Download Yield Spreads - Drake University

Yield Spreads
Finance 298
Analysis of Fixed Income Securities
Drake Fin 284
DRAKE UNIVERSITY
Level of interest rates
Drake
Drake University
Fin 284
We often refer to the “level of interest rates”
in the economy.
How is this measured?
What do we mean by a base rate?
What role does the Federal Reserve Play in
determining the level of interest rates?
What other factors play a role in determining
the level of interest rates?
The “Level of interest rates”
Drake
Drake University
Fin 284
Often interest rates are discussed with the
assumption that there is only one rate in the
economy. This is not true.
There is a structure of rates based upon
different risks and economic forecasts,
however the general level of each rate is
correlated with the others. Therefore interest
rates are tied to a base rate and then
differentiated by the risk premiums we
discussed at the beginning of the semester.
Base rates
Drake
Drake University
Fin 284
Given that risk differentiates interest rates
one place to start is a “risk free” rate. US
treasury securities are often used for this,
should we use short term of long term
treasuries?
A second place to start is with the availability
of borrowing for the banking sector, especially
short tem borrowing which is used to cover
shortages in reserves, the Federal funds rate.
Federal funds rate
Drake
Drake University
Fin 284
The federal funds rate is the market rate for
short term lending between banks. The
substitute for borrowing in this market is
borrowing from the Federal Reserve through
the discount window. Therefore, the Federal
Reserve has a large influence on the level of
both rates. It does not however actually set
the Federal funds rate as we will show soon.
Review of Key Factors Impacting
Interest Rate Volatility
Drake
Drake University
Fin 284
Fisher Classical model of the Savings Market
Household saving (supplies funds) for
business (demands funds)
Saving and Investment
Decisions
Drake
Drake University
Fin 284
Saving Decision
Marginal Rate of Time Preference
Trading current consumption for future consumption
Expected Inflation
Income and wealth effects
Generally higher income – save more
Federal Government
Money supply decisions
Business
Short term temporary excess cash.
Foreign Investment
Loanable Funds Theory
Drake
Drake University
Fin 284
Expands suppliers and borrowers of funds
includes business, government, foreign
participants and households.
Interest rates are determined by the total
demand for funds (borrowing) and the total
supply of funds (Savings).
Savings is positively related to the level of
interest rates. (upward sloping)
Borrowing is negatively related to the level of
interest rates (downward sloping)
Borrowing Decisions
Borrowing Decision
Marginal Productivity of Capital
Expected Inflation
Other
Drake
Drake University
Fin 284
Drake
Equilibrium in the Market
Original Equilibrium
Drake University
Fin 284
Decrease in Income
S’
S
S
D
D
Increase in Marg. Prod Cap
Increase in Inflation Exp.
S’
S
S
D’
D
D’
D
Liquidity Preference Theory
Drake
Drake University
Fin 284
Liquidity Preference
Two assets, money and financial assets
Equilibrium in one implies equilibrium in other
Supply of Money is controlled by Central Bank
and is not related to level of interest rates (A
vertical line)
Similar to Loanable Funds, changes in money
supply and money demand cause a change in
the equilibrium level of interest rates.
Equilibrium in Liquidity Theory
Drake
Drake University
Fin 284
Three main effects of a change in the level of money
Liquidity effect – change in level of money available
(decreasing rate)
Income Effect – in the longer run the increased
economic activity may increase demand for money
(increasing rates)
Price expectations effect it producing close to full
capacity, price increases may cause an increase in the
demand for money (increasing rates)
Liquidity Preference
Drake
Drake University
Fin 284
Money supply is controlled by the central
bank (the Federal Reserve for the US).
Monetary policy therefore plays a key role in
determining the level of interest rates and
corresponding level of economic activity.
The Federal Reserve System
Background and overview
Drake
Drake University
Fin 284
12 Regional Banks
Fed board of Governors 7 members, 14 year
appointments
Federal Open market Committee (FOMC),
Board of Gov, Bank of NY Pres, 5 other Fed
bank pres.
