The Risk and Term Structure of Interest Rates

Transcription

1 Ch a p ter 6 The Risk and Term Structure of Interest Rates PREVIEW In our supply and demand analysis of interest-rate behavior in Chapter 5, we examined the determination of just one interest rate. Yet we saw earlier that there are enormous numbers of bonds on which the interest rates can and do differ. In this chapter, we complete the interest-rate picture by examining the relationship of the various interest rates to one another. Understanding why they differ from bond to bond can help businesses, banks, insurance companies, and private investors decide which bonds to purchase as investments and which ones to sell. We first look at why bonds with the same term to maturity have different interest rates. The relationship among these interest rates is called the risk structure of interest rates, although risk, liquidity, and income tax rules all play a role in determining the risk structure. A bond s term to maturity also affects its interest rate, and the relationship among interest rates on bonds with different terms to maturity is called the term structure of interest rates. In this chapter, we examine the sources and causes of fluctuations in interest rates relative to one another and look at a number of theories that explain these fluctuations. Risk Structure of Interest Rates Figure 1 shows the yields to maturity for several categories of long-term bonds from 1919 to It shows us two important features of interest-rate behavior for bonds of the same maturity: Interest rates on different categories of bonds differ from one another in any given year, and the spread (or difference) between the interest rates varies over time. The interest rates on municipal bonds, for example, are above those on U.S. government (Treasury) bonds in the late 1930s but lower thereafter. In addition, the spread between the interest rates on Baa corporate bonds (riskier than Aaa corporate bonds) and U.S. government bonds is very large during the Great Depression years , is smaller during the 1940s 1960s, and then widens again afterwards. What factors are responsible for these phenomena? Default Risk One attribute of a bond that influences its interest rate is its risk of default, which occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures. A corporation suffering big losses, such as Chrysler Corporation did in the 1970s, might be more likely 120

2 C H A P T E R 6 The Risk and Term Structure of Interest Rates 121 Annual Yield (%) Corporate Aaa Bonds Corporate Baa Bonds U.S. Government Long-Term Bonds State and Local Government (Municipal) F I G U R E 1 Long-Term Bond Yields, Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, ; Federal Reserve: /Releases/h15/update/ The Federal Reserve reports the returns on different quality bonds. Look at the bottom of the listing of interest rates for AAA and BBB rated bonds. to suspend interest payments on its bonds. 1 The default risk on its bonds would therefore be quite high. By contrast, U.S. Treasury bonds have usually been considered to have no default risk because the federal government can always increase taxes to pay off its obligations. Bonds like these with no default risk are called default-free bonds. (However, during the budget negotiations in Congress in 1995 and 1996, the Republicans threatened to let Treasury bonds default, and this had an impact on the bond market, as one application following this section indicates.) The spread between the interest rates on bonds with default risk and default-free bonds, called the risk premium, indicates how much additional interest people must earn in order to be willing to hold that risky bond. Our supply and demand analysis of the bond market in Chapter 5 can be used to explain why a bond with default risk always has a positive risk premium and why the higher the default risk is, the larger the risk premium will be. To examine the effect of default risk on interest rates, let us look at the supply and demand diagrams for the default-free (U.S. Treasury) and corporate long-term bond markets in Figure 2. To make the diagrams somewhat easier to read, let s assume that initially corporate bonds have the same default risk as U.S. Treasury bonds. In this case, these two bonds have the same attributes (identical risk and maturity); their equilibrium prices and interest rates will initially be equal (P c 1 P T 1 and i c 1 i T 1 ), and the risk premium on corporate bonds (i c 1 i T 1 ) will be zero. 1 Chrysler did not default on its loans in this period, but it would have were it not for a government bailout plan intended to preserve jobs, which in effect provided Chrysler with funds that were used to pay off creditors.

3 122 P A R T I I Financial Markets Price of Bonds, P (P increases ) Interest Rate, i (i increases ) Price of Bonds, P (P increases ) Interest Rate, i (i increases ) S T S c i T 2 P T 2 i T 2 P c 1 i c 1 Risk Premium P T 1 i T 1 P c 2 i c 2 D T 2 D c 2 D c 1 D T 1 Quantity of Corporate Bonds (a) Corporate bond market Quantity of Treasury Bonds (b) Default-free (U.S. Treasury) bond market F I G U R E 2 Response to an Increase in Default Risk on Corporate Bonds An increase in default risk on corporate bonds shifts the demand curve from D c 1 to D c 2. Simultaneously, it shifts the demand curve for Treasury bonds from D T 1 to D T 2. The equilibrium price for corporate bonds (left axis) falls from P c 1 to P c 2, and the equilibrium interest rate on corporate bonds (right axis) rises from i c 1 to i c 2. In the Treasury market, the equilibrium bond price rises from P T 1 to P T 2, and the equilibrium interest rate falls from i T 1 to i T 2. The brace indicates the difference between i c 2 and i T 2, the risk premium on corporate bonds. (Note: P and i increase in opposite directions. P on the left vertical axis increases as we go up the axis, while i on the right vertical axis increases as we go down the axis.) Study Guide Two exercises will help you gain a better understanding of the risk structure: 1. Put yourself in the shoes of an investor see how your purchase decision would be affected by changes in risk and liquidity. 2. Practice drawing the appropriate shifts in the supply and demand curves when risk and liquidity change. For example, see if you can draw the appropriate shifts in the supply and demand curves when, in contrast to the examples in the text, a corporate bond has a decline in default risk or an improvement in its liquidity. If the possibility of a default increases because a corporation begins to suffer large losses, the default risk on corporate bonds will increase, and the expected return on these bonds will decrease. In addition, the corporate bond s return will be more uncertain as well. The theory of asset demand predicts that because the expected return on the corporate bond falls relative to the expected return on the default-free Treasury bond while its relative riskiness rises, the corporate bond is less desirable (holding everything else equal), and demand for it will fall. The demand curve for corporate bonds in panel (a) of Figure 2 then shifts to the left, from D c 1 to D c 2. At the same time, the expected return on default-free Treasury bonds increases relative to the expected return on corporate bonds, while their relative riskiness

