Chapter Seven Chapter 6 The Risk Structure and Term Structure of Interest Rates Bonds Are Risky!!! Bonds are a promise to pay a certain amount in the future. How can that be risky? 1. Default risk - the chance the bond s issuer may not make payment. 2. Inflation risk - investor cannot be aware of the real of the payments made. 3. Interest rate risk - a rise in interest rates before bond is sold could mean a capital loss. Default Case Study: What Happened Here? Investors concerns about risk affect their demand for U.S. Treasuries. 1998, Russia defaulted and people lost confidence in emerging market countries. Safest assets are U.S. Treasuries. Demand increased, price increased, and yields declined. 1
Risk arises because an investment has many possible payoffs during the holding horizon. We need to look at the risk the bondholder faces - what are the possible payoffs, and how likely each is to occur. We will compare the risk of a bond s return relative to the default risk-free rate a US government bond. Corporate bond example: Assume the one-year risk-free interest rate is 5 percent. If the company is perceived as default risk-free, the company can issue a 5 percent coupon bond with a face value of $100. If this bond was considered default risk-free, the price of the bond would be the present value of the $105 payment. Price of risk free bond = ($100 + $5)/$1.05 = $100 Suppose, there is now a 5% probability that the company will go bankrupt before paying back the loan. the outcome is either $105 or $0. 2
Suppose 5% probability firm goes bankrupt you get nothing Expected Value of bond payment Possibilities Payoff Probability Payoff x Probability Full Payment $105.95 $99.75 Default $0.05 $0 If the price of the bond is $95, what is the YTM? YTM = $105/$95-1 = 0.1052 Default risk premium is the YTM minus the risk-free rate: Risk Premium = 10.53% - 5% = 5.53 percent. The higher the default risk, the higher the yield and risk premium. Suppose 10% probability firm goes bankrupt you get nothing Expected Value of bond payment Possibilities Payoff Probability Payoff x Probability Full Payment $105.90 $94.50 Default $0.10 $0 Expect to receive $94.50 one-year from now. Discount at risk-free rate = $94.50 $90 1.05 P = $90; YTM = $105/$90 1 = 16.67% Risk premium = 16.67 5 = 11.67% 3
Premium We can calculate the probability of repayment from the interest rates. Call it p. Let 1+k be the return on a one-year corporate debt and 1+ i be the return on a one-year default risk-free treasury. At equilibrium: 1+i = p(1+k) The probability of repayment is the probability of default is 1 p The probability of repayment: 1 i p 1 k 1.05 1.1667 0.90 Yields on 9/20/16 3mo 6mo 9mo 1yr 2yr 3yr 5yr 10yr 20yr 30yr+ BONDS U.S. Treasury 0.29% 0.51% 0.60% 0.68% 0.82% 0.94% 1.23% 1.67% 2.01% 2.40% U.S. Treasury Zeros -- -- -- 0.56% 0.73% 0.89% 1.25% 1.82% 2.32% -- Agency/GSE 0.71% 0.81% 0.96% 1.01% 1.13% 1.42% 1.62% 2.42% 3.13% 3.20% Corporate (Aaa/AAA) -- 0.39% -- 0.73% 1.05% 1.40% 1.59% 2.45% 3.35% 3.91% Corporate (Aa/AA) 0.74% 1.15% 1.08% 1.22% 1.44% 1.62% 1.96% 2.75% 3.60% 4.49% Corporate (A/A) 0.93% 1.25% 1.32% 1.42% 1.84% 1.89% 2.65% 3.44% 4.25% 4.32% Corporate (Baa/BBB) Municipal (Aaa/AAA) 1.21% 1.65% 2.15% 2.15% 2.54% 4.48% 4.88% 5.13% 6.08% 6.42% 0.60% 0.60% 0.77% 0.75% 0.97% 1.12% 1.43% 2.15% 2.85% 2.93% Municipal (Aa/AA) 0.86% 0.75% 0.85% 0.88% 1.63% 1.61% 1.65% 2.59% 3.07% 3.28% Municipal (A/A) 0.75% 0.80% 1.00% 0.99% 1.20% 1.68% 2.52% 3.45% 3.50% 3.45% Taxable Municipal* 0.73% 1.11% 1.05% 1.10% 1.72% 2.05% 2.09% 4.30% 3.94% 3.36% Yields on 9/25/18 BONDS 3mo 6mo 9mo 1yr 2yr 3yr 5yr 10yr 20yr 30yr+ U.S. Treasury 2.25% 2.37% 2.53% 2.64% 2.84% 2.91% 2.98% 3.09% 3.15% 3.22% U.S. Treasury Zeros -- -- -- 2.52% 2.83% 2.90% 3.00% 3.17% 3.25% 3.21% Agency/GSE 2.32% 2.43% 2.61% 2.76% 3.03% 3.19% 3.45% 3.88% 4.26% 3.85% Corporate (Aaa/AAA) 1.99% 2.50% 2.52% 2.72% 2.74% 3.02% 3.40% -- 3.92% 4.38% Corporate (Aa/AA) 2.37% 2.56% 2.71% 2.88% 3.12% 3.47% 3.57% 3.98% 4.21% 4.84% Corporate (A/A) 2.56% 2.74% 2.74% 2.99% 3.49% 3.83% 4.02% 4.56% 5.06% 5.32% Corporate (Baa/BBB) 2.81% 2.91% 3.36% 3.66% 3.83% 4.38% 5.06% 6.04% 6.86% 6.92% Municipal (Aaa/AAA) 1.87% 1.88% 2.00% 2.02% 2.10% 2.22% 2.45% 3.15% 3.86% 3.71% Municipal (Aa/AA) 1.99% 1.95% 2.03% 2.36% 2.21% 2.35% 2.97% 3.47% 4.07% 4.40% Municipal (A/A) 2.00% 2.01% 2.20% 2.18% 2.45% 2.56% 2.79% 3.61% 4.15% 4.38% Taxable Municipal* 2.18% 2.24% 3.35% 2.85% 3.13% 3.36% 3.78% 4.35% 4.13% 4.98% 6-12 4