Independence of the Fed
Instruments of Monetary Policy
Reserve Requirements
Open Market Operations
Discount Window Lending
Drake
Drake University
Fin 284
Reserve Requirements
Drake
Drake University
Fin 284
Setting of the % of required reserves in the banking
sector.
The reserves must either be cash on hand or on
deposit at the Fed.
If reserve requirements are increased banks hold
more money in reserve, decreasing the amount that
is available for lending.
If reserve requirements are decreased banks hold
less money in reserve, increasing the amount
available for lending.
Monetary Control Act of 1980
Drake
Drake University
Fin 284
Moved much of the responsibility of reserve
requirements from the Fed to the Congress.
Rules also expanded to include all depository
institutions. A basic ratio of 12% was established for
all checkable deposits. Likewise a basic rate of 3%
was set for time deposits.
Fed given ability to change the checkable deposit
rate between 8 and 14%.
Using Reserve Requirements
Drake
Drake University
Fin 284
Advantage is that reserve rules affect all
banks the same
Can have large impact because of multiple
deposit creation.
Can cause immediate liquidity problems for
banks with low excess reserves.
Is not used very often.
Open Market Operations
Drake
Drake University
Fin 284
The buying and selling of US government
securities by the Federal Reserve on the open
market.
In other words, it is buying and selling the
securities at the market price and yield.
Open Market Operations
Drake
Drake University
Fin 284
When the Fed purchases securities on the “open
market” it must use its cash reserves (money which
was out of circulation), therefore the amount banks
have available to lend (excess reserves) will
increase.
When the Fed sells these securities on the “open
market” individuals and institutions pay for them
with cash which the Fed then holds in reserve, in
effect removing it from circulation, reducing the
amount of excess reserves in banks.
Open Market Operations and the
Federal Funds Rate
Drake
Drake University
Fin 284
The goal of open market operations is to help
manage the Federal Funds Rate
Fed Funds Rate – the interest rate charged on short
term lending between banks
By effectively increasing and decreasing the
amount of funds available, the fed is impacting
the amount of funds that banks have available to
lend. As supply of funds increases, the rate
charged decreases.
Open Market Operations
Drake
Drake University
Fin 284
Dynamic
intended to change the level of reserves and
the monetary base
Defensive Open Market Operations
Intended to offset movements in other factors
that affect reserves and the monetary base.
Only buys and sells US Treasury and
government securities to avoid conflicts of
interest
Daily Open Market Operations
Drake
Drake University
Fin 284
Conducted at the trading desk, (at the New
York Fed), Both Dynamic and Defensive
Operations are undertaken.
A Day at the Trading Desk
Drake
Drake University
Fin 284
Review of developments in Fed Funds Market on the
previous day and check of actual amount of reserves
on the previous day.
Detailed Forecast developed by staff of short term
factors affecting reserves
(treasury deposits, float, publics holding of
currency…)
Monitor the current developments in the Fed Funds
Market
A Day at the Trading Desk continued
Drake
Drake University
Fin 284
Use forecasts to decide if sales or purchases
need to be made to keep the Fed Funds rate
in its target range.
Call treasury to get updated info on planned
moves
A Day at the Trading Desk continued
Drake
Drake University
Fin 284
Contact Monetary Affairs Division at the Board
of Governors in D.C. and
formulate a proposed course of action.
Midmorning Conference call with Director of
Monetary affairs and one of the
regional bank presidents to propose course of
action for the day
A Day at the Trading Desk
Drake
Drake University
Fin 284
Execution of “temporary” Open Market
Operations mainly through the use of
repurchase agreements and reverse
repurchase agreements. The effect of these
changes are reversed at the maturity of the
agreement.
Conduct any “Outright” Open market
operations (purchase and sale of securities
directly)
Open Market Repurchase
Agreements (Repos)
Drake
Drake University
Fin 284
Used when the Fed believes that there will be
an event that is significant but not long lived.
An example may be a large payment from the
US treasury such as Tax Refunds or Social
Security payments (either would create a
temporary increase in the amount of reserves
available)
Repurchase Agreements
Drake
Drake University
Fin 284
The sale of a security with the promise of
repurchasing it in a very short time (usually
overnight) at a premium.
