Post on 20-Dec-2015
Chapter 11.Chapter 11.The Level & Structure of Interest The Level & Structure of Interest RatesRates
Chapter 11.Chapter 11.The Level & Structure of Interest The Level & Structure of Interest RatesRates
• Loanable funds market
• Risk Structure of Interest Rates• Loanable funds market
• Risk Structure of Interest Rates
I. Loanable Funds MarketI. Loanable Funds MarketI. Loanable Funds MarketI. Loanable Funds Market
• determine equilibrium interest rate
• overall level of interest rates but still many different interest
rates
• determine equilibrium interest rate
• overall level of interest rates but still many different interest
rates
Demand for LFDemand for LFDemand for LFDemand for LF
• behavior of issuers & borrowers
• interest rate is cost of borrowing it is the price of loanable funds
• demand is downward sloping
• behavior of issuers & borrowers
• interest rate is cost of borrowing it is the price of loanable funds
• demand is downward sloping
LF
i
DLF
what shifts demand?what shifts demand?what shifts demand?what shifts demand?
• tax rules favorable tax treatment for interest
payments increase demand mortgage interest deductible bond interest deductible for issuer
• tax rules favorable tax treatment for interest
payments increase demand mortgage interest deductible bond interest deductible for issuer
• expected profitability increases will encourage
investment & borrowing
-- increase demand increases w/ economic expansion,
decreases w/ recession
• expected profitability increases will encourage
investment & borrowing
-- increase demand increases w/ economic expansion,
decreases w/ recession
• government borrowing deficits increase demand surpluses decrease demand
• government borrowing deficits increase demand surpluses decrease demand
Supply of LFSupply of LFSupply of LFSupply of LF
• behavior of savers, lenders, bond buyers
• interest rate is reward for saving postpone present consumption
• supply curve is upward sloping
• behavior of savers, lenders, bond buyers
• interest rate is reward for saving postpone present consumption
• supply curve is upward sloping
LF
iSLF
DLF
what shifts supply?what shifts supply?what shifts supply?what shifts supply?
• tax rules favorable treatment of interest
income pensions tax exempt interest
• tax rules favorable treatment of interest
income pensions tax exempt interest
• income & wealth increases will increase amount and
% of saving
• rate of time preference people more/less willing to
postpone consumption
• income & wealth increases will increase amount and
% of saving
• rate of time preference people more/less willing to
postpone consumption
• FOMC policy if Fed buys Treasuries, increase
supply of LF
• FOMC policy if Fed buys Treasuries, increase
supply of LF
ExampleExampleExampleExample
• Fed sell Treasuries decrease SLF
• Federal gov’t runs a deficit increase DLF
• Fed sell Treasuries decrease SLF
• Federal gov’t runs a deficit increase DLF
LF
iSLF
DLF
interest raterises
What is i?What is i?What is i?What is i?
• benchmark interest rate
• or base interest rate
• minimum rate acceptable to lenders all other rates compared to
benchmark Treasury yield
-- default-free, highly liquid
• benchmark interest rate
• or base interest rate
• minimum rate acceptable to lenders all other rates compared to
benchmark Treasury yield
-- default-free, highly liquid
III. Risk Structure of Interest III. Risk Structure of Interest RatesRatesIII. Risk Structure of Interest III. Risk Structure of Interest RatesRates
• different interest rates on assets with same maturity
• why? assets have different
characteristics
• different interest rates on assets with same maturity
• why? assets have different
characteristics
measurementmeasurementmeasurementmeasurement
• difference between two interest rates spread
• measured in percentage points basis points 1 percentage pt. = 100 basis pts.
• difference between two interest rates spread
• measured in percentage points basis points 1 percentage pt. = 100 basis pts.
example 1example 1example 1example 1
• 3 mo. Tbill .95%
• 3 mo. Commercial paper 1.02 %
• spread
.07 percentage pts.
7 basis pts.
• 3 mo. Tbill .95%
• 3 mo. Commercial paper 1.02 %
• spread
.07 percentage pts.
7 basis pts.
example 2example 2example 2example 2
• 10 yr Tnote 3.85%
• 10 BAA corporate 5.02%
• spread 1.07 percentage pts. 107 basis pts.
