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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 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 investment- grade 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.... View Full Document

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