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Chapter 5 - Chapter 5 Structure of Interest Rates So...

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Chapter 5: Structure of Interest Rates So far (esp. Ch. 4) we looked at how one interest rate, “the overall rate” is determined. But there are a huge number of bonds (tens of thousands of munis, tens of thousands of corporate, many hundreds of Treasuries and other federal agencies; also we have tens of thousands of foreign bonds), each carrying a different rate of interest. How are these rates related to each other? This is the focus of this chapter. Keep in mind – in the subsequent discussion, when we talk about bonds whose return take place in the future, the returns are expected , and may or may not be realized. The terms interest rate, YTM, expected rates, returns, and rates of return are used to mean the same thing. There are two aspects of bonds which are of primary interest in the financial markets: riskiness and maturity. If we keep everything about two bonds the same except risk, the relationship between their YTMs is called risk structure (of interest rates). If we consider two bonds that are identical in every respect except maturity, the relationship between their YTMs is described by the term structure (of interest rates). It should be added that here risk is defined broadly to include default risk and liquidity. And of course, tax considerations matter as well. If a bond’s return is tax free (such as the return on most munis), then its YTM will be lower by the appropriate amount: the yield on a tax-free bond will be the same as the after -tax yield on a bond whose return is subject to income taxes – to make sure that you understand the tax implications work out an example for yourself. Incidentally: the IRS exempts municipal returns from federal taxes, and states exempt returns on US Treasuries from state and local income taxes. Some munis are also exempt from state and local taxes – generally, those munis held by the residents of the issuing states. Test yourself : What is the impact of a decrease in the federal marginal tax rates on: - Demand for corporate bonds and their yields? - Demand for municipal bonds and their yields? For two bonds identical in every respect except riskiness, the following always holds: the riskier bond carries a higher YTM. Can you explain why? There are credit rating agencies (e.g., Moody’s) that rate bonds according to their risk of default (do you know what is meant by default?). But for two bonds identical in every respect except maturity, we can have higher or lower YTM for the longer maturity bond. This leads to the second aspect of bonds: the term structure of interest rates. Before we go on, we have to define what is meant by the yield curve : this is the plot of the relationship between the YTM of bonds with similar risk against their maturity. Usually,
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