• 10 yr Tnote 3.85%
• 10 BAA corporate 5.02%
• spread 1.07 percentage pts. 107 basis pts.
3/5/20043/5/20043/5/20043/5/2004
• 3 mo Tbill .95%
• 3 mo Commerical Paper 1.02%
• 10 yr. Tnote 3.85%
• 10 yr. AAA corporate 4.31%
• 10 yr. BAA corporate 5.02%
• 10 yr. AAA muni 3.47%
• 30 yr. mortgage 5.36%
• 3 mo Tbill .95%
• 3 mo Commerical Paper 1.02%
• 10 yr. Tnote 3.85%
• 10 yr. AAA corporate 4.31%
• 10 yr. BAA corporate 5.02%
• 10 yr. AAA muni 3.47%
• 30 yr. mortgage 5.36%
PatternsPatternsPatternsPatterns
• Baa always the highest yield
• Municipal’s always the lowest (1940)
• Baa > AAA > U.S. > municipal size of the spread varies
• Baa always the highest yield
• Municipal’s always the lowest (1940)
• Baa > AAA > U.S. > municipal size of the spread varies
Risk premiumRisk premiumRisk premiumRisk premium
• base interest rate + risk premium
= interest rate on corporate debt
• base interest rate + risk premium
= interest rate on corporate debt
size of risk premiumsize of risk premiumsize of risk premiumsize of risk premium
• issuer
• default/credit risk
• liquidity
• maturity (chapter 12)
• options
• tax treatment
• issuer
• default/credit risk
• liquidity
• maturity (chapter 12)
• options
• tax treatment
IssuerIssuerIssuerIssuer
• spreads exist among different issuers
• but usually a function of other factors
• spreads exist among different issuers
• but usually a function of other factors
Default risk/ credit riskDefault risk/ credit riskDefault risk/ credit riskDefault risk/ credit risk
• risk of not receiving timely payment of principal and interest
• depends on creditworthiness of issuer structure of bond
• risk of not receiving timely payment of principal and interest
• depends on creditworthiness of issuer structure of bond
U.S. government debtU.S. government debtU.S. government debtU.S. government debt
• zero default risk
• backed by “full faith and credit”
of U.S. government
• why? power to tax largest economy power to issue stable currency
• zero default risk
• backed by “full faith and credit”
of U.S. government
• why? power to tax largest economy power to issue stable currency
Other issuersOther issuersOther issuersOther issuers
• private
• foreign
• municipal
• all have some default risk
• rated for default risk
• private
• foreign
• municipal
• all have some default risk
• rated for default risk
Bond ratingsBond ratingsBond ratingsBond ratings
• bond issuer pays rating agency Moody’s, S&P
• high credit rating low default risk
• bond ratings may change over time
• bond issuer pays rating agency Moody’s, S&P
• high credit rating low default risk
• bond ratings may change over time
default risk & yielddefault risk & yielddefault risk & yielddefault risk & yield
• investors are risk averse• investors are risk averse
higher default risk
lower credit rating
higher yield
• so default risk explains• so default risk explains
Treasuryyields
AAACorpyields
BAACorpyields
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default risk is not constant!default risk is not constant!default risk is not constant!default risk is not constant!
• varies over the business cycle higher in recessions lower in expansions
• Baa vs. Treasury bond yield 12/99 191 basis pts. 2/03 307 basis pts. 3/04 107 basis pts.
• varies over the business cycle higher in recessions lower in expansions
• Baa vs. Treasury bond yield 12/99 191 basis pts. 2/03 307 basis pts. 3/04 107 basis pts.