4 C H A P T E R 6 The Risk and Term Structure of Interest Rates 123 declines. The Treasury bonds thus become more desirable, and demand rises, as shown in panel (b) by the rightward shift in the demand curve for these bonds from D T 1 to D T 2. As we can see in Figure 2, the equilibrium price for corporate bonds (left axis) falls from P c 1 to P c 2, and since the bond price is negatively related to the interest rate, the equilibrium interest rate on corporate bonds (right axis) rises from i c 1 to i c 2. At the same time, however, the equilibrium price for the Treasury bonds rises from P T 1 to P T 2, and the equilibrium interest rate falls from i T 1 to i T 2. The spread between the interest rates on corporate and default-free bonds that is, the risk premium on corporate bonds has risen from zero to i c 2 i T 2. We can now conclude that a bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium. Because default risk is so important to the size of the risk premium, purchasers of bonds need to know whether a corporation is likely to default on its bonds. Two major investment advisory firms, Moody s Investors Service and Standard and Poor s Corporation, provide default risk information by rating the quality of corporate and municipal bonds in terms of the probability of default. The ratings and their description are contained in Table 1. Bonds with relatively low risk of default are called investment-grade securities and have a rating of Baa (or BBB) and above. Bonds with Table 1 Bond Ratings by Moody s and Standard and Poor s Rating Standard Examples of Corporations with Moody s and Poor s Descriptions Bonds Outstanding in 2003 Aaa AAA Highest quality General Electric, Pfizer Inc., (lowest default risk) North Carolina State, Mobil Oil Aa AA High quality Wal-Mart, McDonald s, Credit Suisse First Boston A A Upper medium grade Hewlett-Packard, Anheuser-Busch, Ford, Household Finance Baa BBB Medium grade Motorola, Albertson s, Pennzoil, Weyerhaeuser Co., Tommy Hilfiger Ba BB Lower medium grade Royal Caribbean, Levi Strauss B B Speculative Rite Aid, Northwest Airlines Inc., Six Flags Caa CCC, CC Poor (high default risk) Revlon, United Airlines Ca C Highly speculative US Airways, Polaroid C D Lowest grade Enron, Oakwood Homes

5 124 P A R T I I Financial Markets ratings below Baa (or BBB) have higher default risk and have been aptly dubbed speculative-grade or junk bonds. Because these bonds always have higher interest rates than investment-grade securities, they are also referred to as high-yield bonds. Next let s look back at Figure 1 and see if we can explain the relationship between interest rates on corporate and U.S. Treasury bonds. Corporate bonds always have higher interest rates than U.S. Treasury bonds because they always have some risk of default, whereas U.S. Treasury bonds do not. Because Baa-rated corporate bonds have a greater default risk than the higher-rated Aaa bonds, their risk premium is greater, and the Baa rate therefore always exceeds the Aaa rate. We can use the same analysis to explain the huge jump in the risk premium on Baa corporate bond rates during the Great Depression years and the rise in the risk premium after 1970 (see Figure 1). The depression period saw a very high rate of business failures and defaults. As we would expect, these factors led to a substantial increase in default risk for bonds issued by vulnerable corporations, and the risk premium for Baa bonds reached unprecedentedly high levels. Since 1970, we have again seen higher levels of business failures and defaults, although they were still well below Great Depression levels. Again, as expected, default risks and risk premiums for corporate bonds rose, widening the spread between interest rates on corporate bonds and Treasury bonds. Application The Enron Bankruptcy and the Baa-Aaa Spread In December 2001, the Enron Corporation, a firm specializing in trading in the energy market, and once the seventh-largest corporation in the United States, was forced to declare bankruptcy after it became clear that it had used shady accounting to hide its financial problems. (The Enron bankruptcy, the largest ever in the United States, will be discussed further in Chapter 8.) Because of the scale of the bankruptcy and the questions it raised about the quality of the information in accounting statements, the Enron collapse had a major impact on the corporate bond market. Let s see how our supply and demand analysis explains the behavior of the spread between interest rates on lower quality (Baa-rated) and highest quality (Aaa-rated) corporate bonds in the aftermath of the Enron failure. As a consequence of the Enron bankruptcy, many investors began to doubt the financial health of corporations with lower credit ratings such as Baa. The increase in default risk for Baa bonds made them less desirable at any given interest rate, decreased the quantity demanded, and shifted the demand curve for Baa bonds to the left. As shown in panel (a) of Figure 2, the interest rate on Baa bonds should have risen, which is indeed what happened. Interest rates on Baa bonds rose by 24 basis points (0.24 percentage points) from 7.81% in November 2001 to 8.05% in December But the increase in the perceived default risk for Baa bonds after the Enron bankruptcy made the highest quality (Aaa) bonds relatively more attractive and shifted the demand curve for these securities to the right an outcome described by some analysts as a flight to quality. Just as our analysis predicts in Figure 2, interest rates on Aaa bonds fell by 20 basis points, from 6.97% in November to 6.77% in December. The overall outcome was that the spread between interest rates on Baa and Aaa bonds rose by 44 basis points from 0.84% before the bankruptcy to 1.28% afterward.

