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8 Chapter Marketability, Default Risk, Call Privileges, Prepayment Risk, Taxes, and Other Factors Affecting Interest Rates Money and Capital Markets Financial Institutions and Instruments in a Global Marketplace Eighth Edition Peter S. Rose McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu 8-2 Learning Objectives To see the effects of the marketability, default risk, liquidity, call privileges, prepayment risk, convertibility and taxability of various loans and securities upon their interest rates. To understand why there are so many different interest rates within the global economy. To learn how the “structure of interest rates” is built and why it changes constantly. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8-3 Learning Objectives To appreciate the difficulties of forecasting interest rates and financial asset prices accurately. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8-4 Introduction In the preceding chapter, we examined how expected inflation and security maturity affect interest rates. In this chapter, we will look at how some other factors influence interest rates: marketability, default risk, call privileges, taxation of security income, prepayment risk, and convertibility. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8-5 Marketability and Liquidity Marketability – Can an asset be sold quickly? Marketability is positively related to the size and reputation of the institution issuing the securities and to the number of similar securities outstanding. However, marketability is negatively related to yield. Liquidity – A liquid financial asset is readily marketable. Moreover, its price tends to be stable and reversible. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8-6 Default Risk Default risk – The risk that a borrower will not make all the promised payments at the agreedupon times. Promised yield on a risky asset = risk-free interest rate + default risk premium Expected yield on a risky asset = S piyi pi = probability that the ith possible yield, yi, occurs Anticipated default loss on a risky asset = promised yield – expected yield McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8-7 Default Risk 2003 by2001 The McGraw-Hill Companies, Inc. All rights reserved. Source: McGraw Economic Hill / Irwin Trends, Federal Reserve Bank of Cleveland, July 8-8 Default Risk Factors Influencing Default Risk Premiums Credit ratings by rating companies such as Moody’s and Standard & Poor’s Highly-rated securities are perceived as having negligible default risk. Fluctuations (cycles) in business activity The yield spread between Aaa- and Baa-rated securities increases during economic recessions. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8-9 Average Yields (% per annum) Default Risk 11 10 Baa Corporate Bonds 9 8 Aaa Corporate Bonds 7 6 5 30-year Treasury Bonds 4 1990 1992 10-year Treasury Bonds 1994 1996 1998 2000 2002 2003 by The McGraw-Hill Companies, Inc. All rights reserved. Data McGraw Source: HillBoard / Irwinof Governors of the Federal Reserve System 8 - 10 Default Risk Factors Influencing Default Risk Premiums For corporate securities, the period of time the firm has been in operation, variability in company earnings, and the amount of leverage employed Inflation Default risk premiums tend to be higher and more volatile when inflation is high and volatile. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 11 Default Risk The Junk-Bond Spread and the Economy Junk bond spread = junk bond yields – Aaa corporate bond yields A rise in the junk bond spread indicates a growing fear among bond market investors that marginal-quality corporate borrowers are more likely to default on their debts (i.e. a weakening economy). McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 12 Default Risk New Ways of Dealing with Default Risk Credit derivatives are financial contracts that seek to protect lenders against default risk by shifting that risk to someone else willing to accept it for a fee. In a credit swap, two or more lenders agree to exchange a portion of their expected payments. A credit option may enable the lender to be reimbursed if a credit asset begins to lose value. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 13 Call Privileges A call privilege on a bond contract grants the borrower the option to retire all or a portion of a bond issue by buying back the securities in advance of maturity at a specified call price. A bond may be callable immediately, or the privilege may be deferred for a specified period of time. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 14 Call Privileges Advantages and Disadvantages The call option is an advantage to the security issuer because it grants greater financial flexibility and the potential for reducing future interest costs. However, it is a disadvantage to the security buyer. The holding-period yield may decline if the security is called, and the potential for capital gains is limited. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 15 Call Privileges The Call Premium Issuers of callable securities must pay a call premium in the form of a higher interest rate. The call premium is higher if the market expects interest rates to fall (such that the call risk is higher), the call deferment period is shorter, and the call price is lower. