Transcript Chapter 6 The Risk and Term Structure of Interest Rates

Chapter 6
The Risk and Term
Structure of Interest Rates
Terezia Chen
Jody Giesbrecht
Overview


Web Exercises
Risk Structure of Interest Rates




Default risk
Liquidity
Tax Considerations
Term Structure of Interest Rates


Yield Curves
Expectations Theory, Segmented Markets Theory,
Liquidity Premium Theory, Preferred Habitat Theory
Web Exercises

1. What has the average rate of inflation been
since 1995? What year had the highest and
lowest levels of inflation?

Average rate of inflation: 2.04%
Highest rate: 4.70% in Feb 2003
Lowest rate: 0.60% in Jan 1995


From www.bankofcanada.ca/en/cpi/htm
Web Exercises

2. What is the cost today of a car that cost
$10,000 the year that you were born?

1914 - $189,830.51 – avg inflation rate of 3.22%
1950 - $90,322.58 – avg inflation rate of 3.94%
1975 - $38,356.16 – avg inflation rate of 4.29%


From www.bankofcanada.ca/en/inflation_calc.htm
Web Exercises

3. What happens to the difference between the
adjusted value of an investment compared to its
inflation-adjusted value as:



Inflation increases (3 to 5%)?
 Buying Power: 3% - $8626.09
5% - $7835.26
The investment horizon lengthens (5 to 10 years)?
 Buying Power: 5yrs - $8626.09
10 yrs - $7440.94
Expected returns increase (5 to 8%)?
 Buying Power: 5% - $12120.51
8% - $16064.43
From www.moneychimp.com/articles/econ/inflation_calculator.htm
Risk vs. Term

Relationships among interest rates can be
defined by two aspects:


Risk structure of interest rates – relationship
among the different interest rates on bonds with
the same term to maturity
Term structure of interest rates – relationship
among interest rates on bonds with different
terms to maturity but with same default risk
Risk Structure of Interest Rates

Default Risk



Occurs when issuer of a bond is unable or
unwilling to make interest payments or repay
principle when bond reaches maturity
Default-free bonds – no default risk – Canadian
Government Bonds
Risk Premium – spread between the interest rate
on a risky bond and a default-free bond
Supply & Demand Analysis
Default Risk Information

Credit-Rating Agencies – investment advisory
firms that rate quality of bonds in terms of
probability of default



Agencies used in Canada: Standards & Poors,
Moody’s Investors Service, Fitch Ratings
Junk Bonds
Fallen Angels
“The Junk Bond King”

Michael Milken


Executive at Drexel Burnham Lambert Inc during
1980’s
used high-yield junk bonds for corporate financing
and mergers and acquisitions
Bond Defaults in Canada


CBC article published Sept. 2003
Rate of default lower in Canada than US


Canada: 1.9%
US: 2.4%
Recovery rates for Canadian bonds lower
than in the US

Canada: 30% of par
US: 42% of par
From http://www.cbc.ca/money/story/2003/09/10/moodys_030910.html
Can Lack of Bond Defaults
Last Forever?

Article from the Financial Post by David Berman – June 2007

Default rate hit zero in 2006
More bond upgrades than downgrades
What does this signal for the future?





Possible increase in speculative grade bonds
Higher borrowing costs
Decrease in corporate profit growth
From http://www.canada.com/nationalpost/financialpost/story.html?id=045d7cbd3cc2-4591-abdf-8056956ef88b
Risk Structure of Interest Rates

Liquidity



Ease with which a bond can be traded or sold
Canada bonds considered most liquid
If corporate bonds are traded less widely, liquidity and demand
will decrease. This will cause the price of the bond to fall and,
conversely, the interest rate to rise
As the price falls from P1 to P2,
the interest rate will move
upwards
Risk Structure of Interest Rates

Income Tax Considerations


In some countries, certain government bonds are
not taxable (ex: US municipal bonds)
This might allow for a greater returns than a
taxable corporate bond with a higher stated return
Tax-exempt equivalent yields
Marginal
Tax
Rate
4% TaxExempt
Yield
5%TaxExempt
Yield
6%TaxExempt
Yield
6.5%TaxExempt
Yield
7%TaxExempt
Yield
7.5%TaxExempt
Yield
10 %
4.44
5.56
6.67
7.78
8.33
4.44
15 %
4.71
5.88
7.06
8.24
8.82
4.71
27 %
5.48
6.85
8.22
9.59
10.27
5.48
30 %
5.71
7.14
8.57
10.00
10.71
5.71
35 %
6.15
7.69
9.23
10.77
11.54
6.15
38.6 %
6.51
8.14
9.77
11.40
12.21
6.51
http://moneycentral.msn.com/content/Investing/Simplestrategies/P38652.asp
Term Structure of Interest Rates

Yield Curve – depiction of yields on bonds
when risk, liquidity and tax considerations are
equal but the terms to maturity differ
Term Structure Theories




Expectations Theory
Segmented Markets Theory
Liquidity Premium Theory
Preferred Habitat Theory
Purpose of Theories


To explain why yield curves take on their
specific shapes
To explain 3 empirical facts:



Interest rates on bonds of different maturities
move together over time
When ST rates are low, yield curves are likely to
be upward sloping; when ST rates are high, yield
curves are likely to be inverted
Yield curves almost always slope upward
Expectations Theory

The interest rate on a long-term bond will
equal an average of short-term interest rates
that are expected to occur over the life of the
long-term bond


Assumption: bondholders do not prefer one
maturity over another but will hold bonds with
highest expected returns (perfect substitutes)
Int=(it + it+1 + … + it+(n-1))/n
Segmented Markets Theory

Markets for different maturity bonds are
completely separate and therefore the
interest rate of each bond with a different
maturity is determined by supply and demand
for that bond

Assumption: bonds of different maturities are not
substitutes, so expected return of one bond has
no effect on demand for a bond with a different
maturity
Liquidity Premium Theory

The interest rate on a long-term bond will
equal an average of short-term rates
expected to occur over the life of the bond,
plus a liquidity premium

Assumption: bonds of different maturities are
substitutes but not perfect substitutes (investors
may prefer on maturity over another)
Preferred Habitat Theory

Investors will buy bonds that do not have
their preferred maturity only if they earn a
higher return.

Assumption: investors have a preference for
bonds of one maturity over another in which they
prefer to invest
Relationships Between Theories
Using the Yield Curve



Often unreliable as liquidity premiums may
not be accurate
Slope of yield curve does not always help to
predict future short-term interest rates
Useful for very short-term and long-term but
lacks reliability for intermediate term
Impact of Inverted Yield
Curves

Article by Jim McWhinney - Feb 16, 2006

Occurs when short term rates exceed long
term rates
Historical indicator of recession
Consideration of supply and demand
Impact on investors and consumers



Oil Prices & their Impact



Overall Global Economy
Inflation
Interest Rates
Summary

Looked at two influences on the interest rate
of a bond:



Risk
Term to Maturity
Rational Investors will select portfolios to
meet desired returns based on differing
amounts of risk and varying terms to maturity

Questions?