6 C H A P T E R 6 The Risk and Term Structure of Interest Rates 125 Liquidity Income Tax Considerations Another attribute of a bond that influences its interest rate is its liquidity. As we learned in Chapter 4, a liquid asset is one that can be quickly and cheaply converted into cash if the need arises. The more liquid an asset is, the more desirable it is (holding everything else constant). U.S. Treasury bonds are the most liquid of all long-term bonds, because they are so widely traded that they are the easiest to sell quickly and the cost of selling them is low. Corporate bonds are not as liquid, because fewer bonds for any one corporation are traded; thus it can be costly to sell these bonds in an emergency, because it might be hard to find buyers quickly. How does the reduced liquidity of the corporate bonds affect their interest rates relative to the interest rate on Treasury bonds? We can use supply and demand analysis with the same figure that was used to analyze the effect of default risk, Figure 2, to show that the lower liquidity of corporate bonds relative to Treasury bonds increases the spread between the interest rates on these two bonds. Let us start the analysis by assuming that initially corporate and Treasury bonds are equally liquid and all their other attributes are the same. As shown in Figure 2, their equilibrium prices and interest rates will initially be equal: P c 1 P T 1 and i c 1 i T 1. If the corporate bond becomes less liquid than the Treasury bond because it is less widely traded, then (as the theory of asset demand indicates) its demand will fall, shifting its demand curve from D c 1 to D c 2 as in panel (a). The Treasury bond now becomes relatively more liquid in comparison with the corporate bond, so its demand curve shifts rightward from D T 1 to D T 2 as in panel (b). The shifts in the curves in Figure 2 show that the price of the less liquid corporate bond falls and its interest rate rises, while the price of the more liquid Treasury bond rises and its interest rate falls. The result is that the spread between the interest rates on the two bond types has risen. Therefore, the differences between interest rates on corporate bonds and Treasury bonds (that is, the risk premiums) reflect not only the corporate bond s default risk but its liquidity, too. This is why a risk premium is more accurately a risk and liquidity premium, but convention dictates that it is called a risk premium. Returning to Figure 1, we are still left with one puzzle the behavior of municipal bond rates. Municipal bonds are certainly not default-free: State and local governments have defaulted on the municipal bonds they have issued in the past, particularly during the Great Depression and even more recently in the case of Orange County, California, in 1994 (more on this in Chapter 13). Also, municipal bonds are not as liquid as U.S. Treasury bonds. Why is it, then, that these bonds have had lower interest rates than U.S. Treasury bonds for at least 40 years, as indicated in Figure 1? The explanation lies in the fact that interest payments on municipal bonds are exempt from federal income taxes, a factor that has the same effect on the demand for municipal bonds as an increase in their expected return. Let us imagine that you have a high enough income to put you in the 35% income tax bracket, where for every extra dollar of income you have to pay 35 cents to the government. If you own a $1,000-face-value U.S. Treasury bond that sells for $1,000 and has a coupon payment of $100, you get to keep only $65 of the payment after taxes. Although the bond has a 10% interest rate, you actually earn only 6.5% after taxes. Suppose, however, that you put your savings into a $1,000-face-value municipal bond that sells for $1,000 and pays only $80 in coupon payments. Its interest rate is only 8%, but because it is a tax-exempt security, you pay no taxes on the $80 coupon payment, so you earn 8% after taxes. Clearly, you earn more on the municipal bond

7 126 P A R T I I Financial Markets after taxes, so you are willing to hold the riskier and less liquid municipal bond even though it has a lower interest rate than the U.S. Treasury bond. (This was not true before World War II, when the tax-exempt status of municipal bonds did not convey much of an advantage because income tax rates were extremely low.) Another way of understanding why municipal bonds have lower interest rates than Treasury bonds is to use the supply and demand analysis displayed in Figure 3. We assume that municipal and Treasury bonds have identical attributes and so have the same bond prices and interest rates as drawn in the figure: P m 1 P T 1 and i m 1 i T 1. Once the municipal bonds are given a tax advantage that raises their after-tax expected return relative to Treasury bonds and makes them more desirable, demand for them rises, and their demand curve shifts to the right, from D m 1 to D m 2. The result is that their equilibrium bond price rises from P m 1 to P m 2, and their equilibrium interest rate falls from i m 1 to i m 2. By contrast, Treasury bonds have now become less desirable relative to municipal bonds; demand for Treasury bonds decreases, and D T 1 shifts to D T 2. The Treasury bond price falls from P T 1 to P T 2, and the interest rate rises from i T 1 to i T 2. The resulting lower interest rates for municipal bonds and higher interest rates for Treasury bonds explains why municipal bonds can have interest rates below those of Treasury bonds. 2 Price of Bonds, P (P increases ) Interest Rate, i (i increases ) Price of Bonds, P (P increases ) Interest Rate, i (i increases ) S m S T P m 2 i m 2 P m 1 i m 1 P T 1 i T 1 P T 2 i T 2 D m 1 D m 2 D T 2 D T 1 Quantity of Municipal Bonds (a) Market for municipal bonds Quantity of Treasury Bonds (b) Market for Treasury bonds F I G U R E 3 Interest Rates on Municipal and Treasury Bonds When the municipal bond is given tax-free status, demand for the municipal bond shifts rightward from D m 1 to D m 2 and demand for the Treasury bond shifts leftward from D T 1 to DT 2. The equilibrium price of the municipal bond (left axis) rises from P m 1 to P m 2, so its interest rate (right axis) falls from i m 1 to i m 2, while the equilibrium price of the Treasury bond falls from PT 1 to PT 2 and its interest rate rises from i T 1 to it 2. The result is that municipal bonds end up with lower interest rates than those on Treasury bonds. (Note: P and i increase in opposite directions. P on the left vertical axis increases as we go up the axis, while i on the right vertical axis increases as we go down the axis.) 2 In contrast to corporate bonds, Treasury bonds are exempt from state and local income taxes. Using the analysis in the text, you should be able to show that this feature of Treasury bonds provides an additional reason why interest rates on corporate bonds are higher than those on Treasury bonds.

