© 2004 Pearson Addison-Wesley. All rights reserved 6-1 Risk Structure of Long-Term Bonds in the...

© 2004 Pearson Addison-Wesley. All rights reserved 6-1

Risk Structure of Long-Term Bonds in the United States


Increase in Default Risk on Corporate Bonds


Corporate Bond Market

1. Riskier corporate bonds Dc , Dc shifts left

2. Less liquid corporate bonds Dc , Dc shifts left

3. Pc , ic

Treasury Bond Market1. Relatively more liquid Treasury bonds, DT , DT shifts

right

2. PT , iT Outcome:

Risk premium, ic – iT, rises

Risk premium reflects not only corporate bonds’ default risk, but also lower liquidity


Tax Advantages of Municipal Bonds

6-6

Term Structure: Facts to be Explained1. Interest rates for different maturities move together over

time2. Yield curves tend to have steep upward slope when short

rates are low and downward slope when short rates are high3. Yield curve is typically upward slopingTheories of Term Structure

Expectations TheoryExpectations Theory explains 1 and 2, but not 3

Segmented Markets TheorySegmented Markets explains 3, but not 1 and 2

Liquidity Premium (Preferred Habitat) TheoryCombines features of Expectations Theory and Segmented Markets Theory to get Liquidity Premium (Preferred Habitat) Theory and explains all facts


Interest Rates on Different Maturity Bonds Move Together


Expectations HypothesisKey Assumption: Bonds of different maturities are perfect substitutesImplication: RETe on bonds of different maturities are equalInvestment strategies for two-period horizon1. Buy $1 of one-year bond and when it matures buy another

one-year bond2. Buy $1 of two-year bond and hold it

Expected return from 1 = Expected return from 2

(1 + it)(1 + iet+1) = (1 + i2t)2

1 + it + iet+1+ it ie

t+1 = 1 + 2 i2t + i2t2

i2t = (it + iet+1) / 2

6-10

More generally for n-period bond:

it + iet+1 + ie

t+2 + ... + iet+(n–1)int =

n

In words: Interest rate on long bond = average short rates now and those expected to occur over the life of long bond

Numerical example:One-year interest rate now and expected over the next five years: 5%, 6%, 7%, 8% and 9%:

Interest rate on two-year bond:(5% + 6%)/2 = 5.5%

Interest rate for five-year bond:(5% + 6% + 7% + 8% + 9%)/5 = 7%

Interest rate for one to five year bonds:5%, 5.5%, 6%, 6.5% and 7%.


Expectations Hypothesis and Term Structure FactsExplains why yield curve has different slopes:

1. When short rates are expected to rise in future, average of future short rates = int is above today’s short rate yield curve is upward sloping

2. When short rates are expected to stay same in future, average of future short rates are same as today’s yield curve is flat

3. When short rates are expected to fall yield curve is downward sloping

Expectations Hypothesis explains Fact 1: short rates and long rates move together

If short rate rises are persistent

it today, iet+1, ie

t+2 etc. average of future rates int

Therefore: it int , i.e., short and long rates move together


1. When short rates are “low”, they are expected to rise to normal level.

Long rate (= average of future short rates) will be well above today’s short rate yield curve will have steep upward slope

2. When short rates are high, they are expected to fall to normal. Long rate (= average of future short rates) will be below current short rate yield curve will have downward slope

But the expectations hypothesis doesn’t explain Fact 3: the yield curve usually has upward slope

Short rates are as likely to fall in the future as to riseAverage of future short rates should not be higher than current short rate Yield curve should not usually slope upward On average, yield curve should be flat

Expectations Hypothesis explains Fact 2: yield curves tend to have steep slope when short rates are low and downward slope when short rates are high


Segmented Markets TheoryKey Assumption: Bonds of different maturities are not substitutesImplication: Markets are completely segmentedInterest rate at each maturity is determined separately

Explains Fact 3: yield curve is usually upward slopingPeople typically prefer short holding periods and thus have higher demand for short-term bonds, which have higher price and lower interest rates than long bonds

Does not explain Facts 1 or 2: segmented market theory assumes long and short rates separately determined Rates shouldn’t move togetherYield curve shouldn’t slope steeply upward when short rate is low.


Liquidity Premium (Preferred Habitat) TheoryKey Assumption: Bonds of different maturities are substitutes, but are not perfect substitutes

•Modifies Expectations Theory with Segmented Markets Theory: Investors prefer short bonds to long bonds

must be paid liquidity (term) premium, lnt, to hold long bonds

Results in following modification of Expectations Theory

it + iet+1 + ie

t+2 + ... + iet+(n–1)int = + lnt n


Relationship Between the Liquidity Premium (Preferred Habitat) and Expectations Theories


Numerical Example1. One-year interest rate now and expected over the next five years:

5%, 6%, 7%, 8% and 9%

2. Investors’ preferences for holding short-term bonds liquidity premiums for one to five-year bonds:

0%, 0.25%, 0.5%, 0.75% and 1.0%.

Interest rate on the two-year bond:

(5% + 6%)/2 + 0.25% = 5.75%

Interest rate on the five-year bond:

(5% + 6% + 7% + 8% + 9%)/5 + 1.0% = 8%

Interest rates on one to five-year bonds:

5%, 5.75%, 6.5%, 7.25% and 8%.

Compared to yield curves for the expectations theory, liquidity premium (preferred habitat) theories produce yield curves that are more steeply upward sloped explains all facts


Market Predictions of Future Short Rates


Interpreting Yield Curves 1980–2000

© 2004 Pearson Addison-Wesley. All rights reserved 6-1 Risk Structure of Long-Term Bonds in the...

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