Chapter 7 - c Tax-exempt bond yield =(taxable bond yield...

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Chapter 7 The Risk and Term Structure of Interest Rates I. Ratings and the Risk Structures of Interest Rates a. Bond Ratings Investment-grade bonds: very low default risk Fallen angels: once investment-grade bonds, but issuers fell on hard times b. Commercial Paper Ratings Short-term version of a bond Unsecured Zero-coupon bond Prime-grade commercial paper c. The impact of ratings on yields Lower the rating, lower the price, higher the yield Increase in risk reduces demand Treasury bonds – bench-mark bonds Bond yield = US treasury yield + default risk premium Whenever a company’s bond rating declines, the cost of funds goes us, impairing the company’s ability to finance new ventures II. Differences in Tax Status and Municipal Bonds a. Coupon payments from municipal bonds are tax-exempt b. Investors base decisions on the after-tax yield
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Unformatted text preview: c. Tax-exempt bond yield = (taxable bond yield) x (1- tax rate) d. The higher the tax rate, the wider the gap between the yields on taxable and tax-exempt bonds III. The Term Structure of Interest Rates a. Interest rates of different maturities tend to move together b. Yields on short-term bonds are more volatile than yield on long-term bonds c. Long-term yields tend to be much higher than short-term yields d. The Expectations Hypothesis • Bonds of different maturities are perfect substitutes for each other • Current two-year interest rate should equal the average of 5 percent and the one-year interest rate one year in the future • When interest rates are expected to rise in the future, long-term interest rates will be higher than short-term interest rates e. The Liquidity Premium Theory •...
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