8 C H A P T E R 6 The Risk and Term Structure of Interest Rates 127 Summary The risk structure of interest rates (the relationship among interest rates on bonds with the same maturity) is explained by three factors: default risk, liquidity, and the income tax treatment of the bond s interest payments. As a bond s default risk increases, the risk premium on that bond (the spread between its interest rate and the interest rate on a default-free Treasury bond) rises. The greater liquidity of Treasury bonds also explains why their interest rates are lower than interest rates on less liquid bonds. If a bond has a favorable tax treatment, as do municipal bonds, whose interest payments are exempt from federal income taxes, its interest rate will be lower. Application Effects of the Bush Tax Cut on Bond Interest Rates The Bush tax cut passed in 2001 scheduled a reduction of the top income tax bracket from 39% to 35% over a ten-year period. What is the effect of this income tax decrease on interest rates in the municipal bond market relative to those in the Treasury bond market? Our supply and demand analysis provides the answer. A decreased income tax rate for rich people means that the after-tax expected return on tax-free municipal bonds relative to that on Treasury bonds is lower, because the interest on Treasury bonds is now taxed at a lower rate. Because municipal bonds now become less desirable, their demand decreases, shifting the demand curve to the left, which lowers their price and raises their interest rate. Conversely, the lower income tax rate makes Treasury bonds more desirable; this change shifts their demand curve to the right, raises their price, and lowers their interest rates. Our analysis thus shows that the Bush tax cut raises the interest rates on municipal bonds relative to interest rates on Treasury bonds. Term Structure of Interest Rates We have seen how risk, liquidity, and tax considerations (collectively embedded in the risk structure) can influence interest rates. Another factor that influences the interest rate on a bond is its term to maturity: Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different. A plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations is called a yield curve, and it describes the term structure of interest rates for particular types of bonds, such as government bonds. The Following the Financial News box shows several yield curves for Treasury securities that were published in the Wall Street Journal. Yield curves can be classified as upward-sloping, flat, and downward-sloping (the last sort is often referred to as an inverted yield curve). When yield curves slope upward, as in the Following the Financial News box, the long-term interest rates are above the shortterm interest rates; when yield curves are flat, short- and long-term interest rates are the same; and when yield curves are inverted, long-term interest rates are below short-term interest rates. Yield curves can also have more complicated shapes in which they first slope up and then down, or vice versa. Why do we usually see

9 128 P A R T I I Financial Markets Following the Financial News Yield Curves The Wall Street Journal publishes a daily plot of the yield curves for Treasury securities, an example of which is presented here. It is typically found on page 2 of the Money and Investing section. The numbers on the vertical axis indicate the interest rate for the Treasury security, with the maturity given by the numbers on the horizontal axis. For example, the yield curve marked Yesterday indicates that the interest rate on the three-month Treasury bill yesterday was 1.25%, while the one-year bill had an interest rate of 1.35% and the ten-year bond had an interest rate of 4.0%. As you can see, the yield curves in the plot have the typical upward slope. Source: Wall Street Journal, Wednesday, January 22, 2003, p. C2. Treasury Yield Curve Yield to maturity of current bills, notes and bonds. 5.0% mos. yrs. maturity Source: Reuters Yesterday 1 month ago 1 year ago Check out today s yield curve. upward slopes of the yield curve as in the Following the Financial News box but sometimes other shapes? Besides explaining why yield curves take on different shapes at different times, a good theory of the term structure of interest rates must explain the following three important empirical facts: 1. As we see in Figure 4, interest rates on bonds of different maturities move together over time. 2. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term interest rates are high, yield curves are more likely to slope downward and be inverted. 3. Yield curves almost always slope upward, as in the Following the Financial News box. Three theories have been put forward to explain the term structure of interest rates; that is, the relationship among interest rates on bonds of different maturities reflected in yield curve patterns: (1) the expectations theory, (2) the segmented markets theory, and (3) the liquidity premium theory, each of which is described in the following sections. The expectations theory does a good job of explaining the first two facts on our list, but not the third. The segmented markets theory can explain fact 3 but not the other two facts, which are well explained by the expectations theory. Because each theory explains facts that the other cannot, a natural way to seek a better understanding of the term structure is to combine features of both theories, which leads us to the liquidity premium theory, which can explain all three facts. If the liquidity premium theory does a better job of explaining the facts and is hence the most widely accepted theory, why do we spend time discussing the other two theories? There are two reasons. First, the ideas in these two theories provide the

10 C H A P T E R 6 The Risk and Term Structure of Interest Rates 129 Interest Rate (%) Three-to Five-Year Averages Year Bond Averages 4 2 Three-Month Bills (Short-Term) F I G U R E 4 Movements over Time of Interest Rates on U.S. Government Bonds with Different Maturities Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, ; Federal Reserve: /data.htm#top. groundwork for the liquidity premium theory. Second, it is important to see how economists modify theories to improve them when they find that the predicted results are inconsistent with the empirical evidence. Expectations Theory The expectations theory of the term structure states the following commonsense proposition: The interest rate on a long-term bond will equal an average of short-term interest rates that people expect to occur over the life of the long-term bond. For example, if people expect that short-term interest rates will be 10% on average over the coming five years, the expectations theory predicts that the interest rate on bonds with five years to maturity will be 10% too. If short-term interest rates were expected to rise even higher after this five-year period so that the average short-term interest rate over the coming 20 years is 11%, then the interest rate on 20-year bonds would equal 11% and would be higher than the interest rate on five-year bonds. We can see that the explanation provided by the expectations theory for why interest rates on bonds of different maturities differ is that short-term interest rates are expected to have different values at future dates. The key assumption behind this theory is that buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. Bonds that have this characteristic are said to be perfect substitutes. What this means in practice is that if bonds with different maturities are perfect substitutes, the expected return on these bonds must be equal.