Risk Structure of Interest Rates Hold time to maturity constant and compare yields. Default risk - occurs when the issuer of the bond is unable or unwilling to make interest payments or pay off the face value U.S. T-bonds are considered default free Risk premium the spread between the interest rates on bonds with default risk and the interest rates on T-bonds Liquidity - the ease with which an asset can be converted into cash Income tax - taxable or non taxable Ratings and the Risk Structure of Interest Rates Default is an important risks a bond buyer faces. Independent companies (rating agencies) evaluate the creditworthiness of potential borrowers. These companies estimate the likelihood that the corporate or government borrower will make a bond s promised payments. 5
Bond Ratings The best known bond rating services are Moody s Standard & Poor s A high rating suggests that a bond issuer will have little problem meeting a bond s payment obligations. Bond Ratings The highest-rated bonds, Triple A. Ex: ExxonMobil, Microsoft, and the government of Canada (also JNJ) The top four rating categories are considered investment-grade bonds. These bonds have a very low risk of default. Reserved for most government issuers and corporations that are among the most financially sound. 6
Credit rating & historic default frequencies Moody s Rating 1985 1990 1995 2000 2006 2008 2009 2010 Aaa 0% 0% 0% 0% 0% 0% 0% 0% Aa 0% 0% 0% 0% 0% 0% 0% 0% A 0% 0% 0% 0% 0% 1.201% 0% 0.36% Baa1 0% 0% 0% 0.29% 0% 0.271% 1.144% 0% Baa2 0% 0% 0% 0% 0% 0.794% 0.74% 0% Baa3 0% 0% 0% 0.98% 0% 0.321% 0.70% 0% Ba1 0% 2.67% 0% 0.91% 0% 0% 2.27% 0% Ba2 1.63% 2.82% 0% 0.66% 0.51% 0% 0.60% 0% Ba3 3.77% 3.92% 1.72% 0.99% 0% 2.715% 4.01% 0% B1 4.38% 8.59% 4.35% 3.63% 0.66% 1.783% 4.10% 0.85% B2 7.41% 22.09% 6.36% 3.84% 0.50% 0.825% 8.68% 0% B3 13.86% 28.93% 4.10% 11.72% 1.93% 3.198% 8.52% 0.56% Bond Ratings The distinction between investment-grade and speculative, noninvestment-grade (less than BBB or Baa) is important. Some regulated institutional investors are not allowed to invest in bonds rated below investment grade, which is Baa on Moody s scale or BBB on Standard and Poor s scale. Bond Ratings Speculative grade bonds are bonds issued by companies and countries that may have difficulty meeting their bond payments but are not at risk of immediate default. Bonds with grades below investment grade are often referred to as junk bonds or high-yield bonds. https://finance.yahoo.com/quote /JNK?p=JNK 7
The Impact of Ratings on Yields Bond ratings are designed to reflect default risk. The higher the risk of default. The lower the rating The lower the bond price and the higher its yield. To understand quantitative ratings, it is easier to compare them to a benchmark. The Impact of Ratings on Yields U.S. Treasury issues are viewed as having little default risk, so they are used as benchmark bonds. Yields on other bonds are measured in terms of the spread over Treasuries. Bond yield is the sum of two parts: = U.S. Treasury yield + Default risk premium Supply/Demand Application: Response to an Increase in on Corporate Bonds 8
The Impact of Ratings on Yields If bond ratings properly reflect risk, then the lower the rating of the issuer, the higher the default-risk premium. When Treasury yields move, all other yields move with them. We can see this from a plot of the risk structure of interest rates. Differences in Tax Status and Municipal Bonds Taxes affect the yield on a bond. Bondholders must pay income tax on the interest income they receive from owning privately issued bonds - taxable bonds. The coupon payments on bonds issued by state and local governments, municipal or tax-exempt bonds, are specifically exempt from taxation. Differences in Tax Status and Municipal Bonds What are the tax implications for bond yields? Consider a one-year $100 face value taxable bond with a coupon rate of 6 percent. Par is $100, and yield to maturity is 6 percent. Government sees this 6 percent as taxable income. If tax rate is 30%, the tax is $1.80. Bond yields $104.20 after taxes, equivalent of 4.2 percent. This is the after-tax yield. 9
Taxes and Bond Prices Coupon payments on municipal bonds are exempt from federal Income taxes For 30% tax bracket: After tax yield = (taxable yield) x (1 tax rate) 4.20% = 6% x (1 0.30) Tax equivalent yield = tax exempt yield 1- tax rate http://www.bloomberg.com/markets/ratesbonds/government-bonds/us/ Interest Rates on Municipal and Treasury Bonds 10