The seller is essentially borrowing money
from the other party and using a security
(usually issued by the treasury) as collateral.
Repurchase Agreements
Drake
Drake University
Fin 284
The difference in price represents the interest
rate paid on the loan (it is often referred to as
the repo rate).
Reverse Repo’s are just taking the opposite
side of the agreement (lending the money
today, agreeing to sell back the security it he
future).
Advantages of Open Market
Operations
Drake
Drake University
Fin 284
Conducted at the initiative of the Fed (with
the discount rate they can only encourage
banks to loan more or less)
Flexible and precise
Easily reversed
Implemented quickly
Discount Rate
Drake
Drake University
Fin 284
The Federal Reserve provides short- term
loans to banks to enable them to meet
depositors demands and reserve
requirements.
The Fed sets the discount rate which the rate
of interest changed on the loans.
Using the Discount Rate
Drake
Drake University
Fin 284
When the Fed increases the discount rate it
discourages banks from borrowing, reducing
the money supply.
Increases in the discount rate raise the cost of
borrowing…
When the Fed decreases the discount rate
banks are more willing to borrow so the
money supply will increase
Discount Window Loans
Drake
Drake University
Fin 284
Adjustment Credit Loans – Most common type of
loan to cover short falls of reserves
Seasonal Credit – given to a limited number of banks
that operate in vacation and agriculture areas, rate
tied to the average of the monthly average Fed
Funds rate and CD rates.
Extended Credit – Banks with severe liquidity
problems. ½ point above the rate on seasonal credit
Discount Window Disadvantages
Drake
Drake University
Fin 284
Disadvantages to using the discount window as a
source of funds:
Cost associated with Discount window lending:
Interest rate is high compared to other sources
Concerns that might be raised about the health of
the bank causing increased monitoring:
More likely to be turned down in the future.
Problems with
The Discount Window
Drake
Drake University
Fin 284
The rate is set by the Fed, but it can’t control
the amount of lending.
It is difficult to revise.
It can cause large fluctuations in the spread
between rates in general and the discount
rate, causing unintended changes in the
volume of loan and hence the money supply.
A Big Picture Question
Drake
Drake University
Fin 284
Do we need a lender of last resort if the FDIC
is in existence?
The Announcement Effect – Signal future
monetary policy moves.
The role of lender of last resort promotes
safety and soundness, but the lending
function is not very effective as a tool.
What is Money?
Drake
Drake University
Fin 284
How is it measured and what functions does
it perform?
Does only cash count? What about easily
converted to cash like a treasury bill? What
about “hard assets” like gold?
Functions Performed by Money
Drake
Drake University
Fin 284
Medium of exchange -- Allows trade to occur, barter
is inefficient. Most be accepted by the individuals in
the economy.
Store of Value -- Can be used to hold wealth from
one period to the next as opposed to various goods
which might not be storable
Unit of account -- Basic unit for measuring economic
value. allows for comparison between different
consumption goods, prices wages and incomes.
Measuring money
Drake
Drake University
Fin 284
There is no single measure of money in the
economy, generally measured by a group of
money aggregates. M1, M2, M3, and L are all
aggregates established by the Fed.
M1
Drake
Drake University
Fin 284
M1 = Currency
+ Traveler’s checks held by the public
+ demand deposits (pay no interest)
+ checkable deposits (pay some interest)
M1 is the most liquid measure of money and
closest to the theoretical definition of money
M2
Drake
Drake University
Fin 284
M2 = M1
+ Savings deposits including passbook saving
+ Time deposits of a fixed term
+ Money Market Mutual Funds (individuals, invest in
short term securities, allow check writing)
+ Repurchase agreements
M2 is not as liquid as M1
M3, L
Drake
Drake University
Fin 284
M3 = M2
+ Large denomination time deposits
(>100,000)
+ money market funds held by institutions
L = M3 + short term treasury securities
+ Commercial paper (short-term debt of
corporations
+ US saving bonds
Required Reserves and the Money
Multiplier.
