Chapter 7 & pages 21-23:
The Risk and Term Structure
of Interest Rates
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
Moody’s and Standard and Poor’s
The government has acknowledged a few firms as
“nationally recognized statistical rating
BBB and Higher
The top four categories are considered
Very low risk of default.
Reserved for most government issuers and
corporations that are among the most financially
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
Types of junk bonds:
- once investment-grade, but
issuers fell on hard times.
Cases in which there is little known about the
Material changes in a firm’s or government’s
financial conditions precipitate change in its dept
- lower an issuer’s bond
- upgrade an issuer’s bond
What is a subprime mortgage?
A residential mortgage is called
it does not meet the key standards of
creditworthiness that apply to conventional
Conventional mortgages are those that satisfy
the riles for inclusion in a collection or pool of
mortgages to be guaranteed by a U.S.
The standards cover the size of mortgage,
price of the home, and the ratio between the
the loan-to-value ratio
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.
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
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