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Chapter 3 Structure of Interest Rates © 2001 South-Western College Publishing Company Factors Affecting Yields Among Securities Debt securities offer different yields because they exhibit different characteristics Unfavorable characteristics result in higher yields to entice investors 2 Factors Affecting Yields Among Securities Security yields and prices are affected by levels and changes in: Default risk (also called Credit Risk) Liquidity Tax status Term to maturity Special contract provisions such as embedded options 3 Factors Affecting Yields Among Securities Credit (Default) Risk Benchmark: Risk-free treasury securities Default Risk Premium = Risky security yield Treasury security yield of same maturity Risk premiums for a particular bond can change over time 4 Factors Affecting Yields Among Securities Credit (Default) Risk Investors can assess default risk by checking bond ratings set by Rating Agencies • Moody’s Investor Service • Standard and Poor’s Corporation Anticipated or actual ratings changes can impact security prices and yields Different bonds issued by the same firm can differ in rating 5 Factors Affecting Yields Among Securities Liquidity A liquid investment is easily converted to cash without a loss in value Investors pay more (lower yield) for a more liquid investment • Securities with lower liquidity must offer a higher yield Short-term, low default risk, marketable securities have higher liquidity 6 Factors Affecting Yields Among Securities Tax Status Investors are more concerned with after-tax return or yield Investors require higher yields for higher taxed securities Investors in high tax brackets benefit most from tax-exempt securities 7 Factors Affecting Yields Among Securities Term to Maturity Interest rates typically vary by maturity The term structure of interest rates defines the relationship between maturity and yield • The Yield Curve is the plot of current interest yields versus time to maturity 8 % Yield Time to Maturity Years An upward sloping yield curve indicates that Treasury Securities with longer maturities offer higher annual yields 9 Factors Affecting Yields Among Securities Special Provisions Call Feature: enables borrower to buy back the bonds before maturity at a specified price • Call features are exercised when interest rates have declined • Investors demand higher yield on callable bonds, especially when rates are expected to fall 10 Factors Affecting Yields Among Securities Special Provisions Convertible Bonds • Convertibility feature allows investors to convert the bond into a specified number of common stock shares • Investors will accept a lower yield for convertible bonds 11 A Closer Look At the Term Structure Theories Explaining Shape of Yield Curve Pure Expectations Theory Liquidity Premium Theory Segmented Markets Theory 12 A Closer Look At the Term Structure Pure Expectations Theory Long-term rates are average of current shortterm and expected future short-term rates Yield curve slope reflects market expectations of future interest rates Investors select maturity based on expectations 13 A Closer Look At the Term Structure Pure Expectations Theory Assumes investor has no maturity preferences and transaction costs are low Long-term rates are averages of current short rates and expected short rates • Forward rate: market’s forecast of the future interest rate 14 A Closer Look At the Term Structure Pure Expectations Theory Upward Sloping Yield Curve • Expected higher interest rate levels • Expansive monetary policy • Expanding economy Downward Sloping Yield Curve • Expected lower interest rate levels • Tight monetary policy 15 A Closer Look At the Term Structure Liquidity Premium Theory Investors prefer short-term, more liquid, securities Long-term securities and associated risks are desirable only with increased yields Explains upward sloping yield curve When combined with the expectations theory, yield curves could still be used to interpret interest rate expectations 16 A Closer Look At the Term Structure Segmented Markets Theory Theory explaining segmented, broken yield curves Assumes investors have maturity preference boundaries, e.g., short-term vs. long-term maturities Explains why rates and prices vary significantly between certain maturities 17 A Closer Look At the Term Structure Which Theory is Correct? Although research results differ, there is evidence that expectations theory, liquidity preference theory, and segmented markets theory all have some validity • If term structure is used to assess market’s expectations of future rates, should net out liquidity premium and unique segment characteristics 18 A Closer Look At the Term Structure Uses of the Term Structure Forecast interest rates Forecast recessions Investment decisions • Individuals • Financial institutions Financing decisions 19 International Structure of Interest Rates Capital flows to the highest expected after-tax, real (inflation and other risk-adjusted), foreign exchange adjusted rates of return 20 International Structure of Interest Rates Yield differences between countries are related to: Expected changes in forex rates Varied expected real rates of return Varied expected inflation rates Varied country and business risk Varied central bank monetary policy 21