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Canada (162,378)
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EC223 (81)
Chapter 6

Chapter 6 EC223.docx

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Angela Trimarchi

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EC223 Chapter 6 – The Risk and Term Structure of Interest Rates Week 6 Risk Structure of Interest Rates -The interest rates on corporate bonds are above those on Canada bonds and provincial bonds Default Risk -Risk of default 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 -Canadian government 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 are called default-free bonds -The spread between the interest res on bonds with default risk and default=free bonds, called the risk premium, indicate how much additional interest people must earn in order to be willing to hold that risky bond -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 -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 -Credit-rating agencies are investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default -Bonds with a relatively low risk of default are called investment-grade securities and have a rating of BBB and above -Bonds with ratings below BBB have higher default risk and have been aptly dubbed speculative-grade or junk bonds -Investment-grade securities whose rating has fallen to junk levels are referred to as fallen angels Rating Definitions AAA Highest quality AA Superior quality A Satisfactory quality BBB Adequate quality BB Speculative B Highly speculative CCC, CC, C Very highly speculative D In default Liquidity -Canada 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 is can be costly to sell these bonds in an emergency because it may be hard to find buyers quickly Income Tax Considerations -Tax-exempt status of a bond becomes a significant advantage when income tax rates are very high Summary -The risk structure of interest rates is explained by three factors: default risk, liquidity, and the income EC223 Chapter 6 – The Risk and Term Structure of Interest Rates Week 6 tax treatment of the bond’s interest payments -As a bond’s default risk increases, the risk premium on that bond rises -The greater liquidity of Canada bonds also explains why their interest rates are lower than interest rates on less liquid bonds Term Structure of 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 -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 -A good theory of the term structure of interest rates must explain the following important empirical facts: 1. Interest rate 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 -Four theories have been put forward to explain the term structure of interest rate: the expectations theory, the segmented markets theory, the liquidity premium theory, the preferred habitat theory Expectations Theory -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 -Buyers on 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
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