978-0132994910 Chapter 5 Lecture Note

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Chapter 5

The Risk Structure and Term Structure

of Interest Rates

Brief Chapter Summary and Learning Objectives

5.1 The Risk Structure of Interest Rates (pages 125–137)

Explain why bonds with the same maturity can have different interest rates.

Bonds that have the same maturity may differ with respect to other characteristics that investors

believe are important, such as risk, liquidity, information costs, and taxation.

Bonds with more favorable characteristics have lower interest rates because investors are willing

to accept lower expected returns on those bonds.

5.2 The Term Structure of Interest Rates (pages 137–151)

Explain why bonds with different maturities can have different interest rates.

The liquidity premium theory, the most complete theory of the term structure, holds that the

interest rate on a long-term bond is an average of the interest rates investors expect on

short-term bonds over the lifetime of the long-term bond, plus a term premium that increases in

value the longer the maturity of the bond.

The slope of the yield curve shows the short-term interest rates that bond market participants

expect in the future and can be used to help forecast inflation and economic activity.

Key Terms and Concepts

Bond rating A single statistic that summarizes a

rating agency’s view of the issuer’s likely ability

to make the required payments on its bonds.

Default risk (or credit risk) The risk that the bond

issuer will fail to make payments of interest or

principal.

Expectations theory A theory of the term structure

of interest rates which holds that the interest rate

on a long-term bond is an average of the interest

rates investors expect on short-term bonds over

the lifetime of the long-term bond.

Liquidity premium theory (or preferred habitat

theory) A theory of the term structure of interest

rates that holds that the interest rate on a long-term

bond is an average of the interest rates investors

expect on short-term bonds over the lifetime of the

long-term bond, plus a term premium that increases

in value the longer the maturity of the bond.

Municipal bonds Bonds issued by state and local

governments.

Risk structure of interest rates The relationship

among interest rates on bonds that have different

characteristics but the same maturity.

Segmented markets theory A theory of the term

structure of interest rates that holds that the

interest rate on a bond of a particular maturity is

determined only by the demand and supply of

bonds of that maturity.

Term premium The additional interest investors

require in order to be willing to buy a long-term

bond rather than a comparable sequence of

short-term bonds.

Term structure of interest rates The relationship

among the interest rates on bonds that are otherwise

similar but that have different maturities.

Chapter Outline

Teaching Tips

This chapter is important for courses that emphasize financial markets and for courses that emphasize

policy. It focuses on why bonds with the same maturity may have different yields (the risk

structure); why bonds with the same risk, liquidity, and other characteristics, but with different

maturities, may have different yields (the term structure); and how the risk and term structures

can be used in forecasting. Students generally have some awareness that interest rates differ, but

little understanding of why. The material on the risk structure is usually easily understood, but

the material on the term structure typically requires significant amounts of class time.

Searching for Yield

Faced with low interest rates in the aftermath of the recession of 2007-2009, many investors searched for

ways to earn more from their savings. To earn significantly higher interest rates, investors need to

purchase long-term bonds or bonds with relatively high default risk, so-called junk bonds. As a result,

there was increased demand for junk bonds, causing interest rates on these bonds to reach record lows.

5.1 The Risk Structure of Interest Rates (pages 125–137)

Learning Objective: Explain why bonds with the same maturity can have different interest rates.

A. Default Risk

Default risk is the risk that the bond issuer will fail to make payments of interest and principal.

Bonds with higher default risk pay higher interest rates. The default risk premium on a bond is

the difference between the interest rate on the bond and the interest rate on a Treasury bond

with the same maturity. An increased perceived risk of default leads to a decline in the demand

for a bond, resulting in a lower price and a higher interest rate. During recessions, investors

seek safety, leading to an increase in the demand for U.S. Treasury bonds and a decrease in the

demand for corporate bonds, resulting in a higher risk premium for corporate bonds.

