Transcript Chapter 8 - McGraw Hill Higher Education

8
Chapter
Marketability, Default Risk, Call
Privileges, Prepayment Risk, Taxes, and
Other Factors Affecting Interest Rates
Money and Capital Markets
Financial Institutions and Instruments in a Global Marketplace
Eighth Edition
Peter S. Rose
McGraw Hill / Irwin
Slides by Yee-Tien (Ted) Fu
8-2
 Learning Objectives 
 To see the effects of the marketability, default
risk, liquidity, call privileges, prepayment risk,
convertibility and taxability of various loans
and securities upon their interest rates.
 To understand why there are so many different
interest rates within the global economy.
 To learn how the “structure of interest rates” is
built and why it changes constantly.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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 Learning Objectives 
 To appreciate the difficulties of forecasting
interest rates and financial asset prices
accurately.
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Introduction
 In the preceding chapter, we examined how
expected inflation and security maturity affect
interest rates.
 In this chapter, we will look at how some other
factors influence interest rates:  marketability,
 default risk,  call privileges,  taxation of
security income,  prepayment risk, and
 convertibility.
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Marketability and Liquidity
 Marketability – Can an asset be sold quickly?
 Marketability is positively related to the size
and reputation of the institution issuing the
securities and to the number of similar
securities outstanding. However, marketability
is negatively related to yield.
 Liquidity – A liquid financial asset is readily
marketable. Moreover, its price tends to be
stable and reversible.
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Default Risk
 Default risk – The risk that a borrower will not
make all the promised payments at the agreedupon times.
 Promised yield on a risky asset
= risk-free interest rate + default risk premium
 Expected yield on a risky asset = S piyi
pi = probability that the ith possible yield, yi, occurs
 Anticipated default loss on a risky asset
= promised yield – expected yield
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Default Risk
 2003
by2001
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Source:
McGraw
Economic
Hill / Irwin
Trends, Federal Reserve Bank of Cleveland,
July
8-8
Default Risk
Factors Influencing Default Risk Premiums
 Credit ratings by rating companies such as
Moody’s and Standard & Poor’s

Highly-rated securities are perceived as having
negligible default risk.
 Fluctuations (cycles) in business activity

The yield spread between Aaa- and Baa-rated
securities increases during economic recessions.
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Average Yields (% per annum)
Default Risk
11
10
Baa Corporate Bonds
9
8
Aaa
Corporate
Bonds
7
6
5
30-year
Treasury
Bonds
4
1990
1992
10-year Treasury Bonds
1994
1996
1998
2000
2002
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
Data
McGraw
Source:
HillBoard
/ Irwinof Governors of the Federal Reserve System
8 - 10
Default Risk
Factors Influencing Default Risk Premiums
 For corporate securities, the period of time the
firm has been in operation, variability in
company earnings, and the amount of leverage
employed
 Inflation

Default risk premiums tend to be higher and more
volatile when inflation is high and volatile.
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Default Risk
The Junk-Bond Spread and the Economy
 Junk bond spread =
junk bond yields – Aaa corporate bond yields
 A rise in the junk bond spread indicates a
growing fear among bond market investors
that marginal-quality corporate borrowers are
more likely to default on their debts (i.e. a
weakening economy).
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Default Risk
New Ways of Dealing with Default Risk
 Credit derivatives are financial contracts that
seek to protect lenders against default risk by
shifting that risk to someone else willing to
accept it for a fee.
 In a credit swap, two or more lenders agree to
exchange a portion of their expected payments.
 A credit option may enable the lender to be
reimbursed if a credit asset begins to lose value.
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Call Privileges
 A call privilege on a bond contract grants the
borrower the option to retire all or a portion of
a bond issue by buying back the securities in
advance of maturity at a specified call price.
 A bond may be callable immediately, or the
privilege may be deferred for a specified
period of time.
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Call Privileges
Advantages and Disadvantages
 The call option is an advantage to the security
issuer because it grants greater financial
flexibility and the potential for reducing future
interest costs.
 However, it is a disadvantage to the security
buyer. The holding-period yield may decline if
the security is called, and the potential for
capital gains is limited.
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Call Privileges
The Call Premium
 Issuers of callable securities must pay a call
premium in the form of a higher interest rate.
 The call premium is higher if
 the
market expects interest rates to fall (such that
the call risk is higher),
 the call deferment period is shorter, and
 the call price is lower.
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Prepayment Risk on Loan-Backed Securities
 Prepayment risk is the risk that the purchaser
may receive higher-than-expected repayments
of principal early in the life of loan-backed
securities.
 Prepayment risk is especially valid for the
investors in securities that are backed by home
mortgage loans, as many home loans will be
retired early due to loan refinancing and homeowner turnover.
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Prepayment Risk on Loan-Backed Securities
 Since prepayments may lower the investor’s
return, loan-backed securities with greater
prepayment risks are priced lower.
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Taxation of Security Returns
 Taxes imposed by the federal, state, and local
governments can have a profound effect on the
returns earned by investors on financial assets.
 Thus, governments can use their taxing power
to encourage the investment in certain
financial assets, thereby redirecting the flow of
savings and investment toward areas of critical
social need.
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Taxation of Security Returns
 In particular, governments may
vary the income brackets and tax rates
 tie the applicable tax rates to the length of time that
securities were held
 grant certain amounts of tax exemptions for
various categories
 enable the deduction of capital losses (up to
specified limits)
 change the permissible annual contributions to
educational or retirement accounts

