ECO 412 Ch. 7

The Impact of Ratings on Yields

- Bond ratings are designed to reflect default risk - The lower the rating of the bond, the higher the risk of default and the lower its price and higher its yield. - It is useful to compare bonds with default risk to a standard of comparison (typically U.S. Treasury bonds).

The Liquidity Premium Theory

- Bondholders face both inflation and interest-rate risk even on bonds without default risk (the longer the term of the bond, the greater both types of risk). - Risk is the key to understanding the slope of the yield curve - A bond's inflation risk increases with its time to maturity - The longer the term of the bond, the greater the price changes for a given change in interest rates and the larger potential for capital losses.

Speculative Grade Bonds

- Bonds issued by companies and countries that may have difficulty meeting their bond payments but are not at risk of immediate default. - Highly speculative bonds are those in serious risk of default - All bonds with grades below investment grade are often referred to as junk bonds or high-yield bonds

The Expectations Hypothesis

- Certainty means that the bonds of different maturities are perfect substitutes for each other - The expectations hypothesis implies that the current two-year interest rate should (approximately) equal the average of current one-year rate and the expected one-year interest rate one year in the future. - When interest rates are expected to rise, the long-term interest rate will be higher than short-term interest rates; the yield curve will slope up - Abstracted from risk

Types of Junk Bonds

- Fallen Angels - Bonds that were once investment grade, but their issuers fell on hard times. These were the original junk bonds. - Newly Issued Bonds - Very little is known about them; - Undertaking risky projects

Information in the Term Structure of Interest Rates

- Information from the term structure, particularly the slope of the yield curve, helps to forecast general economic conditions. - Rising short term rates and falling long term rates (inverting the yield curve) are associated with slowdowns in economic activity aka forecast of recession. - When firms anticipate expansion, they issue lower priced long-term bonds and higher long-term interest rates.

Commercial Paper

- Short term version of a bond - The borrower offers no collateral so the debt is unsecured - Issued on a discount basis, as a zero coupon bond specifying a single future payment with a maturity of less than 270 days - More than one third of commercial paper is held by money-market mutual funds.

Default Risk

- Tends to be idiosyncratic - Arises due to differences among bond issuers

Investment Grade Bonds

- These bonds have a very low risk of default - Reserved for most gov't issuers and corporations that are among the most financially sound

Three Important Statistical Regularities

1. Interest rates of different maturities tend to move together 2. Yields on short-term bonds are more volatile than yields on long-term bonds 3. Long-term yields tend to be higher than short-term yields

Bond Yields now have two parts....

1. One that is risk-free (explained by the expectations hypothesis) and; 2. One that is a risk premium (explained by inflation and interest-rate risk) - These form the liquidity premium theory of the term structure of interest rates.

In conclusion...

1. The expectations hypothesis explains: - Why interest rates of different maturities tend to move together - Why yields on short-term bonds are more volatile than yields on long-term bonds 2. When we augment the expectations hypothesis with the liquidity premium theory: - Why long-term yields tend to be higher than short-term yields

Tax-Exempt Bond Yield

= Taxable Bond Yield * (1-Tax Rate) - The higher the tax rate, the wider the gap between the yields on taxable and tax-exempt bonds.

Interest Rate Spreads/Differentials

An analysis of the differences between interest rates on different bonds.

Taxable Bonds

Bondholders must pay income tax on the interest income they receive from owning privately issued bonds - Taxes are also an important factor affecting the yield on a bond

According to the Liquidity Premium Theory...

Even if the interest rates remain constant, the yield curve will remain positively sloped (rise with each year).

Risk Structure of Interest Rates

Focuses on differences in default risk among bond issuers. - Holds the fixed maturity of bonds and compares how bond yields are affected by default risk

Term Structure of Interest Rates

Holds risk fixed on bonds and compares how bond yields are affected by the term to maturity (always done with Treasury issues since their default risk is zero). - This allows for the determination of short-term and long-term interest and how they are linked - These links allow for a detailed analysis of the role of expectations in financial markets.

After-Tax Yield

Investors base their decisions on potential investments based on this yield.

Why are risk spreads useful for assessing economic conditions?

One reason is that interest rates (risk spread) are available every day. In contrast, GDP is only available quarterly, with a lag, and is subject to revisions. Another reason is that the risk spread is forward looking -- the assessment market participants of prospects for bond repayment under expected (future) conditions.

How is bond riskiness measured?

Private companies, called bond rating services, specialize in assessing the financial health of firms and evaluating the ability of these firms to repay debt. Also known as NRSROs. - Best known rating services: Moody's, Standard & Poor's, and Fitch's - The higher the rating, the greater the chances the bond issuers will meet its bond payment obligations

The immediate impact of a pending recession is to raise the risk premium on...

Privately issued bonds.

Forward Guidance

That is, even if the current short rate is zero, by indicating that the future expected rates will also be low or zero, long rates can be influenced as well.

Municipal, or tax-exempt, Bonds

The coupon payments on bonds issued by state of local gov'ts are specifically exempt from taxation. - State and local governments choose not to tax the interest on their own bonds in an effort to: 1. Make their bonds more attractive to investors; 2. Lower their own borrowing costs

The Yield Curve

The plot that shows the relationship between Treasury yields from one month T-bills to 30-year T-bonds.

Bond Yield is the sum of...

U.S. Treasury yield + Default risk premium - The lower the rating of the issuer, the higher the default-risk premium.