11 130 P A R T I I Financial Markets To see how the assumption that bonds with different maturities are perfect substitutes leads to the expectations theory, let us consider the following two investment strategies: 1. Purchase a one-year bond, and when it matures in one year, purchase another one-year bond. 2. Purchase a two-year bond and hold it until maturity. Because both strategies must have the same expected return if people are holding both one- and two-year bonds, the interest rate on the two-year bond must equal the average of the two one-year interest rates. For example, let s say that the current interest rate on the one-year bond is 9% and you expect the interest rate on the one-year bond next year to be 11%. If you pursue the first strategy of buying the two one-year bonds, the expected return over the two years will average out to be (9% 11%)/2 10% per year. You will be willing to hold both the one- and two-year bonds only if the expected return per year of the two-year bond equals this. Therefore, the interest rate on the twoyear bond must equal 10%, the average interest rate on the two one-year bonds. We can make this argument more general. For an investment of $1, consider the choice of holding, for two periods, a two-period bond or two one-period bonds. Using the definitions i t today s (time t) interest rate on a one-period bond i e t 1 interest rate on a one-period bond expected for next period (time t 1) i 2t today s (time t) interest rate on the two-period bond the expected return over the two periods from investing $1 in the two-period bond and holding it for the two periods can be calculated as: (1 i 2t )(1 i 2t ) 1 1 2i 2t (i 2t ) 2 1 = 2i 2t (i 2t ) 2 After the second period, the $1 investment is worth (1 i 2t )(1 i 2t ). Subtracting the $1 initial investment from this amount and dividing by the initial $1 investment gives the rate of return calculated in the previous equation. Because (i 2t ) 2 is extremely small if i 2 t 10% 0.10, then (i 2t ) we can simplify the expected return for holding the two-period bond for the two periods to 2i 2t With the other strategy, in which one-period bonds are bought, the expected return on the $1 investment over the two periods is: (1 i t )(1 i e t 1) 1 1 i t i e t 1 i t (i e t 1) 1 i t i e t i t (i e t 1) This calculation is derived by recognizing that after the first period, the $1 investment becomes 1 i t, and this is reinvested in the one-period bond for the next period, yielding an amount (1 i t )(1 i e t 1). Then subtracting the $1 initial investment from this amount and dividing by the initial investment of $1 gives the expected return for the strategy of holding one-period bonds for the two periods. Because i t (i e t 1) is also extremely small if i t i e t , then i t (i e t 1) 0.01 we can simplify this to: i t i e t 1 Both bonds will be held only if these expected returns are equal; that is, when: 2i 2t i t i e t 1

12 C H A P T E R 6 The Risk and Term Structure of Interest Rates 131 Solving for i 2t in terms of the one-period rates, we have: which tells us that the two-period rate must equal the average of the two one-period rates. Graphically, this can be shown as: Today 0 We can conduct the same steps for bonds with a longer maturity so that we can examine the whole term structure of interest rates. Doing so, we will find that the interest rate of i nt on an n-period bond must equal: Equation 2 states that the n-period interest rate equals the average of the oneperiod interest rates expected to occur over the n-period life of the bond. This is a restatement of the expectations theory in more precise terms. 3 A simple numerical example might clarify what the expectations theory in Equation 2 is saying. If the one-year interest rate over the next five years is expected to be 5, 6, 7, 8, and 9%, Equation 2 indicates that the interest rate on the two-year bond would be: while for the five-year bond it would be: i t i 2t i t i e t 1 2 Year 1 i 2t i t i e t 1 2 i n t i t i e t 1 i e t 2... i e t (n 1) n 5% 6% 2 5.5% 5% 6% 7% 8% 9% 5 7% Doing a similar calculation for the one-, three-, and four-year interest rates, you should be able to verify that the one- to five-year interest rates are 5.0, 5.5, 6.0, 6.5, and 7.0%, respectively. Thus we see that the rising trend in expected short-term interest rates produces an upward-sloping yield curve along which interest rates rise as maturity lengthens. The expectations theory is an elegant theory that provides an explanation of why the term structure of interest rates (as represented by yield curves) changes at different times. When the yield curve is upward-sloping, the expectations theory suggests that short-term interest rates are expected to rise in the future, as we have seen in our numerical example. In this situation, in which the long-term rate is currently above the short-term rate, the average of future short-term rates is expected to be higher than the current short-term rate, which can occur only if short-term interest rates are expected to rise. This is what we see in our numerical example. When the yield curve is inverted (slopes downward), the average of future short-term interest rates is i e t 1 Year 2 (1) (2) 3 The analysis here has been conducted for discount bonds. Formulas for interest rates on coupon bonds would differ slightly from those used here, but would convey the same principle.

13 132 P A R T I I Financial Markets Segmented Markets Theory expected to be below the current short-term rate, implying that short-term interest rates are expected to fall, on average, in the future. Only when the yield curve is flat does the expectations theory suggest that short-term interest rates are not expected to change, on average, in the future. The expectations theory also explains fact 1 that interest rates on bonds with different maturities move together over time. Historically, short-term interest rates have had the characteristic that if they increase today, they will tend to be higher in the future. Hence a rise in short-term rates will raise people s expectations of future shortterm rates. Because long-term rates are the average of expected future short-term rates, a rise in short-term rates will also raise long-term rates, causing short- and longterm rates to move together. The expectations theory also explains fact 2 that yield curves tend to have an upward slope when short-term interest rates are low and are inverted when shortterm rates are high. When short-term rates are low, people generally expect them to rise to some normal level in the future, and the average of future expected short-term rates is high relative to the current short-term rate. Therefore, long-term interest rates will be substantially above current short-term rates, and the yield curve would then have an upward slope. Conversely, if short-term rates are high, people usually expect them to come back down. Long-term rates would then drop below short-term rates because the average of expected future short-term rates would be below current shortterm rates and the yield curve would slope downward and become inverted. 4 The expectations theory is an attractive theory because it provides a simple explanation of the behavior of the term structure, but unfortunately it has a major shortcoming: It cannot explain fact 3, which says that yield curves usually slope upward. The typical upward slope of yield curves implies that short-term interest rates are usually expected to rise in the future. In practice, short-term interest rates are just as likely to fall as they are to rise, and so the expectations theory suggests that the typical yield curve should be flat rather than upward-sloping. As the name suggests, the segmented markets theory of the term structure sees markets for different-maturity bonds as completely separate and segmented. The interest rate for each bond with a different maturity is then determined by the supply of and demand for that bond with no effects from expected returns on other bonds with other maturities. The key assumption in the segmented markets theory is that bonds of different maturities are not substitutes at all, so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity. This theory of the term structure is at the opposite extreme to the expectations theory, which assumes that bonds of different maturities are perfect substitutes. The argument for why bonds of different maturities are not substitutes is that investors have strong preferences for bonds of one maturity but not for another, so they will be concerned with the expected returns only for bonds of the maturity they prefer. This might occur because they have a particular holding period in mind, and 4 The expectations theory explains another important fact about the relationship between short-term and long-term interest rates. As you can see in Figure 4, short-term interest rates are more volatile than long-term rates. If interest rates are mean-reverting that is, if they tend to head back down after they are at unusually high levels or go back up when they are at unusually low levels then an average of these short-term rates must necessarily have lower volatility than the short-term rates themselves. Because the expectations theory suggests that the long-term rate will be an average of future short-term rates, it implies that the long-term rate will have lower volatility than short-term rates.

