ECON 310 Chapter 6: Chapter 6 Notes

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ECON 310
Chad Hogan

Chapter 6 Notes: The Risk and Term Structure of Interest Rates PREVIEW - Risk structure of interest rates - the relationship of among bonds with the same yield to maturity, but different interest rates, although risk, liquidity, and income tax rules all play a role in determining the risk structure - Term Structure of Interest Rates - a bond’s term to maturity also affects its interest rate, and the relationship among interest rates on bonds with different terms to maturity RISK STRUCTURE OF INTEREST RATES - Interest rates with the same maturity: - Interest rates on different categories of bonds, although they generally move together, differ from one another in any given year, and the spread (or the difference) between the interest rates varies over time DEFAULT RISK - Default - 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 - Default-free bonds - bonds, such as US Treasury bonds, with no default risk - Risk premium - the spread between interest rates on bonds with default risk and interest rates on default-free bonds, both of the same maturity - How much additional interest people must earn to be willing to hold the risky bond - Increase in default risk on corporate bonds 1. An increase in default risk shifts the demand curve for corporate bonds left 2. And shifts the demand curve for Treasury bonds to the right 3. Which raises the price of Treasury bonds and lowers the price of corporate bonds, and therefore lowers the interest rate on Treasury bonds and raises the interest rate on corporate bonds, thereby increasing the spread between the interest rates on corporate versus Treasury bonds - An increase in the default risk of a company means the firm is suffering large losses and the expected return on the 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 - Credit rating agencies - investment advisory firms that rate the quality of corporate and municipal bonds in terms of their probability of default - Moody’s Investor Service, Standard and Poor’s Corporation, and Fitch Ratings - Investment grade - bonds up to the BBB status - Junk bonds - bonds with ratings below BBB have higher default risk and have been aptly dubbed speculative-grade - High-yield bonds - these bonds always have higher interest rates than investment-grade securities - Corporate bonds have higher interest rates than the US Treasury bonds because they always have some degree of default risk LIQUIDITY - Another attribute that influences the bond interest rates - The more liquid an asset is, the more attractive it is for the buyer - US Treasury bonds are the most liquid because they are the most-widely traded - The lower liquidity of corporate bonds increases the spread between the corporate and Treasury bonds - The differences between interest rates on corporate bonds and Treasury bonds (risk premiums) reflect not only the corporate bond's default risk, but also its lesser liquidity INCOME TAX CONSIDERATIONS - Municipal bonds - state and local government bonds, which are not default-free (they have defaulted in the past) - Also, not as liquid as Treasury bonds - Interest payments for municipal bonds are exempt from federal income taxes - same effect as an increase in their expected return - Interest rates on municipal and treasury bonds 1. Tax-free status shifts the demand for municipal bonds to the right 2. Shifts the demand for Treasury bonds to the left 3. The result that municipal bonds end up with a higher price and a lower interest rate than
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