3Default RiskThe spread between the interest rates on bonds with default risk and default-free bonds, called the risk premium, indicates how much additional interest people must earn in order to be willing to hold that risky bond.A bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium.
4Credit Rating Agencies These companies rate securities according to how likely they are viewed to default.A rating of Baa (BBB) or above is referred to as Investment GradeA bond with a rating below this is known as a junk bond or high yield bond.
6LiquidityAnother attribute of a bond that influences its interest rate is its liquidity; a liquid asset is one that can be quickly and cheaply converted into cash if the need arises. The more liquid an asset is, the more desirable it is (higher demand), holding everything else constant.
7Income Tax Considerations 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.Treasury bonds are exempt from state and local income taxes, while interest payments from corporate bonds are fully taxable.
8Yield Curve and Term Structure Yield Curve – a collection of yields to maturity on bonds with differing maturities but the same risk, liquidity and tax considerationsTerm Structure – the relationship between the different yields to maturity for a given yield curve.
9Criteria for Term Structure Theories The goal of a term structure theory is to explainWhy interest rates on bonds of different maturities move togetherWhen short-term interest rates are low, yield curves are more likely to have an upwards slope; when short term rates are high, yield curves are more likely to have a downwards slope and be inverted.Yield curves almost always have an upwards slope.
10Yield Curve ModelsInterest rates for different maturities move together.
11Term Structure Theories Expectations theoryThe interest rate on a long-term bond will equal an average of the short-term interest rates that people expect over its life.Market Segmentation theoryThe markets for different-maturity bonds as completely separate and segmentedAn extension of this theory is the Preferred Habitat theory which proposes that investors and borrowers may stray away from their preferred market segment if there are relatively better rates to compensate themLiquidity Premium theoryThe interest rate on a long-term bond will equal the average of the short term interest rates expected to occur over the life of the long term bond plus a liquidity premium that responds to the supply-and-demand conditions for that bond.
12Discount FactorA discount factor is the value today of 1 dollar paid at a specific time in the future.In our standard interest rate formula we haveNote
13Treasury Note Maturity 2-10 years Auctioned monthly in the same way as Treasury BillsSemi-annual coupons of ½ the interest rateThese are auctioned using a semi-annual yield to maturityThe coupon rate on the bond is set to the largest rate divisible by 0.125% such that the premium on the bond is less than par. The rate is floored at 0.125%.
14Expectations Theory1 – Interest rates move together – as long term rates are an average of short term rates movements in short term rates will imply movements in long term rates2 – Yield curves tend to have an upward slope when short term rates are low and when short term rates are high the yield curve is generally inverted. If one thinks that rates revert to some sort of mean then if short term rates are low we will see long term rates much higher and vice versa.3 – The theory does not explain why yield curves are generally upward sloping. The typical upward slope of yield curve implies that short-term interest rates are generally expected to increase.
15Liquidity Premium theory This theory extends the Expectations theory to account for the fact that yield curves are generally upward sloping.If the expectations theory were true then short term interest rates would generally rise.The Liquidity premium theory adds a positive premium to compensate investors for the additional risk of longer term bonds.
16Liquidity Premium Theory Approximation:Where is the interest rate on an n-period bond starting at time t.More precisely:
17Important PointThe liquidity premium in the two formulas on the previous slide do not have the same meaning.IF YOU USE THE FIRST FORMULA FOR THE HOMEWORK OR MIDTERM YOU WILL GENERALLY GET THE ANSWER WRONG!!!!My daughter chose the formatting
18Liquidity Premium Theory Explains the third fact that yield curves are generally upward slopingEven if short term rates are expected to stay high on average you expect longer term rates to be higherA Yield curve will only become inverted if short term rates are expected to decrease very rapidly.