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Course: FIN 320, Fall 2011

School: DePaul

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Fin 320 Chapter 7 & pages 21-23: The Risk and Term Structure of Interest Rates Lecture 5 1 Risk & Term Structure: 1. Why do different bonds have different yields? 1. The risk structure 2. Differences in tax status 3. The term structure 2. What information is there in the relative yield of different bonds? 2 Bond Ratings Bond Ratings Moodys and Standard and Poors Ratings Groups Investment Grade...

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320 Chapter Fin 7 & pages 21-23: The Risk and Term Structure of Interest Rates Lecture 5 1 Risk & Term Structure: 1. Why do different bonds have different yields? 1. The risk structure 2. Differences in tax status 3. The term structure 2. What information is there in the relative yield of different bonds? 2 Bond Ratings Bond Ratings Moodys and Standard and Poors Ratings Groups Investment Grade Non-Investment Speculative Grade Highly Speculative The government has acknowledged a few firms as nationally recognized statistical rating organizations (NRSROs) 3 WSJ, August 6, 2011 4 Bond Ratings: BBB and Higher The top four categories are considered investmentgrade bonds. Very low risk of default. Reserved for most government issuers and corporations that are among the most financially sound. 5 Bond Ratings BB and lower Speculative grade bonds are companies and countries that may have difficulty meeting their bond payments but are not at risk of immediate default. Highly speculative bonds includes debts that are in serious risk of default. Both speculative grades are often referred to as junk bonds or high-yield bonds. 6 Bond Ratings Types of junk bonds: Fallen angels - once investment-grade, but issuers fell on hard times. Cases in which there is little known about the issuer. Material changes in a firms or governments financial conditions precipitate change in its dept ratings. Ratings downgrade - lower an issuers bond rating. Ratings upgrade - upgrade an issuers bond rating. 7 8 What is a subprime mortgage? A residential mortgage is called subprime when it does not meet the key standards of creditworthiness that apply to conventional prime mortgages. Conventional mortgages are those that satisfy the riles for inclusion in a collection or pool of mortgages to be guaranteed by a U.S. Government agency. The standards cover the size of mortgage, price of the home, and the ratio between the two: the loan-to-value ratio (LTV ratio) 9 Subprime loans may fail to meet some or all of these standards for a qualifying mortgage. Like other loans, subprime loans can be at a fixed or variable rate (ARMs). ARMs typically provide a low interest rate, or teaser rate, for a couple of years and then the interest resets to a higher rate. This gives borrowers the ability to refinance after the introductory rate is up. 10 Although, at their peak, subprime mortgages accounted for less than 15 percent of overall residential mortgages, they helped trigger the financial disruptions of 2007-2009. The key reason is some large, highly leveraged financial institutions held a sizable volume of MBS backed by subprime mortgages. These financial institutions had bet the house on subprime mortgage securities. 11 As the government sought to reform the financial system after the financial crisis of 2007-2009, the role of ratings agencies attracted great attention. Investors around the world had relied on the high ratings agencies had awarded to a large groups of mortgage-backed securities (MBS). As housing prices began to fall, agencies gave sharp downgrades. Downgrades lowered MBS prices 12 What caused the ratings errors? Data didnt have sufficient information. Firms hire the agencies to consult on what types of MBS have the highest ratings and then rate them - conflict of interest. Ratings agencies are compensated by the issuers of the bonds. Agencies used a single rating scale to represent default probabilities, independent of other characteristics, like liquidity. May have led investors to underestimate other important risks. 13 Commercial Paper: What is it? Short-term (less than 270 days) bond Unsecured. Issued on a discount basis Only most creditworthy borrowers can issue it. More than one third is held by money-market mutual funds. 14 Commercial Paper 15 Bond Ratings and Risk: Impact of Ratings on Yields Risk Bond Demand Bond Price Bond Yield 16 The Impact of Ratings on Yields U.S. Treasury issues are the closet to risk-free and are commonly referred to as benchmark bonds. Yields on other bonds are measured in terms of the spread over Treasuries. Bond yield is the sum of two parts: = U.S. Treasury yield + Default risk premium 17 The Impact of Ratings on Yields If bond ratings property reflect risk, then the lower the rating if the issuer, the higher the default-risk premium. When Treasury yields move, all other yields move with them. We can see this from Figure 7.2 showing a plot of the risk structure of interest rates. 18 19 Tax Status and Bond Prices Coupon Payments on Municipal Bonds are exempt from Federal Tax Payments. Interest income from bonds issued by one government are not taxed by another government 20 Tax Status and Bond Prices Tax-Exempt Bond Yield = (Taxable Bond Yield) x (1- Tax Rate). 21 Differences in Tax Status and Municipal Bonds What are the tax implications for bond yields? Consider a one-year $100 face value taxable bond with a coupon rate of 6 percent. Par is $100, yield to maturity is 6 percent. Government sees this at 6 percent taxable income. If tax rate is 30%, the tax is $1.80. Bond yields $104.20 after taxes, equivalent of 4.2 percent. 22 Asset-backed commercial paper (ABCP) is a short-term liability with a maturity of up to 270 days. ABCP is collateralized by assets that financial institutions place in a special portfolio. These played a special role in the housing boom that preceded the financial crisis of 2007-2009. 23 To lower costs and limit asset holding, some large banks created firms (a form of shadow bank) that issued ABCP and used the money to buy mortgages and other loans. The payment stream generated by the loans was used to compensate the holders of the ABCP. This also allowed banks to boost leverage and take on more risk. When mortgage volume surged, these shadow banks issued more ABCP to finance expansion. 