Drake
Drake University
Fin 284
When new money enters the banking system
it expands the money supply by a much
larger amount.
This is referred to as the “creation of money”
Example
Drake
Drake University
Fin 284
Assumes that the Fed purchases securities on
the open market (the total amount of money
as measured by the aggregates has not
changed).
Fed purchases $10 Million dollars of US
securities from bank A.
Bank A now has an extra $10 million that it
wants to lend out (it is now cash).
Example Continued
Drake
Drake University
Fin 284
Assuming that the required reserve ratio is
12% the banks required reserves have
increased by $1.2 Million and the amount it
has in excess reserves has increased by $8.8
Million.
Now assume it loans out the $8.8 Million to a
firm who uses it to buy parts and equipment
from a vendor who deposit is it in a second
bank (Bank B).
Example continued
Drake
Drake University
Fin 284
Bank B has an increase of ($8.8million)(1-.12)
in required reserves or $7.744 million.
This continues again and again until the total
change in demand deposits is equal to:
DR+(1-REQ)DR+(1-REQ)2DR+(1REQ)3DR+…. = DR/REQ
Quick Question 1
Drake
Drake University
Fin 284
How does this impact the level of interest
rates?
Answer
The increase in the amount of excess
reserves causes banks to lower the
amount they are charging on loans to
attract new customers.
Quick Question 2
Drake
Drake University
Fin 284
Does the level of interest rates impact the
level of the money supply? (leakages)
It is assumed that the level of the money
supply impacts the level of interest rates, but
does the reverse also hold true?
Answers
Drake
Drake University
Fin 284
Yes, If banks do not lend out all of their
money. If rates are high there is a high
opportunity cost of not making loans.
No, However if rates are low, the firm may
be willing to have excess reserves.
Leakages
Drake
Drake University
Fin 284
Also we assumed that all of the money was
deposited and none held in the form of cash.
If some of the funds are held as cash, there
are foregone interest earnings for the
individual (an opportunity cost to the
investor).
Any lending that is less than the full amount
possible can be referred to leakages, These
cause the impact of the change in the money
supply to be less.
Leakages
Drake
Drake University
Fin 284
In an open economy foreign exchange can
also serve as a leakage.
How is monetary policy determined?
Drake
Drake University
Fin 284
The Fed is attempting to attain a given set of
macroeconomic goals.
Goals
Drake
Drake University
Fin 284
High employment – Full Employment and
Balanced Growth Act of 1978 (Humphrey
Hawkins). Committed the government (and
the Fed) to promoting high employment
consistent with a stable price level.
Key is how big should or can employment
be? The “natural rate of unemployment”
constrains the ability to always increase
employment.
Economic Growth
Drake
Drake University
Fin 284
Growth is measured by increases in real GDP.
Biggest current question is why has growth
slowed in the last 20 years?
Price Stability
Drake
Drake University
Fin 284
Targeting inflation is the latest “fad” among
central banks. The belief is that keeping
prices stable can decrease uncertainty and
lead the economy toward the other goals.
Interest rate Stability –
Drake
Drake University
Fin 284
Again the main idea is decreasing uncertainty
and promoting Stability in Financial Markets
Stability in Foreign Exchange
Markets
Drake
Drake University
Fin 284
Not always able to control Asian Financial
crisis is a good example.
Conflict among Goals.
Drake
Drake University
Fin 284
The goals often interfere with each other, for
example stable prices and high employment.
If the Phillips curve is correct there is a
tradeoff between unemployment and
inflation. Often low unemployment has
resulted in high inflation ad vice versa.
Conflicts continued
Drake
Drake University
Fin 284
Likewise since interest rates are linked to the
price level (fisher equation) Interest rate
stability and high employment are not always
compatible.
Which should a central bank target? How
should they set their objective?
Goals vs. Targets
Drake
Drake University
Fin 284
Sets Goals (Employment, Inflation) then
establishes targets for key variables that
should be consistent with reaching the goals
The targets are the means of obtaining the
desired goals.
Operating Targets:
Drake
Drake University
Fin 284
Variables that are directly effected by the
policy tools of the central bank.
