Chapter 5. The Term and Risk Structure of Interest Rates. Learning Objectives. The Term Structure of Rates and the Yield Curve

Transcription

1 Chapter 5 The Term and Risk Structure of Interest Rates Learning Objectives Envision and draw the yield curve and describe the determinants of its slope Explain how risk is important in influencing interest rates Comprehend the impact on interest rates of income taxes 5-2 the Yield Curve Term Structure Relationship among Yields of different maturities of the same type of security Yield Curve (Figure 5.1) Graphical relationship between yield and maturity Yield is measured on the vertical axis and term to maturity is on the horizontal 5-3 1

2 Yield Curve (Figure 5.1) (Cont.) The basic question does the curve slope upward, downward, or horizontal (Figure 5.1) In the real world yields on all maturities tend to move together while there are distinct, divergent patterns between movements in short-term and longterm yields. 5-4 FIGURE 5.1 Three alternative yield curves. 5-5 Curve Supply and Demand Determined by relative supply/demand of different maturities Deals with each maturity by itself and ignores the interrelationships between different maturities of the same security 5-6 2

3 The Pure Expectations Approach Short-term and long-term securities are very good substitutes for each other within investor s portfolios who collectively impact the market Therefore, there are not separate markets for short-term and long-term securities, there is a single market 5-7 Curve (Cont.) The Pure Expectations Approach (Cont.) These investors are interested in the return over the period and not the maturity date of the final payment Implies that expectation of future short-term rates determines how long-term rates are related to short-term rates Buying and selling pressure maintains the long-term rate as an average of current short-term rate and the expected future short-term rates 5-8 The Pure Expectations Approach (Cont.) If expected future short-term rates are above current shortterm rates yield curve will be upward sloping Alternatively, lower expected short-term rates will cause the curve to be downward sloping The key to expectations theory is that short-term securities and long-term securities are good substitutes for each other 5-9 3

4 The Liquidity Premium Modification Prices of long-term securities are more volatile Possibly suffer capital loss if owner needs to sell security prior to maturity Prefer to hold short-term securities for liquidity Demand liquidity (risk) premium for exposure to price uncertainty with long-term securities Suggests long-term rates will always be higher than shortterm 5-10 The Preferred Habitat Approach Different investors actually have a preference for different maturities depends on their liquidity needs This suggests the supply/demand concept for different maturities will establish the specific rates for each maturity range Changes in supply/demand can cause the rates to get out of line with expectations The Preferred Habitat Approach (Cont.) However, Investors will drop preferred habitat if rates get out of line with expectations and switch portfolio holdings This portfolio adjustment will cause the rates to become more in line with the expectations theory

5 Different Theories of the Shape of the Yield Real-World Observations When interest rates are high relative to past rates, investors expect them to decline and the price of bonds to rise in the future resulting in big capital gains Investors would then favor long-term securities, which drives up price and lowers yield downward sloping yield curve (Figure 5.2) 5-13 FIGURE 5.2 Yields on U.S. government securities Real-World Observations (cont.) Opposite if interest rates are low relative to past results in an upward sloping curve Historically, over the business cycle short-term rates fluctuate more than longer-term rates (Figure 5.3) Yield curves tend to be upward sloping more often, suggesting the liquidity premium is the dominant theory

6 FIGURE 5.3 Three different Treasury rates Summary of term structure theory Expectations theory forms the foundation of the slope of the curve Liquidity premium theory makes a long-term permanent modification that suggests an upward sloping curve Over short periods, relative supplies of securities have an impact on yields, altering the shape of the curve 5-17 An Aside on Marketability Recently issued government bonds (current coupon on the run ) are more marketable as compared to older issues ( off the run ) Because these newly issued bonds are highly marketable, they carry somewhat lower yields to maturity as compared to older issues

7 Risk and Tax Structure of Rates Default Risk Other than US Federal government securities, bonds carry a risk of default Risk on municipal bonds used to be considered very low However, experience of New York City (1975), Cleveland (1978) and Orange Country, California (1995) suggest these bonds are becoming riskier Corporate bonds generally have a higher default risk than municipal bonds Investors will expect higher return to compensate for increased default risk 5-19 Risk and Tax Structure of Rates (Cont.) Default Risk (Cont.) Standard and Poor s and Moody s Investors Service rate the default risk on bonds which serve as a guide to investors The introduction of risk in the yield curve will cause the curve to shift since another variable other than maturity has changed The higher the perceived risk, the greater the upward shift of the curve for that particular security (Figure 5.4) 5-20 FIGURE 5.4 Riskier securities carry higher yields

8 Risk and Tax Structure of Rates (Cont.) Tax Structure Investors are concerned about the after tax return on bonds Although municipal bonds are riskier than federal government bonds, tax exempt status of municipal bonds will generally result in a lower yield (downward shift of the curve) (Figure 5.4) 5-22 TABLE 5.1 A Guide to Bond Ratings 5-23 Appendix BOND PRICE VOLATILITY: DURATION VERSUS MATURITY 8

9 APPENDIX BOND PRICE VOLATILITY: DURATION VERSUS MATURITY Problem with relationship between bond price volatility and maturity stems from the way maturity is defined Maturity is typically the date of final repayment of principal This ignores the fact that the bond makes coupon payments before principal is repaid 5-25 APPENDIX BOND PRICE VOLATILITY: DURATION VERSUS MATURITY (cont.) More comprehensive measure of maturity is duration Duration is defined as a weighted average of the time periods when a bond s payments are made Takes into account the timing of coupon and principal payments A bond with longer duration has greater price volatility than a bond with short duration The higher the yield to maturity, the lower the duration of a bond Lower coupon payments mean longer duration Duration always equals maturity for zero-coupon bond (and is less than maturity for bonds with coupons 5-26 TABLE 5A.1 Duration of Bonds with Different Maturities