Finance 430 Chapter 5

Yield Curve

A plot of the yields on bonds with different terms to maturity but the same risk, liquidity, and tax considerations. Describes the term structure of interest rates for particular bonds, such as government bonds.

Liquidation Premium Theory

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 (also called a term premium) that responds to supply-and-demand conditions for that bond.

Expectations Theory

The interest rate on 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.

If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? What effect would it have on interest rates on US Treasury securities?

The interest rates for municipal bonds after taxes would then be lower, decreasing your return for these securities, which would make them less favorable than US Treasury bonds. US treasury bonds would then become more highly demanded, increasing the interest rates .

Default Risk

Occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures.

What effect would reducing income tax rates have on the interest rates of municipal bonds? Would interest rates of treasury securities be affected and, if so, how?

Reducing the income tax rates would not have any effect on municipal bonds since these are not part of the taxable income. Treasury securities interest rates would be affected though, due to the fact that they are included in taxable income. A reduction in income taxes would mean an increase in the after tax interest rate for US Treasury bonds, therefore decreasing the demand for municipal bonds, and increasing the demand for US Treasury bonds and increasing the interest rate for these securities.

If corporate bonds become less liquid than treasury bonds

(if we assume both securities started equal to each other) demand will fall for corporate bonds, shifting the demand curve left, The Treasury bond now becomes relatively more liquid in comparison, so its demand shifts right. - These shifts show the price of the less liquid corporate bond falls and interest rates rise, while the more liquid Treasury Bond price rises, and the interest rate falls. The Result is that the spread between the interest rates on the two bond types increases.

Default Risk Examples

- Corporations suffering big losses such as major airline companies (Delta, United, US Airways, etc) in the mid-2000s, might be more likely to suspend interest payments on its bonds. The default risk on these bonds therefore would be quite high. - By contrast, U.S. Treasury bonds have usually been considered to have no default risk because the federal government can always increase taxes to pay off its obligations.

The risk structure of interest rates is explained by three factors

1. Default Risk 2. Liquidity 3. Income Tax Treatment of Bond's Interest Payments

Three theories have been put forward to explain the term structure of interest rates, that is, the relationship among interest rates on bonds of different maturities reflected in yield curve patterns:

1. Expectations Theory 2. Market Segmentation Theory 3. Liquidity Theory

Yield Curves can be Classified as:

1. Upward-Sloping • Long Term Interest Rates are above short-term interest rates 2. Flat • Long-Term Interest Rates and Short Term Interest Rates are the Same 3. Downward-Sloping • Often referred to as an inverted yield curve. • Long-Term interest rates are lower than short term interest rates.

Bond Ratings by Standard and Poor's

AAA - Highest Quality (Lowest Default Risk) AA - High Quality A - Upper Medium Quality BBB - Medium BB - Lower Medium B - Speculative CCC - Poor (high default risk) D - Highly Spec.

Market Segmentation Theory

Sees term structure and markets for different-maturity bonds as completely separate and segmented

Why do U.S. Treasury Bills have lower interest rates than large-denomination negotiable bank C.D.'s?

Because US Treasury bills are considered default-free bonds, meaning their is no risk for default, which lowers the interest rates paid, as well as the fact that US Treasury bills are very liquid due to the large amount of these bonds that are bought/sold

Liquidation Premium Theory Assumptions

Bonds of different maturities are substitutes, which means expected return on one bond does influence expected return on another bond of a different maturity, but it allows investors to prefer one bond maturity over another - Bonds of different maturities are substitutes but not perfect substitutes.

Speculative Grade Securities (junk bonds)

Bonds with relatively high default risk (Lower than BBB). Because these bonds always have higher interest rates than investment-grade securities, they are also referred to as high- yield bonds.

Investment Grade Securities

Bonds with relatively low risk of default (BBB and above rating)

Default Free Bonds

Bonds without any default risk

My Municipal Bonds Have Lower Interest Rates then US T Bills for last 40 years

Explanation lies in the fact that interest payments on municipal bonds are exempt from federal income taxes, a factor that has the same effect on the demand for municipal bonds as an increase in their expected return.

If a yield curve looks like the one shown here, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market's predictions about the inflation rate in the future? (line is bell - curved shaped)

The short term interest rates are expected to stay relatively the same over some time. Then in the moderate future they are expected to decrease dramatically at first, then start to decrease more slowly for the long term.

Risk Premium

The spread between the interest rates on bonds with default risk and default-free bonds, both on the same maturity. Indicates how much additional interest people must earn to be willing to hold that risky bond

"If bonds of different maturities are close substitutes, their interest rates are more likely to move together." Is this statement true, false, or uncertain? Explain your answer

This statement is true due to the liquidity premium theory as well as the risk structure. If bonds of different maturities are close substitutes, that means that the shorter term bond interest rates will affect the longer term bond's interest rates as well. Based on the expectations theory, the longer term bond's interest rate will be the average of the interest rates paid by the short-term bonds during this period.

If a yield curve looks like the one shown here, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market's predictions about the inflation rate in the future. (the line starts flat and as it goes right curves upward)

This yield curve would suggest that short term interest rates are expected to fall moderately for some time, but then levy out and remain the same after that. The inflation rates will most likely stay the same during this time period (uncertain on the answer for the inflation rates part of the question)

Key assumption in market segmentation theory

bonds of different maturities are not substitutes at all, so expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity.

Key Assumptions in Expectations Theory

buyers of bonds do not prefer bonds of one maturity over the other, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. Bonds that have this characteristic are said to be perfect substitutes. What this means in practice is that if bonds with different maturities are perfect substitutes, the expected return on these bonds must be equal.

Increases in Default Risk due to large losses

default risk on corporate bonds will increase, and the expected return on these bonds will decrease.In addition, the corporates bond's return will be more uncertain.

Expected Returns on Default FreeTreasury Bonds

increases relative to the expected return on corporate bonds, while their relative riskiness declines. The Treasury bond thus, becomes more desirable, demand rises, as shown by the rightward shift in the demand curve for these bonds.We can conclude that a bond with default risk will always have positive risk premium, and an increase in its default risk will raise the risk premium.

Credit Rating Agencies

investment advisory firms that rate the quality of corporate and municipal bonds in terms of probability of default.

interest rate behavior for bonds of the same maturity

o Interest Rates on different categories of bonds differ from one another in any given year o The spread (difference) between the interest rates varies over time.

The theory of asset demand

predicts that because the expected return on the corporate bond falls relative to the expected return on the default-free Treasury bond, while its relative riskiness rises, the corporate bond is less desirable (holding all else equal), and demand for it will fall.

Liquidity of Bonds

• U.S. Treasury bonds are the most liquid of all long-term bonds, because they are so widely traded that they are the easiest to sell quickly and the cost of selling them is low. • Corporate bonds are not as liquid, because fewer bonds for any one corporation are traded; thus, it can be costly to sell these bonds in an emergency, because it might be hard to find buyers quickly (due to potential lack of demand)