Interest Rates: Part 2

GD20503Financial Markets and Institutions

OutlinesWhy Debt Securities Yields VaryExplaining Actual Yield DifferentialsEstimating the Appropriate YieldTerm Structure of Interest Rates

Introduction

The annual interest rate offered by debt securities at a given point in time varies among debt securities.

Debt securities offer different yields because they exhibit different characteristics that influence the yield to be offered.

In general, securities with unfavorable characteristics will offer higher yields to entice investors.

Yields on debt securities are affected by the following characteristics: (i) Credit risk; (ii) Liquidity; Tax status; and (iv) Term of maturity.

Why Debt Securities Yields Vary1. Credit (Default) Risk

If all other characteristics besides credit (default) risk are

equal, securities with a higher degree of risk will offer higher

yields.

Rating Agencies

1.) Moody’s Investor Service

2.) Standard and Poor’s Corporation

The higher the rating, the lower the perceived credit risk

Accuracy of Credit Ratings

Enron Scandal in 2001

Exhibit 3.1 Rating Classification by Rating Agencies

2. Liquidity

The ease of conversion to cash without loss of value

The lower a securities liquidity, the higher the yield preferred by investor

3. Tax Status

Investors are more concerned with after-tax income.

Taxable securities must offer a higher before-tax yield

To compute the equivalent Before-Tax

Yield:

where τat = After-tax yield

τbt = Before-tax yield

T = Investor’s marginal tax rate

)1( Tbtat

4. Term to Maturity

Maturity dates will differ between debt securities

The term structure of interest rates defines the relationship between term to maturity and the annualized yield

Explaining Actual Yield Differentials

Explaining Actual Yield Differentials

Small differentials can be significantBasis points (bp) are often quoted where

1bp = .01% = .0001

Yield Differentials of Money Market SecuritiesSecurities: commercial paper, certificates of

deposit, bankers acceptances.Yields are just slightly higher than the risk-free T-

bills

Yield Differentials of Capital Market SecuritiesMunicipal bonds have lowest before-tax yieldTreasury bonds may have higher before-tax yield

than municipal bonds but have lowest after-tax yield

Corporate bonds may have highest yields

Exhibit 3.4 Yield Differences of Corporate Bonds

Estimating the Appropriate Yield

Yn = Rf,n + DP + LP + TA

where:

Yn = yield of an n-day debt security

Rf,n = yield of an n-day Treasury (risk-free) security

DP = default premium to compensate for credit risk

LP = liquidity premium to compensate for less liquidity

TA = adjustment due to difference in tax status

Example 1:Suppose that the three-month Treasury bill’s

annualized rate is 8% and Elizabeth Company plan to issue 90-day commercial paper.

Assume that Elizabeth Company believes that a 0.7% default risk premium, a 0.2% liquidity premium and a 0.3% tax adjustment are necessary to sell its commercial paper to investors.

Thus, the appropriate yield is Yn = Rf,n + DP + LP + TA

= 8% + 0.7% + 0.2% + 0.3% = 9.2%

Term Structure of Interest Rates

Pure Expectations Theory: Term structure is determined solely by the

expectations of future rates.Impact of an expected increase in interest rates:

- Leads to an upward sloping yield curveImpact of an expected decline in interest rates:

- Leads to a downward sloping yield curveThe following figures show how interest rate

expectations affect the yield curve.

Liquidity Premium Theory: Investors prefer short-term rather than long-term

securities because a shorter maturity represents greater liquidity.

However, they may be willing to invest in long-term securities only if compensated with a premium for lower liquidity.

Liquidity may be a more critical factor to investors at particular points in time, and the liquidity premium will change over time accordingly.

Impact of Liquidity Premium on the Yield Curve under Three Different Scenarios

Segmented Markets Theory: Investors choose securities with maturities that

satisfy their forecasted cash needsLimitations of the theory: Some borrowers and savers have the flexibility to

choose among various maturities

Integrating the Theories of the Term StructureIf we assume the following conditionsInvestors and borrowers currently expect interest

rates to rise. (E)Most borrowers need long-term funds, while most

investors have only short-term funds to invest. (S)Investors prefer more liquidity to less. (L)

Then all three conditions place upward pressure on long-term yields relative to short term yields leading to upward sloping yield curve

Effect of Conditions in Example of Yield Curve

Use of the Term Structure

Forecast interest ratesForecast recessionsInvestment decision

Why the Slope of the Yield Curve ChangesIf interest rate at all maturities are affected

in the same manner by the existing conditions, the slope of the yield curve would remain the same.

However, conditions may cause short-term yields to change in a manner that differs from the change in long-term yields.

Potential Impact of Treasury Shift from Long-Term to Short-Term Financing

How the Yield Curve Changed over time

Yield Curves among Foreign Countries