Risk Structure of Interest RatesDefault RiskU.S. Treasury bonds are usually considered to be default-free bonds because the U.S. government can raise taxes or print money to pay debts. Corporations must generate revenue in order to pay their debts.Develop graph here.Risk premium -- the additional interest that must be earned in order to entice someone to hold a risky bond over a risk-free bond. The higher the potential of default; the higher the risk premium.Credit-rating agencies rate the probability of default of different bonds.Investment-grade securities have a low risk of default and have a rating of Baa (or BBB) or above.Speculative-grade (junk bonds) securities have a higher riskof default and thus are given a lower bond rating. Speculative-grade bonds are also sometimes called high-yield bonds because they do generate higher yields if they do not default.LiquidityLiquidity means how quickly an asset can be converted intoa medium of exchange. The U.S. Treasury bond market is an extremely active market. The corporate bond market is smaller. Treasury bonds are the most liquid long-term bonds.Develop graph here.Income Tax ConsiderationsMunicipal bonds are federal-income tax exempt. You must pay income tax on interest earned on U.S. Treasury bonds and on corporate bonds.Develop graph here.Term Structure of Interest RatesThe time to maturity influences the interest rates on bonds that have identical risk structure factors.Yield curve -- a plot of the yields on bonds with differing-terms to maturity but identical risk structure factors such as Treasury securities.Three empirical facts about the term structure of interest rates.1. Interest rates tend to move together over time.2. Yield curves are more likely to have an upward slope when short-term rates are low and a downward slope when short-term rates are high.3. Yield curves usually have an upward slope.Expectations hypothesisLong-term yields are an average of expectedfuture short-term yieldsexpected futures one-year rates = 5 6 7 8 9yield on two-year security (5 +6)/2 = 5.5yield on five-year security(5 + 6 + 7 + 8 + 9)/5 = 7Short-term will be more volatile than long since averaging. The change in one year does not have as large of an impact on the long term.If the first year expected interest rate increases from 5 to 6, then the yield increases 1% for a one-year security but only .2% for the five-year security (7.2)This does not explain why the yield curve’s usual shape has an upward slope.Segmented Markets TheoryBonds of different maturities are not substitutes at all. The interest rate at each maturity is determined separately.Since people typically prefer short holding periods, there will be a higher demand for short-term bonds and thus a higher price andlower yield for short-term than long-term. This explains the typical upward-slope of the yield curve.Since each interest rate is determined separately, it does not explain why the rates tend to move together.Liquidity Premium TheoryLong-term bonds have higher interest rate risk.Bondholders require an additional premium to compensate for this increased risk.If the term premium for the next five years is0 .25 .5 .75 1Then using the previous estimates for the five-year path of interest rates, the yield on atwo-year security is(5 + 6)/2 + .25 = 5.75Yield on a five-year security is (5 + 6 + 7 + 8 + 9)/5 + 1 = 8Yield curves and market expectationsSteep upward-slope -- expect higher interest rates (inflation)Mild upward-slope -- expect interest rates to stay about the sameFlat -- expect interest rates to fall some in the futureDownward-slope (inverted yield curve) -- expect interest rates to fall sharply in the future
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