THE RISK AND TERM STRUCTURE OF INTEREST RATES

WHY BONDS WITH THE SAME TERM OF MATURITY HAVE DIFFERENT INTEREST
RATES?

The relationship among these interest rates is called the risk structure of
interest rates.

Term structure of interest rates the relationship among interest

rates on bonds with different terms to maturity.

Given similar terms of maturity, different bonds earn different interest

rates because of the difference in the following factors:

1) Default Risk

Default risk 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 suffer big losses might be more likely to suspend

interest payments on its bonds. The default risk on its bond would
therefore be quite high.

Treasury bonds no default risk because government can

always increase taxes to pay off its obligations. Bonds like this are
called default-free bonds.

Risk Premium the spread between the interest rates on

bonds with default risk and default-free bonds.

Bond with default risk always has a positive risk premium

the higher the default risk is, the larger the risk premium will
be.
 Pb r Pb r
Sc St

P2 r2

P1 r1 P1
r1 P2 r2

D2 D1c
D1 D2c

From graph:
Increase in default risk the corporation suffer losses, the expected
return on corporate bonds decrease. So that, the demand for corporate
bonds decrease. The equilibrium price of corporate bond falls from P1 to P2
and interest rate on corporate bonds increase from r 1 to r2. At the same
time the demand for treasury bonds rises from D1 to D2. The equilibrium
price increase from P1 to P2 and the interest rates for treasury bonds
decrease from r1 to r2.

The risk premium on corporate bond has risen from zero to r2c r2. So, we
can conclude that a bond with default risk will always have a positive risk
premium.

2) Liquidity

Liquidity is one of the bond attribute that influence interest rates.

The more liquid an asset is, the more desirable it is. 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 is low. Corporate
bonds are not liquid because fewer bonds for any one corporation are
traded, thus it can be costly to sell this bonds.

Using the same graph:

If corporate bond become less liquid than TB, its demand will fall. The TB
becomes relatively liquid in comparison with the CB. The demand curve for
TB shift to the right. From the graph, it shows that the price of the less
liquid asset falls and interest rates rise, while the price of the more liquid
asset rises and the interest rates falls.

The result is the spread between the interest rates on the two bonds has
risen.

3) Income tax

Pb r Pb r
Sc St

P1 r1

P2 r2 P2
r2 P1 r1

D1 D2m
D2 D1m

From graph:

If the municipal bond is given tax-free status, it raises their after tax
expected return relative to TB and makes MB more desirable. Demand for
MB increase. The result is equilibrium price increase and the interest rate
falls. TB become less desirable. Demand falls. The result is equilibrium
price fall and the interest rate increased.

As a conclusion, if tax free is given, we are willing to hold the riskier and
less liquid asset even though it has lower interest rates.
TERM STRUCTURE OF INTEREST RATE

Another factor that can influence interest rate on bonds is its term of
maturity.

Yield Curve ------- is a plot of the yields on bonds with differing terms to
maturity but the risk, liquidity and tax are considered the same.

When yield curve slop upward, the long term interest rates are above
the short term interest rate.

When yield curves are flat, short term and long term interest rates are
the same.

When yield curves are downward sloping, long term interest rates are
below short term interest rates.

Yield ( % )

upward sloping

flat

downward sloping

yearsto maturity

The theory of the term structure must also explain the following facts:

1. interest rates on bonds of different maturities move together

over time.
2. when short-term interest rates are low, yield curve are more likely
to have an upward slope, when short-term interest rates are high,
yield curves are more likely to slope downward.
3. yield curve almost always slope upward.
1) Expectation Theory

It states that the interest rates 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.

The key assumption:

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.

If bonds with different maturities are perfect substitutes, the

expected return must be equal.

(Refer to manual for example)

Findings:

When the yield curve is upward sloping, the short-term interest rates
are expected to rise in the future. 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 one.

When yield curve is slope downward, the average of future short-term

interest rate is expected to below the current short term rate.
When the yield curve is flat, it suggests that the short-term rates
are not expected to change.

This theory explain facts 1 and facts 2.

2) Segmented Market Theory

It sees market 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.
Key assumptions:

Bonds of different maturities are not substitutes at all, so the

expected returns on holding bond of one maturity has no effect on
the demand for a bond of another maturity.

It explains fact 3 that the yield curve always slope upward.

- the demand for long term bond is relatively lower than for short-
term bond, long term bonds will have lower prices and higher
interest rates, and hence the yield curve will always upward sloping.

3) Liquidity Premium and Preferred Habitat theories

It states that the interest rates 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.

Assumption:

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.

Investor tend to prefer short term bonds.

Liquidity premium theory

} liquidity premium

expectation theory

yrs to maturity