14 C H A P T E R 6 The Risk and Term Structure of Interest Rates 133 Liquidity Premium and Preferred Habitat Theories if they match the maturity of the bond to the desired holding period, they can obtain a certain return with no risk at all. 5 (We have seen in Chapter 4 that if the term to maturity equals the holding period, the return is known for certain because it equals the yield exactly, and there is no interest-rate risk.) For example, people who have a short holding period would prefer to hold short-term bonds. Conversely, if you were putting funds away for your young child to go to college, your desired holding period might be much longer, and you would want to hold longer-term bonds. In the segmented markets theory, differing yield curve patterns are accounted for by supply and demand differences associated with bonds of different maturities. If, as seems sensible, investors have short desired holding periods and generally prefer bonds with shorter maturities that have less interest-rate risk, the segmented markets theory can explain fact 3 that yield curves typically slope upward. Because in the typical situation the demand for long-term bonds is relatively lower than that for shortterm bonds, long-term bonds will have lower prices and higher interest rates, and hence the yield curve will typically slope upward. Although the segmented markets theory can explain why yield curves usually tend to slope upward, it has a major flaw in that it cannot explain facts 1 and 2. Because it views the market for bonds of different maturities as completely segmented, there is no reason for a rise in interest rates on a bond of one maturity to affect the interest rate on a bond of another maturity. Therefore, it cannot explain why interest rates on bonds of different maturities tend to move together (fact 1). Second, because it is not clear how demand and supply for short- versus long-term bonds change with the level of short-term interest rates, the theory cannot explain why yield curves tend to slope upward when short-term interest rates are low and to be inverted when short-term interest rates are high (fact 2). Because each of our two theories explains empirical facts that the other cannot, a logical step is to combine the theories, which leads us to the liquidity premium theory. The liquidity premium theory of the term structure states that the interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium (also referred to as a term premium) that responds to supply and demand conditions for that bond. The liquidity premium theory s key assumption is that bonds of different maturities are substitutes, which means that the expected return on one bond does influence the expected return on a bond of a different maturity, but it allows investors to prefer one bond maturity over another. In other words, bonds of different maturities are assumed to be substitutes but not perfect substitutes. Investors tend to prefer shorterterm bonds because these bonds bear less interest-rate risk. For these reasons, investors must be offered a positive liquidity premium to induce them to hold longerterm bonds. Such an outcome would modify the expectations theory by adding a positive liquidity premium to the equation that describes the relationship between longand short-term interest rates. The liquidity premium theory is thus written as: i nt i t i e t 1 i e t 2... i e t (n 1) n l nt (3) 5 The statement that there is no uncertainty about the return if the term to maturity equals the holding period is literally true only for a discount bond. For a coupon bond with a long holding period, there is some risk because coupon payments must be reinvested before the bond matures. Our analysis here is thus being conducted for discount bonds. However, the gist of the analysis remains the same for coupon bonds because the amount of this risk from reinvestment is small when coupon bonds have the same term to maturity as the holding period.

15 134 P A R T I I Financial Markets /YieldCurve.html This site lets you look at the dynamic yield curve at any point in time since where l nt the liquidity (term) premium for the n-period bond at time t, which is always positive and rises with the term to maturity of the bond, n. Closely related to the liquidity premium theory is the preferred habitat theory, which takes a somewhat less direct approach to modifying the expectations hypothesis but comes up with a similar conclusion. It assumes that investors have a preference for bonds of one maturity over another, a particular bond maturity (preferred habitat) in which they prefer to invest. Because they prefer bonds of one maturity over another they will be willing to buy bonds that do not have the preferred maturity only if they earn a somewhat higher expected return. Because investors are likely to prefer the habitat of short-term bonds over that of longer-term bonds, they are willing to hold long-term bonds only if they have higher expected returns. This reasoning leads to the same Equation 3 implied by the liquidity premium theory with a term premium that typically rises with maturity. The relationship between the expectations theory and the liquidity premiums and preferred habitat theories is shown in Figure 5. There we see that because the liquidity premium is always positive and typically grows as the term to maturity increases, the yield curve implied by the liquidity premium theory is always above the yield curve implied by the expectations theory and generally has a steeper slope. A simple numerical example similar to the one we used for the expectations hypothesis further clarifies what the liquidity premium and preferred habitat theories in Equation 3 are saying. Again suppose that the one-year interest rate over the next five years is expected to be 5, 6, 7, 8, and 9%, while investors preferences for holding short-term bonds means that the liquidity premiums for one- to five-year bonds are 0, 0.25, 0.5, 0.75, and 1.0%, respectively. Equation 3 then indicates that the interest rate on the two-year bond would be: 5% 6% % 5.75% F I G U R E 5 The Relationship Between the Liquidity Premium (Preferred Habitat) and Expectations Theory Because the liquidity premium is always positive and grows as the term to maturity increases, the yield curve implied by the liquidity premium and preferred habitat theories is always above the yield curve implied by the expectations theory and has a steeper slope. Note that the yield curve implied by the expectations theory is drawn under the scenario of unchanging future one-year interest rates. Interest Rate, i nt Liquidity Premium (Preferred Habitat) Theory Yield Curve Expectations Theory Yield Curve Liquidity Premium, l nt Years to Maturity, n 25 30

