How Do Risk and Term Structure Affect Interest Rates?

Financial Markets and Institutions

Ninth Edition

Chapter 5

How Do Risk and Term

Structure Affect Interest

Rates?

Chapter Preview (1 of 4)

In the last chapter, we examined interest rates, but made a

big assumption—there is only one economy-wide interest

rate. Of course, that isn’t really the case.

In this chapter, we will examine the different rates that we

observe for financial products.

Chapter Preview (2 of 4)

We will fist examine bonds that offer similar payment

streams but differ in price. The price differences are due to

the risk structure of interest rates. We will examine in

detail what this risk structure looks like and ways to examine

it.

Chapter Preview (3 of 4)

Next, we will look at the different rates required on bonds

with different maturities. That is, we typically observe higher

rates on longer-term bonds. This is known as the term

structure of interest rates. To study this, we usually look at

Treasury bonds to minimize the impact of other risk factors.

Chapter Preview (4 of 4)

So, in sum, we will examine how the individual risk of a bond

affects its required rate. We also explore how the general

level of interest rates varies with the maturity of the debt

instruments. Topics include:

•Risk Structure of Interest Rates

•Term Structure of Interest Rates

Risk Structure of Interest Rates

•To start this discussion, we first examine the yields for

several categories of long-term bonds over the last 90

years.

•You should note several aspects regarding these rates,

related to different bond categories and how this has

changed through time.

Figure 5.1 Long-Term Bond Yields, 1919–2016

Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal

Reserve Bank of St. Louis FRED database, https://fred.stlouisfed.org/series/GS10, https://fred.stlouisfed.org/series/AAA,

https://fred.stlouisfed.org/series/BAA.

Risk Structure of Long Bonds in the U.S.

The figure shows two important features of the interest-rate

behavior of bonds.

•Rates on different bond categories change from one year

to the next.

•Spreads on different bond categories change from one

year to the next.

Factors Affecting Risk Structure of

Interest Rates

To further examine these features, we will look at three

specific risk factors.

•Default Risk

•Liquidity

•Income Tax Considerations

Default Risk Factor

One attribute of a bond that influences its interest rate is its

risk of default, which occurs when the issuer of the bond is

unable or unwilling to make interest payments when

promised.

Default Risk

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 (or just print money).

Bonds like these with no default risk are called default-free

bonds.

Default Risk Factor (1 of 3)

But are these bonds truly default-free bonds? During the

budget negotiations in Congress in 1995–1996, and then

again in 2011–2013, the Republicans threatened to let