Bond ratings (p. 400)Bond ratings (p. 400)Bond ratings (p. 400)Bond ratings (p. 400)
AAA
AA
A
Aaa
Aa
A
BBB
BB
B
Baa
Ba
B
CCC
CC
C
Caa
Ca
C
Moody’sS&P
Investmentgrade
High Yield
B. LiquidityB. LiquidityB. LiquidityB. Liquidity
• how quickly/cheaply can bond be sold for cash?• how quickly/cheaply can bond be
sold for cash?
higher liquidity
lower yield
liquidity is not ratedliquidity is not ratedliquidity is not ratedliquidity is not rated
• Treasuries most liquid
• depends on size of issuer
• related to default risk bonds in default very illiquid higher-rated bonds tend to be
more liquid
• Treasuries most liquid
• depends on size of issuer
• related to default risk bonds in default very illiquid higher-rated bonds tend to be
more liquid
Embedded OptionsEmbedded OptionsEmbedded OptionsEmbedded Options
• special rights granted to holder or issuer of bond
• affect on yield spread depends on option beneficial to issuer? beneficial to holder?
• special rights granted to holder or issuer of bond
• affect on yield spread depends on option beneficial to issuer? beneficial to holder?
options for issueroptions for issueroptions for issueroptions for issuer
• increase yield relative to option-free bond
• call provision issuer has right to pay off bond
early issuer often calls bonds when
interest rate falls
• increase yield relative to option-free bond
• call provision issuer has right to pay off bond
early issuer often calls bonds when
interest rate falls
options for holderoptions for holderoptions for holderoptions for holder
• decrease yield relative to an option-free bond
• put provision holder has right to sell back bond
early holder more likely to exercise right
at higher interest rates
• decrease yield relative to an option-free bond
• put provision holder has right to sell back bond
early holder more likely to exercise right
at higher interest rates
• issuer options must offer higher yield to get
special rights
• holder options must accept lower yield in
exchange for special rights
• issuer options must offer higher yield to get
special rights
• holder options must accept lower yield in
exchange for special rights
Tax treatmentTax treatmentTax treatmentTax treatment
• depends on the issuer municipal Treasury corporate
• depends on the issuer municipal Treasury corporate
municipal bond interestmunicipal bond interestmunicipal bond interestmunicipal bond interest
• exempt from federal income tax
• possibly exempt from state income tax if issuer & bondholder are in same
state
• exempt from federal income tax
• possibly exempt from state income tax if issuer & bondholder are in same
state
Treasury bond interestTreasury bond interestTreasury bond interestTreasury bond interest
• exempt from state income tax• exempt from state income tax
Corporate bond interestCorporate bond interestCorporate bond interestCorporate bond interest
• fully taxable• fully taxable
morefavorabletax treatment
lowerbefore-tax yield
tax treatment explainstax treatment explainstax treatment explainstax treatment explains
Treasuryyields
muniyields
Corpyields< <
example 1example 1example 1example 1
• 10 yr. municipal Baa bond, 6%
• 10 yr. corporate Baa bond, 8%
• tax rate 28%
• after tax yield?
muni = 6%
corporate = 8%(1-.28) = 5.76%
• 10 yr. municipal Baa bond, 6%
• 10 yr. corporate Baa bond, 8%
• tax rate 28%
• after tax yield?
muni = 6%
corporate = 8%(1-.28) = 5.76%
example 2example 2example 2example 2• 10 yr. municipal Baa bond, 6%
• tax rate 28%
• what corporate yield would make investors indifferent?
corp. yield (1-.28) = 6%
corp. yield = 8.33%
equivalent taxable yield
• 10 yr. municipal Baa bond, 6%
• tax rate 28%
• what corporate yield would make investors indifferent?
corp. yield (1-.28) = 6%
corp. yield = 8.33%
equivalent taxable yield
example 3example 3example 3example 3
• 10 yr. municipal Baa bond, 6%
• 10 yr. corporate Baa bond, 8%
• what tax rate makes investor indifferent?
8% (1- t) = 6%
t = 25%
• 10 yr. municipal Baa bond, 6%
• 10 yr. corporate Baa bond, 8%
• what tax rate makes investor indifferent?
8% (1- t) = 6%
t = 25%
impact of tax ratesimpact of tax ratesimpact of tax ratesimpact of tax rates
• higher tax brackets derive more benefit from muni’s
• changing tax rates will affect the corporate-municipal yield spread
• IRS rulings could make muni debt taxable
• higher tax brackets derive more benefit from muni’s
• changing tax rates will affect the corporate-municipal yield spread
• IRS rulings could make muni debt taxable