Transcript Risk Premiums and Term Structure

Bond Ratings and Risk
Raters
Moody’s, Standard and Poor’s, Fitch
Ratings
Investment Grade
Non-Investment – Speculative Grade
Highly Speculative
Bond Yield = U.S. Treasury Yield + Default Risk Premium
Long-Term Bond Interest Rates and Ratings
Short-Term Interest Rates and Risk
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
Web Link:
US Treasury
Bloomberg.com
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 shortterm 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
(1  i2y )(1  i2y )
Return from one year bond and then another one year bond
(1 i1y )(1 i )
e
1y
If bonds of different maturities are perfect
substitutes for each other, both options are
equally good:
(1 i2y )(1 i2y )  (1 i1y )(1 )
e
1y
Or
i 2y 
i1y  i
e
1y
2
•According to the
expectations theory:
int 
i1t  i
e
1t 1
i
e
1t  2
n
 ....  i
e
1t  n 1
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, rpn
int  rp n 
i1t  i
e
1t 1
i
e
1t  2
n
 ....  i
e
1t  n 1
Risk premia increase when the economy enters
recessions