Tax Status and Bond Prices Coupon Payments on Municipal Bonds are exempt from Federal Taxes Tax-Exempt Bond Yield = (Taxable Bond Yield) x (1- Tax Rate) State and local governments can raise funds at a lower interest rates because of the tax exempt status of their bonds
Term Structure of Interest Rates : Term Structure : the relationship among bonds with the same risk characteristics but different terms to maturity Yield Curve : A plot of the term structure, with the yield to maturity on the vertical axis and the time to maturity on the horizontal axis
Term Structure “Facts” Interest Rates of different maturities tend to move together Yields on short-term bond are more volatile than yields on long-term bonds Long-term yields tend to be higher than short-term yields.
Expectations Hypothesis Bonds of different maturities are perfect substitutes for each other. – –You end up with the same future value whether you buy a long-term bond and carry it to maturity or whether you buy a short-term bond now and turn the proceeds over for new short- term bonds when the old bonds mature An investor with a two-year horizon can: – –Buy a 2 year bond now or – –Buy a one year bond now and another one year bond in one year, when the first bond matures
Total return from 2 year bonds over 2 years Return from one year bond and then another one year bond
If bonds of different maturities are perfect substitutes for each other, both options are equally good: Or
BUT … Expectations Theory can not explain why long-term rates are usually above short term rates. Liquidity Premium Theory The yield curve’s upward slope is explained by the fact that long-term bonds are riskier than short-term bonds. Bondholders face both inflation and interest-rate risk. The longer the term of the bond, the greater both types of risk.
Liquidity Premium Theory: There is a risk premium on long-term bonds … the longer the term, n, the greater the risk premium, rp n
Risk premia increase when the economy enters recessions