Chapter 3

Structure of Interest Rates

© 2001 South-Western College Publishing Company

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Factors Affecting Yields Among Securities

Debt securities offer different yields because they exhibit different characteristicsUnfavorable characteristics result in higher

yields to entice investors

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Factors Affecting Yields Among Securities

Security yields and prices are affected by levels and changes in:Default risk (also called Credit Risk)LiquidityTax statusTerm to maturitySpecial contract provisions such as

embedded options

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Factors Affecting Yields Among Securities

Credit (Default) RiskBenchmark: Risk-free treasury securitiesDefault Risk Premium = Risky security yield -

Treasury security yield of same maturityRisk premiums for a particular bond can

change over time

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Factors Affecting Yields Among Securities

Credit (Default) Risk Investors can assess default risk by

checking bond ratings set by Rating Agencies • Moody’s Investor Service• Standard and Poor’s Corporation

Anticipated or actual ratings changes can impact security prices and yields

Different bonds issued by the same firm can differ in rating

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Factors Affecting Yields Among Securities

LiquidityA liquid investment is easily converted to

cash without a loss in value Investors pay more (lower yield) for a more

liquid investment

• Securities with lower liquidity must offer a higher yield

Short-term, low default risk, marketable securities have higher liquidity

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Factors Affecting Yields Among Securities

Tax Status Investors are more concerned with after-tax

return or yield Investors require higher yields for higher

taxed securities Investors in high tax brackets benefit most

from tax-exempt securities

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Factors Affecting Yields Among Securities

Term to Maturity Interest rates typically vary by maturityThe term structure of interest rates defines

the relationship between maturity and yield

• The Yield Curve is the plot of current interest yields versus time to maturity

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%

YearsTime to Maturity

Yield

An upward sloping yield curve indicates that TreasurySecurities with longer maturities offer higher annual yields

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Factors Affecting Yields Among Securities

Special ProvisionsCall Feature: enables borrower to buy back

the bonds before maturity at a specified price

• Call features are exercised when interest rates have declined

• Investors demand higher yield on callable bonds, especially when rates are expected to fall

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Factors Affecting Yields Among Securities

Special ProvisionsConvertible Bonds

• Convertibility feature allows investors to convert the bond into a specified number of common stock shares

• Investors will accept a lower yield for convertible bonds

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A Closer Look At the Term Structure

Theories Explaining Shape of Yield CurvePure Expectations TheoryLiquidity Premium TheorySegmented Markets Theory

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A Closer Look At the Term Structure

Pure Expectations TheoryLong-term rates are average of current short-

term and expected future short-term ratesYield curve slope reflects market expectations

of future interest rates Investors select maturity based on

expectations

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A Closer Look At the Term Structure

Pure Expectations TheoryAssumes investor has no maturity

preferences and transaction costs are lowLong-term rates are averages of current short

rates and expected short rates

• Forward rate: market’s forecast of the future interest rate

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A Closer Look At the Term Structure

Pure Expectations TheoryUpward Sloping Yield Curve

• Expected higher interest rate levels

• Expansive monetary policy

• Expanding economyDownward Sloping Yield Curve

• Expected lower interest rate levels

• Tight monetary policy

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A Closer Look At the Term Structure

Liquidity Premium Theory Investors prefer short-term, more liquid,

securitiesLong-term securities and associated risks are

desirable only with increased yieldsExplains upward sloping yield curveWhen combined with the expectations theory,

yield curves could still be used to interpret interest rate expectations

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A Closer Look At the Term Structure

Segmented Markets TheoryTheory explaining segmented, broken yield

curvesAssumes investors have maturity preference

boundaries, e.g., short-term vs. long-term maturities

Explains why rates and prices vary significantly between certain maturities

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A Closer Look At the Term Structure

Which Theory is Correct? Although research results differ, there is

evidence that expectations theory, liquidity preference theory, and segmented markets theory all have some validity

• If term structure is used to assess market’s expectations of future rates, should net out liquidity premium and unique segment characteristics

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A Closer Look At the Term Structure

Uses of the Term StructureForecast interest ratesForecast recessions Investment decisions

• Individuals

• Financial institutionsFinancing decisions

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International Structure of Interest Rates

Capital flows to the highest expected after-tax, real (inflation and other risk-adjusted), foreign exchange adjusted rates of return

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International Structure of Interest Rates

Yield differences between countries are related to:Expected changes in forex ratesVaried expected real rates of returnVaried expected inflation ratesVaried country and business riskVaried central bank monetary policy