Some examples include reserve aggregates,
the monetary base, federal funds rate,
borrowed reserves…
Intermediate Targets
Drake
Variables that have a direct effect on the
goals, but are not directly effected by the
central banks monetary tools.
Examples include M1, M2 etc…
Drake University
Fin 284
Monetary Policy
Drake
Drake University
Fin 284
Since Targets are more long term in nature,
the central bank aims at the targets in an
attempt to steer the economy toward its
goals.
Often there is conflict in choosing the correct
target.
For example in class we showed, choosing a
monetary aggregate lessens the ability of the
bank to control interest rates and vice versa.
Choosing Targets
Drake
Drake University
Fin 284
Operating Targets should be:
Measurable
Central Bank has some control over changes
in the variable
Have an intermediate target as its goal.
Intermediate Targets should be:
Measurable
Central Bank has some control over changes in the
variable.
Have a predictable impact on the goal
A quick Historical Perspective of the Fed
Drake
Drake University
Fin 284
Pre 1920’s Discount rate is the primary tool
1920 – 1930 Expanded use of Open Market
Operations
1930’s The Great Depression
The introduction of the Reserve Requirement
(Thomas Amendment to the Agricultural Adjustment
Act of 1933
Pegging of Interest rate and war finance. Fed would
make Open Market Purchases to keep the interest
rates fixed to pre war levels.
Historical Perspective continued
Drake
Drake University
Fin 284
1950’sand 60’s
Money Market Conditions. Use of Free
reserves as indicator resulting in procyclical
monetary policy.
1970’s Targeting Monetary Aggregates and
the federal funds rate
Widening of target range for Fed Funds Rate
Specifically the Fed targeted the amount of
non borrowed reserves (total reserves less
those borrowed from the discount window)
Historical Perspective continued
Drake
Drake University
Fin 284
1982-early 1990’s
De-emphasis on monetary aggregates, return
toward federal funds targeting
Target became growth in borrowed reserves was
kept to a specific range.
Fed recognizes the need to target foreign exchange
rate stability
Stock market crash of 1987 forced Fed to think
about stability in the financial markets which also
became a point of emphasis.
Historical Perspective continued
Drake
Drake University
Fin 284
Mid to late 1990’s
Fed still used the fed funds rate as primary
tool, but was more tolerant of growth than
before.
One explanation was a possible new paradigm
of increased productivity. There has been
debate about whether or not this new
productivity growth actually exist.
Base Interest Rates Revisited
Drake
Drake University
Fin 284
Generally in the US, fixed income securities
are compared to the on - the – run treasury
with a similar maturity.
This represents a rate that is considered to as
close as risk free as possible.
Is the treasury actually risk free?
No – there is still a possibility of default and it
faced both price risk and reinvestment rate
risk, but it is the closest to risk free.
Yield Spreads and Risk
Premiums
Drake
Drake University
Fin 284
The difference in yield between any two assets
should represent differences in risk. The extra
return earned on a riskier security is termed the
risk premium.
Generally the risk premium is quoted in basis
points.
Yield Spread = Yield on Bond A – Yield on Bond B
Where yield on bond B is being used as a
benchmark
Relative Yield Spreads
Drake
Drake University
Fin 284
Spreads are also measured relative to a base rate
relative
yield
spread
yield on bond A - yield on bond B

yield on bond b
yield yield on bond A

ratio yield on bond B
Factors impacting yield spreads
1.
2.
3.
4.
5.
6.
7.
Drake
Type of issuer
Issuers creditworthiness
Maturity
Embedded options
Taxability
Liquidity
Other risks associated with
previously discussed premiums
Drake University
Fin 284
Type of Issuer
Drake
Drake University
Fin 284
Federal Government vs. Private vs. Muni
Intermarket Spread
The spread in yield between bonds with the
same maturity but offered in different sectors.
Usually calculated using the Treasury
Intramarket Spread
The spread between two bonds in the same
sector.
Often split by industry classification (banks vs.
industrial) for example.
