Lesson 6: Risk Structure and Term Structure of Interest Rates |
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Upon completion of this lesson, you should be able to do the following:
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IntroductionThis lesson examines the relationships among many different interest rates and the term structure of interest rates. From the last lesson, the assumption was made that there was only one interest rate. However, there are many interest rates. There are four factors that cause interest rates to differ. Differences in Interest Rates1. Default risk the possibility a borrower will not pay back the principal and/or interest on the loans. For example, the U.S. government bonds have little risk of default (called default-risk-free instruments ), because the government can raise taxes, "print money," or issue new debt, when it gets into financial trouble. Business corporations have some risk of default. The business can bankrupt and not be able to pay off its debt. The difference between the interest rate on the U.S. government bonds and corporate bonds is called the default risk premium . The risk premium is the additional interest investors must earn in order to hold a "risky" bond and the risk premium is always positive. Private firms such as Standard & Poor's Corporation and Moody's Investor Service determine the size of the default risk of corporations. These companies calculate a single statistic, called the bond rating . The bond rating is based on a corporation's net worth, cash flow, and ability to meet its debt obligations. Start the model with government and corporate bonds that have zero risk. Bond prices and interest rates are the same for both markets. Corporations have financial trouble, so investors think there is a risk of default. Some investors demand less corporate bonds (demand curve shifts left), and invest in government bonds. The government bonds are considered default-free and the demand curve shifts right. |
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The first thing you notice is the government bonds increase in price, while the price of corporate bonds fall. The market interest rate always go in the opposite direction of the price of bonds. When government bond prices increases, the market interest rates decrease. The corporate bond prices decrease, causing the market interest rate to increase. The difference between the government bond and corporate bond interest rates is the risk premium. As the default risk increases, then the risk premium increases too. During recessions, when some businesses start failing, the default risk increases, so the risk premium increases, and the difference between government and corporate interest rates increase too. 2. Liquidity - U.S. government securities are the most liquid and widely traded, so they are the easiest to buy and sell. Corporate bonds are not as liquid and not as widely traded, so there could be difficulties in quickly selling them. This model is very similar to the risk of default model that was depicted above. Start the model with the same liquidity in the government bond and corporate bond markets. |
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The secondary markets become stronger for government bonds, so liquidity increases for these securities. The investors are attracted to the government bonds, because they are more liquid and demand increases (demand curve shifts to the right). Investors decrease their trading of corporate bonds, because they are less liquid, causing the demand curve to shift left. The government bond prices increase, causing the interest rate for government bonds to decrease. The corporate bond prices decrease, causing the market interest rate for corporate bonds to increase. The difference between the two interest rates reflect the degree of liquidity. However it is still called a risk premium. 3. Information costs - the more time and money to acquire information on securities imposes high information costs. These costs are included in the interest rate and are the cost of borrowing. For example, U.S. government securities are well known and have the lowest information costs out of all securities. Large corporations are well-known and have low information costs. The information costs for new and small companies are high and therefore, these companies will pay a higher interest rate when they borrow funds. Using a model to demonstrate this, start the model for high and low-information-cost bond markets with the same level of information. The liquidity and risk of default for these two markets are the same. |
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The costs of acquiring information increases, causing investors to be attracted to the low-information-cost bonds. The demand increases for low-information-cost bonds, causing the market price to increases and market interest rate to decrease. The high-information-cost bonds are not as attractive as an investment, so investors buy less bonds, causing bond prices to decrease and interest rates to increase. Therefore, low-information-cost bonds have a lower interest rate. 4. Taxes - U.S. government bonds have lower risk of default and higher liquidity than municipal bonds (state and local government bonds). For the last 50 years, the interest rates of municipal bonds have been lower than U.S. government bonds. The reason is the interest earned on municipal bonds are exempt from U.S. government taxes, while U.S. government securities are taxed. If you bought municipal bonds, you would earn less interest than U.S. government securities. However, you pay no taxes, which compensates you for the higher risk and lower liquidity. Using the same model as the default risk and liquidity models, start the model that both the municipal bond and non-municipal bond markets are subjected to income taxes. The default risk, liquidity, and information costs are equivalent for both markets. |
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The government passes laws that exempt municipal bonds from taxation. Investors are attracted to municipal bonds and demand increases, causing the market price to increases and market interest rate to decrease. The non-municipal bonds are not as attractive as an investment, so investors buy less bonds, causing bond prices to decrease and interest rates to increase. Therefore, municipal bonds have a lower interest rate. Term Structure of Interest Rates |
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Three theories have been proposed to explain why the yield curve has these two characteristics.
The yield curve is a useful indicator of economic activity. When a yield curve is downward sloping, specifically a three-month T-Bill has a higher interest rate than a 10-year T-bond, a recession usually occurs one year later. |