Teaching Tips

At the height of the financial crisis in the fall of 2008, the default risk premium for bonds of companies

rated Baa by Moody’s surpassed 6%, higher than any time since the 1930s. Have students discuss how

this increase in the default risk premium can be used as a measure of the severity of the financial crisis

(that is, as a measure of the difficulty corporations issuing investment-grade bonds have in obtaining

credit).

B. Liquidity and Information Costs

An increase in a bond’s liquidity or a decrease in the cost of acquiring information about the

bond will increase the demand for the bond, resulting in a higher price and a lower interest rate.

C. Tax Treatment

Investor’s care about the after-tax return on their investments; that is, the return the investors

have left after paying their taxes. Other things equal, a bond with coupons that are not subject

to taxes has a lower interest rate than a bond with taxable coupons. The coupons on municipal

bonds are typically not subject to federal, state, or local taxes. The coupons on Treasury bonds

are subject to federal tax, but not to state or local taxes. The coupons on corporate bonds can be

subject to federal, state, and local taxes.

5.2 The Term Structure of Interest Rates (pages 137–151)

Learning Objective: Explain why bonds with different maturities can have different interest rates.

A. Explaining the Term Structure

One way to analyze the term structure is by looking at the Treasury yield curve, which is the

relationship on a particular day among the interest rates on Treasury bonds of different maturities.

See Figure 5.4 on page 138 for the Treasury yield curves for a day in 2007 and a day in 2012.

Any explanation of the term structure should be able to account for three important facts:

 Interest rates on long-term bonds are usually higher than interest rates on short-term

bonds.

 Interest rates on short-term bonds are occasionally higher than interest rates on long-term

bonds.

 Interest rates on bonds of all maturities tend to rise and fall together.

B. The Expectations Theory of the Term Structure

The expectations theory holds that the interest rate on a long-term bond is an average of the interest

rates investors expect on short-term bonds over the lifetime of the long-term bond. According to the

expectations theory, investors view bonds of different maturities as being perfect substitutes.

Because interest rates on long-term bonds are usually higher than interest rates on short-term bonds,

the expectations theory implies that future short-term rates are typically expected to rise at any

particular point in time, which is unrealistic.

C. The Segmented Markets Theory of the Term Structure

The segmented markets theory assumes bonds of different maturity are in separate markets.

Factors that affect the demand for Treasury bills or other short-term bonds will have no effect

on the demand for Treasury bonds or other long-term bonds. Because long-term bonds carry higher

interest-rate risk and tend to be less liquid, investors need to be compensated by receiving higher

interest rates on long-term bonds than on short-term bonds. The segmented markets theory fails to

explain why short-term interest rates are sometimes higher than long-term interest rates as well as

why interest rates tend to move together.

D. The Liquidity Premium Theory

The liquidity premium theory (also known as the preferred habitat theory) holds that the interest

rate on a long-term bond is an average of the interest rates investors expect on short-term bonds

over the

lifetime of the long-term bond, plus a term premium that increases in value the longer the maturity

of the bond.

Table 5.4 on page 149 summarizes and compares the three theories of term structure of interest

rates: the expectations theory, the segmented markets theory, and the liquidity premium theory.

E. Can The Term Structure Predict Recessions?

The slope of the yield curve shows the short-term interest rates that bond market participants

expect

in the future. If fluctuations in expected real interest rates are small, the yield curve contains

expectations of future inflation rates. The yield curve can also indicate likely future economic

activity. With only one exception, every time the yield on the 3-month bill was higher than the

yield

on the 10-year note, a recession followed within a year.

Teaching Tips

In the fall of 2012, some policymakers and economists expressed fear of rapidly increasing inflation in

the next few years. Meanwhile, interest rates on long-term bonds, such as the five-year and ten-year

Treasury bonds, were at historically low levels of about 0.6% and 1.6%, respectively. Have students

discuss what these interest rates on bonds imply about the bond markets’ view of future inflation. Are low

interest rates on long-term bonds consistent with expectations of rapidly increasing inflation?