Corporate Yield Spreads 1994-2003
Drake
Drake University
10
Fin 284
6
5
8
7
4
6
AAA
5
3
BBB
Treas
4
AAA-Treas
2
BBB-Treas
3
2
1
1
0
Jan-94
0
Nov-94 Sep-95
Jul-96
May-97 Mar-98 Jan-99
Date
Nov-99 Sep-00
Jul-01
May-02 Mar-03
Spread
Yield
9
Credit Worthiness
Drake
Drake University
Fin 284
Quality Spread – the difference in yield
between a treasury bond and another bond
that is identical except for issuer (also called
credit spread.
Options
Drake
Drake University
Fin 284
Call Option
Benefits the issuer causing an increase in the
spread
Put Option
Benefits the investor lowering the spread
Taxability
Drake
Drake University
Fin 284
Having a tax break decreases the yield and
therefore the spread.
equivalent
tax exempt yield

taxable yield 1 - marginal tax rate
Liquidity
Greater liquidity lowers the yield and
therefore the spread
Drake
Drake University
Fin 284
Maturity
Drake
Drake University
Fin 284
Bond yields will differ with the maturity of
bond.
Generally with all other constraints the same
the longer the term to maturity the higher the
yield. However, economic fluctuations may
impact that relationship.
The difference based upon maturity keeping
everything else the same is referred to the
term structure of interest rates. The
relationship is graphed in a “yield curve”
Treasury Yield Curve
Drake
Drake University
Fin 284
The most commonly investigated and used
term structure is the treasury yield curve.
Treasuries are used since they are considered
free of default, and therefore differ mainly in
maturity. Also the treasury is the benchmark
used to set base rates.
The treasury market is also very liquid so
there are no problems with liquidity
Current Treasury Yield Curve
Drake
Drake University
Fin 284
The most straightforward way to represent
the yield curve is by graphing the
combinations of yield and maturity
The problem with this measure is that it does
not account for differences in coupon rates
across bonds of similar maturities. Therefore
there are some alternative methods we need
to explore.
Yield Curves Previous 6 Months
0.06
Drake
Drake University
Fin 284
0.05
Yield
0.04
7/31/2003
0.03
8/29/2003
9/30/2003
0.02
10/31/2003
0.01
11/28/2003
12/31/2003
0
0.00
5.00
10.00
15.00
Maturity (Years)
20.00
Yield Curves Previous 5 quarters
Drake
Drake University
Fin 284
0.06
0.05
Yield
0.04
0.03
12/31/2002
3/31/2003
0.02
6/30/2003
9/30/2003
0.01
12/31/2003
0
0.00
5.00
10.00
Maturity (Years)
15.00
20.00
Drake
0 .1
US Treas Interest Rates
Jan 1990- Dec 2003
Drake University
Fin 284
1-mo
0 .0 9
3-mo
0 .0 8
6-mo
0 .0 7
1-yr
0 .0 6
2-yr
0 .0 5
3-yr
0 .0 4
5-yr
0 .0 3
7-yr
0 .0 2
10-yr
0 .0 1
20-yr
0
12 /8 /19 8 9
30-yr
9 /3 /19 9 2
5/3 1/19 9 5
2 /2 4 /19 9 8
11/2 0 /2 0 0 0
8 /17/2 0 0 3
Drake
US Treas Rates Jan 1990 Dec 2003
Drake University
Fin 284
0.1
0.09
Downward sloping yield curve
0.08
0.07
3-mo
Yield
0.06
0.05
1-yr
0.04
5-yr
0.03
0.02
20-yr
0.01
0
12/ 8/ 1989
9/ 3/ 1992
5/ 31/ 1995
2/ 24/ 1998
Date
11/ 20/ 2000
8/ 17/ 2003
Drake
Yield Curve 2000
Drake University
Fin 284
0.07
0.065
0.06
Yield
0.055
0.05
12/31/1999
0.045
3/31/2000
6/30/2000
0.04
9/29/2000
12/29/2000
0.035
0.00
5.00
10.00
15.00
20.00
Maturity (years)
25.00
30.00
35.00