Chapter 6 The Risk and Term Structure of Interest Rates

1
Chapter 6The Risk and Term Structure of Interest
Rates

• Terezia Chen
• Jody Giesbrecht

2
Overview

• Web Exercises
• Risk Structure of Interest Rates
• Default risk
• Liquidity
• Tax Considerations
• Term Structure of Interest Rates
• Yield Curves
• Expectations Theory, Segmented Markets Theory,
  Liquidity Premium Theory, Preferred Habitat Theory

3
Web Exercises

• 1. What has the average rate of inflation been
  since 1995? What year had the highest and lowest
  levels of inflation?
• Average rate of inflation 2.04
• Highest rate 4.70 in Feb 2003
• Lowest rate 0.60 in Jan 1995
• From www.bankofcanada.ca/en/cpi/htm

4
Web Exercises

• 2. What is the cost today of a car that cost
  10,000 the year that you were born?
• 1914 - 189,830.51 avg inflation rate of 3.22
• 1950 - 90,322.58 avg inflation rate of 3.94
• 1975 - 38,356.16 avg inflation rate of 4.29
• From www.bankofcanada.ca/en/inflation_calc.htm

5
Web Exercises

• 3. What happens to the difference between the
  adjusted value of an investment compared to its
  inflation-adjusted value as
• Inflation increases (3 to 5)?
• Buying Power 3 - 8626.09 5 - 7835.26
• The investment horizon lengthens (5 to 10 years)?
• Buying Power 5yrs - 8626.09 10 yrs -
  7440.94
• Expected returns increase (5 to 8)?
• Buying Power 5 - 12120.51 8 - 16064.43
• From www.moneychimp.com/articles/econ/inflation_ca
  lculator.htm

6
Risk vs. Term

• Relationships among interest rates can be defined
  by two aspects
• Risk structure of interest rates relationship
  among the different interest rates on bonds with
  the same term to maturity
• Term structure of interest rates relationship
  among interest rates on bonds with different
  terms to maturity but with same default risk

7
Risk Structure of Interest Rates

• Default Risk
• Occurs when issuer of a bond is unable or
  unwilling to make interest payments or repay
  principle when bond reaches maturity
• Default-free bonds no default risk Canadian
  Government Bonds
• Risk Premium spread between the interest rate
  on a risky bond and a default-free bond

8
Supply Demand Analysis
9
Default Risk Information

• Credit-Rating Agencies investment advisory
  firms that rate quality of bonds in terms of
  probability of default
• Agencies used in Canada Standards Poors,
  Moodys Investors Service, Fitch Ratings
• Junk Bonds
• Fallen Angels

10
The Junk Bond King

• Michael Milken
• Executive at Drexel Burnham Lambert Inc during
  1980s
• used high-yield junk bonds for corporate
  financing and mergers and acquisitions

11
Bond Defaults in Canada

• CBC article published Sept. 2003
• Rate of default lower in Canada than US
• Canada 1.9 US 2.4
• Recovery rates for Canadian bonds lower than in
  the US
• Canada 30 of par US 42 of par

From http//www.cbc.ca/money/story/2003/09/10/mood
ys_030910.html
12
Can Lack of Bond Defaults Last Forever?

• Article from the Financial Post by David Berman
  June 2007
• Default rate hit zero in 2006
• More bond upgrades than downgrades
• What does this signal for the future?
• Possible increase in speculative grade bonds
• Higher borrowing costs
• Decrease in corporate profit growth
• From http//www.canada.com/nationalpost/financialp
  ost/story.html?id045d7cbd-3cc2-4591-abdf-8056956e
  f88b

13
Risk Structure of Interest Rates

• Liquidity
• Ease with which a bond can be traded or sold
• Canada bonds considered most liquid
• If corporate bonds are traded less widely,
  liquidity and demand will decrease. This will
  cause the price of the bond to fall and,
  conversely, the interest rate to rise

As the price falls from P1 to P2, the interest
rate will move upwards
14
Risk Structure of Interest Rates

• Income Tax Considerations
• In some countries, certain government bonds are
  not taxable (ex US municipal bonds)
• This might allow for a greater returns than a
  taxable corporate bond with a higher stated return

 Tax-exempt equivalent yields

MarginalTax Rate  4 Tax-ExemptYield   5Tax-ExemptYield   6Tax-ExemptYield   6.5Tax-ExemptYield   7Tax-ExemptYield   7.5Tax-ExemptYield 
10 4.44 5.56 6.67 7.78 8.33 4.44
15 4.71 5.88 7.06 8.24 8.82 4.71
27 5.48 6.85 8.22 9.59 10.27 5.48
30 5.71 7.14 8.57 10.00 10.71 5.71
35 6.15 7.69 9.23 10.77 11.54 6.15
38.6 6.51 8.14 9.77 11.40 12.21 6.51
http//moneycentral.msn.com/content/Investing/Simp
lestrategies/P38652.asp
15
Term Structure of Interest Rates

• Yield Curve depiction of yields on bonds when
  risk, liquidity and tax considerations are equal
  but the terms to maturity differ

16
Term Structure Theories

• Expectations Theory
• Segmented Markets Theory
• Liquidity Premium Theory
• Preferred Habitat Theory

17
Purpose of Theories

• To explain why yield curves take on their
  specific shapes
• To explain 3 empirical facts
• Interest rates on bonds of different maturities
  move together over time
• When ST rates are low, yield curves are likely to
  be upward sloping when ST rates are high, yield
  curves are likely to be inverted
• Yield curves almost always slope upward

18
Expectations Theory

• The interest rate on a long-term bond will equal
  an average of short-term interest rates that are
  expected to occur over the life of the long-term
  bond
• Assumption bondholders do not prefer one
  maturity over another but will hold bonds with
  highest expected returns (perfect substitutes)
• Int(it it1 it(n-1))/n

19
Segmented Markets Theory

• Markets for different maturity bonds are
  completely separate and therefore the interest
  rate of each bond with a different maturity is
  determined by supply and demand for that bond
• Assumption bonds of different maturities are not
  substitutes, so expected return of one bond has
  no effect on demand for a bond with a different
  maturity

20
Liquidity Premium Theory

• The interest rate on a long-term bond will equal
  an average of short-term rates expected to occur
  over the life of the bond, plus a liquidity
  premium
• Assumption bonds of different maturities are
  substitutes but not perfect substitutes
  (investors may prefer on maturity over another)

21
Preferred Habitat Theory

• Investors will buy bonds that do not have their
  preferred maturity only if they earn a higher
  return.
• Assumption investors have a preference for bonds
  of one maturity over another in which they prefer
  to invest

22
Relationships Between Theories
23
Using the Yield Curve

• Often unreliable as liquidity premiums may not be
  accurate
• Slope of yield curve does not always help to
  predict future short-term interest rates
• Useful for very short-term and long-term but
  lacks reliability for intermediate term

24
Impact of Inverted Yield Curves

• Article by Jim McWhinney - Feb 16, 2006
• Occurs when short term rates exceed long term
  rates
• Historical indicator of recession
• Consideration of supply and demand
• Impact on investors and consumers

25
Oil Prices their Impact

• Overall Global Economy
• Inflation
• Interest Rates

26
Summary

• Looked at two influences on the interest rate of
  a bond
• Risk
• Term to Maturity
• Rational Investors will select portfolios to meet
  desired returns based on differing amounts of
  risk and varying terms to maturity

27

• Questions?