16 C H A P T E R 6 The Risk and Term Structure of Interest Rates 135 while for the five-year bond it would be: 5% 6% 7% 8% 9% 5 1% 8% Doing a similar calculation for the one-, three-, and four-year interest rates, you should be able to verify that the one- to five-year interest rates are 5.0, 5.75, 6.5, 7.25, and 8.0%, respectively. Comparing these findings with those for the expectations theory, we see that the liquidity premium and preferred habitat theories produce yield curves that slope more steeply upward because of investors preferences for shortterm bonds. Let s see if the liquidity premium and preferred habitat theories are consistent with all three empirical facts we have discussed. They explain fact 1 that interest rates on different-maturity bonds move together over time: A rise in short-term interest rates indicates that short-term interest rates will, on average, be higher in the future, and the first term in Equation 3 then implies that long-term interest rates will rise along with them. They also explain why yield curves tend to have an especially steep upward slope when short-term interest rates are low and to be inverted when short-term rates are high (fact 2). Because investors generally expect short-term interest rates to rise to some normal level when they are low, the average of future expected shortterm rates will be high relative to the current short-term rate. With the additional boost of a positive liquidity premium, long-term interest rates will be substantially above current short-term rates, and the yield curve would then have a steep upward slope. Conversely, if short-term rates are high, people usually expect them to come back down. Long-term rates would then drop below short-term rates because the average of expected future short-term rates would be so far below current shortterm rates that despite positive liquidity premiums, the yield curve would slope downward. The liquidity premium and preferred habitat theories explain fact 3 that yield curves typically slope upward by recognizing that the liquidity premium rises with a bond s maturity because of investors preferences for short-term bonds. Even if shortterm interest rates are expected to stay the same on average in the future, long-term interest rates will be above short-term interest rates, and yield curves will typically slope upward. How can the liquidity premium and preferred habitat theories explain the occasional appearance of inverted yield curves if the liquidity premium is positive? It must be that at times short-term interest rates are expected to fall so much in the future that the average of the expected short-term rates is well below the current short-term rate. Even when the positive liquidity premium is added to this average, the resulting longterm rate will still be below the current short-term interest rate. As our discussion indicates, a particularly attractive feature of the liquidity premium and preferred habitat theories is that they tell you what the market is predicting about future short-term interest rates just from the slope of the yield curve. A steeply rising yield curve, as in panel (a) of Figure 6, indicates that short-term interest rates are expected to rise in the future. A moderately steep yield curve, as in panel (b), indicates that short-term interest rates are not expected to rise or fall much in the future. A flat yield curve, as in panel (c), indicates that short-term rates are expected to fall moderately in the future. Finally, an inverted yield curve, as in panel (d), indicates that short-term interest rates are expected to fall sharply in the future.

17 136 P A R T I I Financial Markets Yield to Maturity Yield to Maturity Term to Maturity (a) Future short-term interest rates expected to rise Term to Maturity (b) Future short-term interest rates expected to stay the same Yield to Maturity Yield to Maturity Term to Maturity (c) Future short-term interest rates expected to fall moderately Term to Maturity (d) Future short-term interest rates expected to fall sharply F I G U R E 6 Yield Curves and the Market s Expectations of Future Short-Term Interest Rates According to the Liquidity Premium Theory Evidence on the Term Structure In the 1980s, researchers examining the term structure of interest rates questioned whether the slope of the yield curve provides information about movements of future short-term interest rates. 6 They found that the spread between long- and short-term interest rates does not always help predict future short-term interest rates, a finding that may stem from substantial fluctuations in the liquidity (term) premium for longterm bonds. More recent research using more discriminating tests now favors a different view. It shows that the term structure contains quite a bit of information for the very short run (over the next several months) and the long run (over several years) 6 Robert J. Shiller, John Y. Campbell, and Kermit L. Schoenholtz, Forward Rates and Future Policy: Interpreting the Term Structure of Interest Rates, Brookings Papers on Economic Activity 1 (1983): ; N. Gregory Mankiw and Lawrence H. Summers, Do Long-Term Interest Rates Overreact to Short-Term Interest Rates? Brookings Papers on Economic Activity 1 (1984):

18 C H A P T E R 6 The Risk and Term Structure of Interest Rates 137 Summary but is unreliable at predicting movements in interest rates over the intermediate term (the time in between). 7 The liquidity premium and preferred habitat theories are the most widely accepted theories of the term structure of interest rates because they explain the major empirical facts about the term structure so well. They combine the features of both the expectations theory and the segmented markets theory by asserting that a long-term interest rate will be the sum of a liquidity (term) premium and the average of the short-term interest rates that are expected to occur over the life of the bond. The liquidity premium and preferred habitat theories explain the following facts: (1) Interest rates on bonds of different maturities tend to move together over time, (2) yield curves usually slope upward, and (3) when short-term interest rates are low, yield curves are more likely to have a steep upward slope, whereas when short-term interest rates are high, yield curves are more likely to be inverted. The theories also help us predict the movement of short-term interest rates in the future. A steep upward slope of the yield curve means that short-term rates are expected to rise, a mild upward slope means that short-term rates are expected to remain the same, a flat slope means that short-term rates are expected to fall moderately, and an inverted yield curve means that short-term rates are expected to fall sharply. Application Interpreting Yield Curves, Figure 7 illustrates several yield curves that have appeared for U.S. government bonds in recent years. What do these yield curves tell us about the public s expectations of future movements of short-term interest rates? Study Guide Try to answer the preceding question before reading further in the text. If you have trouble answering it with the liquidity premium and preferred habitat theories, first try answering it with the expectations theory (which is simpler because you don t have to worry about the liquidity premium). When you understand what the expectations of future interest rates are in this case, modify your analysis by taking the liquidity premium into account. The steep inverted yield curve that occurred on January 15, 1981, indicated that short-term interest rates were expected to decline sharply in the future. In order for longer-term interest rates with their positive liquidity premium to be well below the short-term interest rate, short-term interest rates must be expected to decline so sharply that their average is far below the current short-term rate. Indeed, the public s expectations of sharply lower short-term interest rates evident in the yield curve were realized soon after January 15; by March, three-month Treasury bill rates had declined from the 16% level to 13%. 7 Eugene Fama, The Information in the Term Structure, Journal of Financial Economics 13 (1984): ; Eugene Fama and Robert Bliss, The Information in Long-Maturity Forward Rates, American Economic Review 77 (1987): ; John Y. Campbell and Robert J. Shiller, Cointegration and Tests of the Present Value Models, Journal of Political Economy 95 (1987): ; John Y. Campbell and Robert J. Shiller, Yield Spreads and Interest Rate Movements: A Bird s Eye View, Review of Economic Studies 58 (1991):