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Taxation of Security Returns
A Brief History of Marginal Income Tax Rates
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by The2002
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Source:
McGraw
Economic
Hill / Irwin
Trends, Federal Reserve Bank of Cleveland,
January
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Taxation of Security Returns
 Tax-exempt securities represent a subsidy to
induce investors to support local governments.
 The exemption privilege shifts the burden of
federal taxation from buyers of municipal
bonds to other taxpayers.
 However, the privilege lowers the interest rates
at which municipals can be sold in the open
market relative to comparable taxable bonds.
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Taxation of Security Returns
 After-tax yield = (1 – t )  Before-tax yield
where t is the investor’s marginal tax rate
 An investor will be indifferent between taxable
and tax-exempt securities when
Tax-exempt yield = (1 – t )  Taxable yield
 To make valid comparisons between taxable
and tax-exempt issues, the taxed investor
should convert all expected yields to an aftertax basis.
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Convertible Securities
 Convertible (or hybrid) securities are special
issues of corporate bonds or preferred stock
that can be exchanged for a specific number of
shares of the issuing firm’s common stock.
 Convertibles offer the investor the prospect of
a stable interest or dividend income, as well as
capital gains on common stock on conversion.
 Hence, investors are generally willing to pay a
premium for convertibles.
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Convertible Securities
 Note that the issuer may call in the securities
early, forcing conversion.
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The Structure of Interest Rates
 The risk-free interest rate underlies all interest
rates and is a component of all rates.
 All other interest rates are scaled upward by
varying degrees from the risk-free rate,
depending on such factors as inflation, the
term (maturity) of a loan, the risk of borrower
default, the risk of prepayment, and the
marketability, liquidity, convertibility, and tax
status of the securities to which those rates
apply.
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The Structure of Interest Rates
An Example
During the month of January 2002 …
The long-term U.S.
The corporate Baa
while
Treasury bond rate
bond rate averaged
+ 1.85% = 7.60%
averaged 5.75%
Real risk-free rate +3.00%
Expected inflation +2.00%
Liquidity premium +0.75%
Total = 5.75%
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Premiums for:
 marketability
+0.35%
Call risk
+0.25%
Default risk
+1.25%
Total = 1.85%
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8 - 27
Money and Capital Markets in Cyberspace
 The world wide web addresses a number of the
foregoing issues at a variety of websites:

http://www.gac.edu/~elvis/EM42/Chapter7

http://www.taxpolicycenter.org/

http://www.federalreserve.gov/releases/

http://www.clev.frb.org/research/
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Chapter Review
 Introduction
 Marketability and Liquidity
 Default Risk
The Premium for Default Risk
 The Expected Rate of Return on a Risky Asset
 Anticipated Default Loss
 Factors Influencing Default Risk Premiums
 The Junk-Bond Spread and the Economy
 New Ways of Dealing with Default Risk

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Chapter Review
 Call Privileges
Advantages and Disadvantages
 The Call Premium

 Prepayment Risk on Loan-Backed Securities
 Taxation of Security Returns

Comparing Taxable and Tax-Exempt Securities
 Convertible Securities
 The Structure of Interest Rates
McGraw Hill / Irwin
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