24 When the ABCP matures, issuers have to borrow (or sell underlying assets) to be able to return the principal to the ABCP holders. The risk was that the issuers be would unable to borrow - they faced rollover risk. If they were also unable to sell the long-term assets easily, the shadow banks would face failure. 25 The uncertainty in the value of mortgages lead ABCP purchasers to realize the risk and ABCP purchases halted. Firms that has issued ABCP faced an immediate threat to their survival. Unable to sell assets or obtain other funding caused many to fail. Some banks rescued their shadow banks, facing heightened liquidity needs and pressures to sell assets during the worst time the middle of a crisis. 26 Term Structure of Interest Rates: Definition of the Term Structure: The relationship among bonds with the same risk characteristics but different maturities is called the term structure of interest rates. Yield Curve: A plot of the term structure, with the yield to maturity on the vertical axis and the time to maturity on the horizontal axis. 27 Term Structure of Interest Rates 28 Term Structure of Interest Rates: Facts to Explain 1. Interest Rates of different maturities tend to move together 2. Yields on short-term bond are more volatile than yields on long-term bonds 3. Long-term yields tend to be higher than short-term yields. 29 The Expectations Hypothesis Assumption: Bonds of different maturities are perfect substitutes for each other. Implies: Investor w/ a two-year horizon indifferent between: 1. A 2 yr bond for 2 yrs 2. A 1 yr bond and a second 1yr bond in 1 yr. 30 The Expectations Hypothesis If current interest rate is 5 percent and future interest rate is 7 percent, then the current two-year interest rate will be (5+7)/2 = 6%. When interest rates are expected to rise, long-term interest rate will be higher than short-term interest rates. The yield curve will slope up. 31 The Expectations Hypothesis WSJ 9/20/11 32 The Expectations Hypothesis 33 The Expectations Hypothesis If bonds of different maturities are perfect substitutes for each other, then we can construct investment strategies that must have the same yields. Options: 1. Invest in a two-year bond and hold it to maturity i2t is interest rate - 2 year bond bought today, t. One dollar yields (1 + i2t)(1 + i2t) two years later. 34 The Expectations Hypothesis 2. Invest in two one-year bonds, one today and one when the first matures. One-year bond today has interest i1t. One-year bond purchased in year 2 has interest ie1t+1, where e is expected. One dollar invested today returns (1 + i1t)(1 + ie1t+1) 35 The Expectations Hypothesis The expectations hypothesis tells us investors will be indifferent between the two options. This means they must have the same return: (1 + i2t)(1 + i2t) = (1 + i1t)(1 + ie1t+1) We can now write the two-year interest rate as the average of the current and future expected oneyear interest rates: i t +i i2t = 1 2 e 1+ t1 36 The Expectations Hypothesis 37 Expectations Hypothesis General formula: i nt = i1t + i e 1t +1 +i e 1t + 2 + .... + i e 1t + n 1 n 38 Expectations Hypothesis Explains: 1. Interest Rates of different maturities tend to move together 2. Yields on short-term bond are more volatile than yields on long-term bonds BUT NOT 3. Long-term yields tend to be higher than short-term yields. 39 Liquidity Premium Theory The yield curves upward slope is explained by the fact that long-term bonds are riskier than short-term bonds. Bondholders face both inflation and interest-rate risk. The longer the term of the bond, the greater both types of risk. 40 Liquidity Premium Theory Explaining the fact that the yield curve normally slopes up: Bondholders face both inflation and interest-rate risk. The longer the term of the bond, the greater both types of risk. The bigger the risk, the higher the risk premium 41 The Liquidity Premium Theory Together this forms the liquidity premium theory of the term structure of interest rates. We can add the risk premium to our previous equation to get: e e e 1t 1t +1 1t + 2 1t + n 1 nt n i = rp + i +i +i + .... + i n 42 Information Content of Interest Rates: Risk Structure When the economy starts to slow, it puts a strain on private firms. A slower economy means a higher default probability Increased default risk is different across firms Firms already doing poorly, do even worse 43 During financial crises, people take cover. They sell risky investments & buy safe ones. An increase in the demand for government bonds coupled with a decrease in the demand for virtually everything else is called a flight to quality. This leads to an increase in the risk spread. The 1998 Russian default on its bonds lead to a serious flight to quality causing the financial markets to cease to function properly. 44 Information Content of Interest Rates: Term Structure When the yield curve slopes down, it is called inverted An inverted yield curve is a very valuable forecasting tool It signals an economic downturn 45 46 Question 3 Suppose the risk premium on bonds increases. How would the change affect your forecast of future economic activity, and why? 47 I. * G i ven t he data in the t able below, would you say that this economy is heading for a boom or for a recessi on? Explain your choice. 3-month 10-y ear Baa corporate Treasury -bil l rate Treasury bond 10-year bond January 1.0% 3% 7% February 1.05% 3.5% 7.2% March 1.1% 4% 7.6% April 1.2% 4.6% 8% May 1.25% 5% 8.2% 48 Answer: Th e information in both the t erm structure and t he r isk st ructure point t o a heal thy economy. The t erm spread (t he gap bet ween the 3 month Treasury yield and t he 10 year Treasury bond yiel d) is positive and widening. Th is tell s us that t he yiel d curve is upward sl oping and gett ing more steeply upward sloping. This impli es that interest rat es are ex pected to continue to rise in the futurea si gn t hat the economy is expect ed to do well. The risk spread (the gap bet ween the Treasury and corporat e 10 year bonds) i s narrowing. This is a sign of a heal thy eco nomy as people do not requi re such a high risk premi um on corporate bonds. 49
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