19 138 P A R T I I Financial Markets Interest Rate (%) January 15, 1981 March 28, 1985 May 16, March 3, 1997 January 23, Terms to Maturity (Years) F I G U R E 7 Yield Curves for U.S. Government Bonds Sources: Federal Reserve Bank of St. Louis; U.S. Financial Data, various issues; Wall Street Journal, various dates. The steep upward-sloping yield curves on March 28, 1985, and January 23, 2003, indicated that short-term interest rates would climb in the future. The long-term interest rate is above the short-term interest rate when shortterm interest rates are expected to rise because their average plus the liquidity premium will be above the current short-term rate. The moderately upward-sloping yield curves on May 16, 1980, and March 3, 1997, indicated that short-term interest rates were expected neither to rise nor to fall in the near future. In this case, their average remains the same as the current shortterm rate, and the positive liquidity premium for longer-term bonds explains the moderate upward slope of the yield curve. Summary 1. Bonds with the same maturity will have different interest rates because of three factors: default risk, liquidity, and tax considerations. The greater a bond s default risk, the higher its interest rate relative to other bonds; the greater a bond s liquidity, the lower its interest rate; and bonds with tax-exempt status will have lower interest rates than they otherwise would. The relationship among interest rates on bonds with the same maturity that arise because of these three factors is known as the risk structure of interest rates.

20 C H A P T E R 6 The Risk and Term Structure of Interest Rates Four theories of the term structure provide explanations of how interest rates on bonds with different terms to maturity are related. The expectations theory views long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond; by contrast, the segmented markets theory treats the determination of interest rates for each bond s maturity as the outcome of supply and demand in that market only. Neither of these theories by itself can explain the fact that interest rates on bonds of different maturities move together over time and that yield curves usually slope upward. 3. The liquidity premium and preferred habitat theories combine the features of the other two theories, and by so doing are able to explain the facts just mentioned. They view long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond plus a liquidity premium. These theories allow us to infer the market s expectations about the movement of future short-term interest rates from the yield curve. A steeply upwardsloping curve indicates that future short-term rates are expected to rise, a mildly upward-sloping curve indicates that short-term rates are expected to stay the same, a flat curve indicates that short-term rates are expected to decline slightly, and an inverted yield curve indicates that a substantial decline in short-term rates is expected in the future. Key Terms default, p. 120 default-free bonds, p. 121 expectations theory, p. 129 inverted yield curve, p. 127 junk bonds, p. 124 liquidity premium theory, p. 133 preferred habitat theory, p. 134 risk premium, p. 121 risk structure of interest rates, p. 120 segmented markets theory, p. 132 term structure of interest rates, p. 120 yield curve, p. 127 QUIZ Questions and Problems Questions marked with an asterisk are answered at the end of the book in an appendix, Answers to Selected Questions and Problems. 1. Which should have the higher risk premium on its interest rates, a corporate bond with a Moody s Baa rating or a corporate bond with a C rating? Why? *2. Why do U.S. Treasury bills have lower interest rates than large-denomination negotiable bank CDs? 3. Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so? *4. If bonds of different maturities are close substitutes, their interest rates are more likely to move together. Is this statement true, false, or uncertain? Explain your answer. 5. If yield curves, on average, were flat, what would this say about the liquidity (term) premiums in the term structure? Would you be more or less willing to accept the expectations theory? *6. Assuming that the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yield curves for the following series of one-year interest rates over the next five years: (a) 5%, 7%, 7%, 7%, 7% (b) 5%, 4%, 4%, 4%, 4% How would your yield curves change if people preferred shorter-term bonds over longer-term bonds? 7. Assuming that the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yield curves for the following path of one-year interest rates over the next five years: (a) 5%, 6%, 7%, 6%, 5% (b) 5%, 4%, 3%, 4%, 5% How would your yield curves change if people preferred shorter-term bonds over longer-term bonds?

21 140 P A R T I I Financial Markets *8. If a yield curve looks like the one shown in figure (a) in this section, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market s predictions about the inflation rate in the future? Yield to Maturity 13. If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? What effect would the change have on interest rates on U.S. Treasury securities? *14. If the yield curve suddenly becomes steeper, how would you revise your predictions of interest rates in the future? 15. If expectations of future short-term interest rates suddenly fall, what would happen to the slope of the yield curve? Web Exercises (a) 9. If a yield curve looks like the one shown in (b), what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market s predictions about the inflation rate in the future? Yield to Maturity (b) *10. What effect would reducing income tax rates have on the interest rates of municipal bonds? Would interest rates of Treasury securities be affected, and if so, how? Using Economic Analysis to Predict the Future Term to Maturity Term to Maturity 11. Predict what will happen to interest rates on a corporation s bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future. What will happen to the interest rates on Treasury securities? *12. Predict what would happen to the risk premiums on corporate bonds if brokerage commissions were lowered in the corporate bond market. 1. The amount of additional interest investors receive due to the various premiums changes over time. Sometimes the risk premiums are much larger than at other times. For example, the default risk premium was very small in the late 1990s when the economy was so healthy business failures were rare. This risk premium increases during recessions. Go to (historical data) and find the interest rate listings for AAA and Baa rated bonds at three points in time, the most recent, June 1, 1995, and June 1, Prepare a graph that shows these three time periods (see Figure 1 for an example). Are the risk premiums stable or do they change over time? 2. Figure 7 shows a number of yield curves at various points in time. Go to and click on Markets at the top of the page. Find the Treasury yield curve. Does the current yield curve fall above or below the most recent one listed in Figure 7? Is the current yield curve flatter or steeper than the most recent one reported in Figure 7? 3. Investment companies attempt to explain to investors the nature of the risk the investor incurs when buying shares in their mutual funds. For example, Vanguard carefully explains interest rate risk and offers alternative funds with different interest rate risks. Go to /FundsStocksOverview. a. Select the bond fund you would recommend to an investor who has very low tolerance for risk and a short investment horizon. Justify your answer. b. Select the bond fund you would recommend to an investor who has very high tolerance for risk and a long investment horizon. Justify your answer.