Chapter 6 The Risk and Term Structure of Interest Rates Terezia Chen Jody Giesbrecht
Dec 18, 2015
Chapter 6The 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=045d7cbd-3cc2-4591-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% Tax-Exempt
Yield
5%Tax-Exempt
Yield
6%Tax-Exempt
Yield
6.5%Tax-Exempt
Yield
7%Tax-Exempt
Yield
7.5%Tax-Exempt
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?