1. Chapter 6 The Risk and Term Structure of Interest Rates
Terezia Chen
Jody Giesbrecht

2. Overview Web Exercises Risk Structure of Interest Rates
Default risk
Liquidity
Tax Considerations
Term Structure of Interest Rates
Yield Curves
Expectations Theory, Segmented Markets Theory, Liquidity Premium Theory, Preferred Habitat Theory

3. Web Exercises
1. What has the average rate of inflation been since 1995? What year had the highest and lowest levels of inflation?
Average rate of inflation: 2.04%
Highest rate: 4.70% in Feb 2003
Lowest rate: 0.60% in Jan 1995
From

4. Web Exercises
2. What is the cost today of a car that cost $10,000 the year that you were born?
$189, – avg inflation rate of 3.22%
$90, – avg inflation rate of 3.94%
$38, – avg inflation rate of 4.29%
From

5. Web Exercises
3. What happens to the difference between the adjusted value of an investment compared to its inflation-adjusted value as:
Inflation increases (3 to 5%)?
Buying Power: 3% - $ % - $
The investment horizon lengthens (5 to 10 years)?
Buying Power: 5yrs - $ yrs - $
Expected returns increase (5 to 8%)?
Buying Power: 5% - $ % - $
From

6. Risk vs. Term
Relationships among interest rates can be defined by two aspects:
Risk structure of interest rates – relationship among the different interest rates on bonds with the same term to maturity
Term structure of interest rates – relationship among interest rates on bonds with different terms to maturity but with same default risk

7. Risk Structure of Interest Rates
Default Risk
Occurs when issuer of a bond is unable or unwilling to make interest payments or repay principle when bond reaches maturity
Default-free bonds – no default risk – Canadian Government Bonds
Risk Premium – spread between the interest rate on a risky bond and a default-free bond

8. Supply & Demand Analysis

9. Default Risk Information
Credit-Rating Agencies – investment advisory firms that rate quality of bonds in terms of probability of default
Agencies used in Canada: Standards & Poors, Moody’s Investors Service, Fitch Ratings
Junk Bonds
Fallen Angels

10. “The Junk Bond King” Michael Milken
Executive at Drexel Burnham Lambert Inc during 1980’s
used high-yield junk bonds for corporate financing and mergers and acquisitions

11. Bond Defaults in Canada
CBC article published Sept. 2003
Rate of default lower in Canada than US
Canada: 1.9% US: 2.4%
Recovery rates for Canadian bonds lower than in the US
Canada: 30% of par US: 42% of par
Give Canada Airlines Corp. example
From

12. Can Lack of Bond Defaults Last Forever?
Article from the Financial Post by David Berman – June 2007
Default rate hit zero in 2006
More bond upgrades than downgrades
What does this signal for the future?
Possible increase in speculative grade bonds
Higher borrowing costs
Decrease in corporate profit growth
From

13. Risk Structure of Interest Rates
Liquidity
Ease with which a bond can be traded or sold
Canada bonds considered most liquid
If corporate bonds are traded less widely, liquidity and demand will decrease. This will cause the price of the bond to fall and, conversely, the interest rate to rise
As the price falls from P1 to P2, the interest rate will move upwards

14. Risk Structure of Interest Rates
Income Tax Considerations
In some countries, certain government bonds are not taxable (ex: US municipal bonds)
This might allow for a greater returns than a taxable corporate bond with a higher stated return
 Tax-exempt equivalent yields
Marginal Tax Rate
 4% Tax-Exempt Yield 
 5%Tax-Exempt Yield 
 6%Tax-Exempt Yield 
 6.5%Tax-Exempt Yield 
 7%Tax-Exempt Yield 
 7.5%Tax-Exempt Yield 
10 %
4.44
5.56
6.67
7.78
8.33
15 %
4.71
5.88
7.06
8.24
8.82
27 %
5.48
6.85
8.22
9.59
10.27
30 %
5.71
7.14
8.57
10.00
10.71
35 %
6.15
7.69
9.23
10.77
11.54
38.6 %
6.51
8.14
9.77
11.40
12.21

15. Term Structure of Interest Rates
Yield Curve – depiction of yields on bonds when risk, liquidity and tax considerations are equal but the terms to maturity differ

16. Term Structure Theories
Expectations Theory
Segmented Markets Theory
Liquidity Premium Theory
Preferred Habitat Theory

17. Purpose of Theories
To explain why yield curves take on their specific shapes
To explain 3 empirical facts:
Interest rates on bonds of different maturities move together over time
When ST rates are low, yield curves are likely to be upward sloping; when ST rates are high, yield curves are likely to be inverted
Yield curves almost always slope upward

18. Expectations Theory
The interest rate on a long-term bond will equal an average of short-term interest rates that are expected to occur over the life of the long-term bond
Assumption: bondholders do not prefer one maturity over another but will hold bonds with highest expected returns (perfect substitutes)
Int=(it + it+1 + … + it+(n-1))/n

19. Segmented Markets Theory
Markets for different maturity bonds are completely separate and therefore the interest rate of each bond with a different maturity is determined by supply and demand for that bond
Assumption: bonds of different maturities are not substitutes, so expected return of one bond has no effect on demand for a bond with a different maturity

20. Liquidity Premium Theory
The interest rate on a long-term bond will equal an average of short-term rates expected to occur over the life of the bond, plus a liquidity premium
Assumption: bonds of different maturities are substitutes but not perfect substitutes (investors may prefer on maturity over another)

21. Preferred Habitat Theory
Investors will buy bonds that do not have their preferred maturity only if they earn a higher return.
Assumption: investors have a preference for bonds of one maturity over another in which they prefer to invest

22. Relationships Between Theories

23. Using the Yield Curve
Often unreliable as liquidity premiums may not be accurate
Slope of yield curve does not always help to predict future short-term interest rates
Useful for very short-term and long-term but lacks reliability for intermediate term

24. Impact of Inverted Yield Curves
Article by Jim McWhinney - Feb 16, 2006
Occurs when short term rates exceed long term rates
Historical indicator of recession
Consideration of supply and demand
Impact on investors and consumers

25. Oil Prices & their Impact
Overall Global Economy
Inflation
Interest Rates

26. Summary Looked at two influences on the interest rate of a bond:
Risk
Term to Maturity
Rational Investors will select portfolios to meet desired returns based on differing amounts of risk and varying terms to maturity

27. Questions?