Would you use an interest-carry-trade strategy for your personal investments? Identify the difficulties with this strategy for an individual investor. b. If you were an investment adviser for an institutional investor, would you advise that investor to use an interest-carry-trade strategy? Identify the difficulties with this strategy for an institutional investor. b. If the yield curve was inverted, or downward sloping, would an institutional investor still find an interest-carry-trade strategy to be possible? Briefly explain. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 35 of 50

Solved Problem 5. 2 A In Your Interest Can You Make Easy Money from the Term Structure? Solving the Problem Step 1 Review the chapter material. Step 2 Answer part (a) by explaining whether an individual investor can profitably engage in an interest carry trade. • • The yield curve is typically upward sloping, so borrowing short term and investing the funds long term seems a good investment strategy. But the average investor would have difficulty using this strategy because the gap between the rate at which she can borrow and the long-term bond rate is often too small or even negative. Step 3 Consider the situation of an institutional investor to answer part (b). • • Unlike individual investors, institutional investors can borrow at a low short-term rate and they face less default risk. But interest rate carry trade would not bring potential profits because the expectations theory holds that the average of the expected short-term interest rates should be roughly equal to the equivalent long-term interest rates. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 36 of 50

Solved Problem 5. 2 A In Your Interest Can You Make Easy Money from the Term Structure? Solving the Problem (continued) Step 3 Answer part (b) by explaining whether the interest carry trade would still be possible if the yield curve were inverted. • If the yield curve were inverted, an institutional investor could borrow long term and invest the funds at the higher short-term rates. • In this case, the investor would be subject to reinvestment risk— the risk that the interest rate on new short-term investments will declined after the short-term investment mature. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 37 of 50

The Segmented Markets Theory of the Term Structure Segmented markets theory holds that the interest rate on a bond of a particular maturity is determined only by the demand supply of bonds of that maturity. Two related observations: 1. Investors in the bond market do not all have the same objectives. 2. Investors do not see bonds of different maturities as being perfect substitutes for each other. • Segmented markets means that investors in the market for bonds of one maturity do not participate in markets for bonds of other maturities. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 38 of 50

The Segmented Markets Theory of the Term Structure • Compared to short-term bonds, long-term bonds are subject to greater interest-rate risk, and they are often less liquid. • The yield curve is typically upward sloping because more investors are in the market for short-term bonds, causing their prices to be higher and their interest rates lower than long-term bonds. • But the segmented markets theory cannot explain a downward-sloping yield curve, or why interest rates of all maturities tend to rise and fall together. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 39 of 50

The Liquidity Premium Theory Liquidity premium theory (or preferred habitat theory) holds that the interest rate on a long-term bond is an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond, plus a term premium. Term premium is the additional interest investors require in order to be willing to buy a long-term bond rather than a comparable sequence of short-term bonds. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 40 of 50

The Liquidity Premium Theory • This theory adds a term premium to the expectations theory’s equation: where is the term premium on a two-year bond. The interest rate on an n-period bond is equal to: The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 41 of 50

Solved Problem 5. 2 B Using the Liquidity Premium Theory to Calculate Expected Interest Rates Given the data and the liquidity premium theory, what did investors expect the interest rate to be on the one-year Treasury bill two years from that time if the term premium on a two-year Treasury note was 0. 20% and the term premium on a three-year Treasury note was 0. 40%? The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 42 of 50

Solved Problem 5. 2 B Using the Liquidity Premium Theory to Calculate Expected Interest Rates Solving the Problem Step 1 Review the chapter material. Step 2 Use the liquidity premium equation that links the interest rate on a long-term bond to the interest rates on short-term bonds to calculate the interest rate that investors expected on the one-year Treasury bill in one year. Step 3 Answer the problem by using the result from step 2 to calculate the interest rate investors expected on the one-year Treasury bill in two years. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 43 of 50

The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 44 of 50

Can the Term Structure Predict Recessions? • Economists have found the yield curve to be useful for predicting recessions. • During every recession since 1953, the term spread between the yields on long-term and short-term Treasury securities narrowed significantly. • During recessions, interest rates typically fall, and short-term rates tend to fall more than long-term rates. • In this situation, the liquidity premium theory predicts that long-term rates should fall relative to short-term rates, making the yield curve inverted. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 45 of 50

Can the Term Structure Predict Recessions? Figure 5. 7 Interpreting the Yield Curve Models of the term structure help analysts use data on the Treasury yield curve to forecast the future path of the economy. The Term Structure of Interest Rates © 2014 Pearson Education, Inc. 46 of 50

Answering the Key Question At the beginning of this chapter, we asked the question: “Should the government more closely regulate credit rating agencies? ” Like other policy questions, this question has no definitive answer. During the financial crisis of 2007– 2009, many bonds had much higher levels of default risk than the credit rating agencies had indicated. Some observers argued that the rating agencies had a conflict of interest in being paid by the firms whose bond issues they rate. Other observers argued that the ratings may have been accurate when given, but the creditworthiness of the bonds declined rapidly following the housing bust and the financial crisis. © 2014 Pearson Education, Inc. 47 of 50