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 16 Prepayment Risk on Loan-Backed Securities Prepayment risk is the risk that the purchaser may receive higher-than-expected repayments of principal early in the life of loan-backed securities. Prepayment risk is especially valid for the investors in securities that are backed by home mortgage loans, as many home loans will be retired early due to loan refinancing and homeowner turnover. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 17 Prepayment Risk on Loan-Backed Securities Since prepayments may lower the investor’s return, loan-backed securities with greater prepayment risks are priced lower. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 18 Taxation of Security Returns Taxes imposed by the federal, state, and local governments can have a profound effect on the returns earned by investors on financial assets. Thus, governments can use their taxing power to encourage the investment in certain financial assets, thereby redirecting the flow of savings and investment toward areas of critical social need. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 19 Taxation of Security Returns In particular, governments may vary the income brackets and tax rates tie the applicable tax rates to the length of time that securities were held grant certain amounts of tax exemptions for various categories enable the deduction of capital losses (up to specified limits) change the permissible annual contributions to educational or retirement accounts McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 20 Taxation of Security Returns A Brief History of Marginal Income Tax Rates 2003 by The2002 McGraw-Hill Companies, Inc. All rights reserved. Source: McGraw Economic Hill / Irwin Trends, Federal Reserve Bank of Cleveland, January 8 - 21 Taxation of Security Returns Tax-exempt securities represent a subsidy to induce investors to support local governments. The exemption privilege shifts the burden of federal taxation from buyers of municipal bonds to other taxpayers. However, the privilege lowers the interest rates at which municipals can be sold in the open market relative to comparable taxable bonds. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 22 Taxation of Security Returns After-tax yield = (1 – t ) Before-tax yield where t is the investor’s marginal tax rate An investor will be indifferent between taxable and tax-exempt securities when Tax-exempt yield = (1 – t ) Taxable yield To make valid comparisons between taxable and tax-exempt issues, the taxed investor should convert all expected yields to an aftertax basis. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 23 Convertible Securities Convertible (or hybrid) securities are special issues of corporate bonds or preferred stock that can be exchanged for a specific number of shares of the issuing firm’s common stock. Convertibles offer the investor the prospect of a stable interest or dividend income, as well as capital gains on common stock on conversion. Hence, investors are generally willing to pay a premium for convertibles. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 24 Convertible Securities Note that the issuer may call in the securities early, forcing conversion. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 25 The Structure of Interest Rates The risk-free interest rate underlies all interest rates and is a component of all rates. All other interest rates are scaled upward by varying degrees from the risk-free rate, depending on such factors as inflation, the term (maturity) of a loan, the risk of borrower default, the risk of prepayment, and the marketability, liquidity, convertibility, and tax status of the securities to which those rates apply. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 26 The Structure of Interest Rates An Example During the month of January 2002 … The long-term U.S. The corporate Baa while Treasury bond rate bond rate averaged + 1.85% = 7.60% averaged 5.75% Real risk-free rate +3.00% Expected inflation +2.00% Liquidity premium +0.75% Total = 5.75% McGraw Hill / Irwin Premiums for: marketability +0.35% Call risk +0.25% Default risk +1.25% Total = 1.85% 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 27 Money and Capital Markets in Cyberspace The world wide web addresses a number of the foregoing issues at a variety of websites: http://www.gac.edu/~elvis/EM42/Chapter7 http://www.taxpolicycenter.org/ http://www.federalreserve.gov/releases/ http://www.clev.frb.org/research/ McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 28 Chapter Review Introduction Marketability and Liquidity Default Risk The Premium for Default Risk The Expected Rate of Return on a Risky Asset Anticipated Default Loss Factors Influencing Default Risk Premiums The Junk-Bond Spread and the Economy New Ways of Dealing with Default Risk McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 8 - 29 Chapter Review Call Privileges Advantages and Disadvantages The Call Premium Prepayment Risk on Loan-Backed Securities Taxation of Security Returns Comparing Taxable and Tax-Exempt Securities Convertible Securities The Structure of Interest Rates McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved.