Chapter 6 - Risk and Term Structure of Interest Rates
In CH 5 we assumed just one interest rate in the economy, the interest rate on bonds.
We now look at why interest rate will vary, either due to differences in
Risk structure of interest rates
is the analysis of why interest rates on bonds with
will vary, due to differences in
Term Structure of interest rates
looks at why interest rates on bonds with
(e.g. T-bills) will vary due to differences in term to
Figure 1 on page 129 shows how interest rates on four bonds with the same maturity
have moved over time from 1920-1999 - municipals (tax free), T-bonds, Corporate
Baa (medium quality) bonds and Corporate Aaa (high quality) bonds. We want to
explain the movement of (nominal) interest rates over time and the spread between
(nominal) interest rates.
Some of the spread is explained by tax treatment - munis are tax free, corporates are
completely taxable and T-bonds are taxable at the federal, but not state level.
Bond yields also differ due to differences in default risk. Default risk is the probability
of: _________ interest payments, _________ interest payments, _________ payments
or complete default/liquidation. Risk-free bonds, like T-bonds, are default-free
bonds. The spread between the risk-free rate on treasuries and the rate/yield on all
other risky bonds is the
Municipal bonds are usually very safe, but are not completely risk-free. There is a
chance that a local municipality won't make the payments on time or will make partial
payments. All state governments, county governments and city governments have a
credit rating, reflecting their creditworthiness.
We can show the
on bonds using the S & D for Bonds framework (see
page 130). We start by assuming that there is no risk of default for corporate bonds,
so that T-bonds and corporate bonds sell for the same price (P
) and have the same
) (assume that risk and maturity are identical). If we now make the more
realistic assumption that the corporate bond is more risky than the Tbond, what would
happen to the demand for Tbonds, price and interest rate?_____________
What would happen to the demand for corporate bonds, price and interest rate?
In equilibrium, the spread, or difference, between the Tbond and the corporate will be
the risk premium (see page 130). Risk premium is always positive for corporate and
muni bonds (on an after tax basis), and the riskier the company/govt. agency, the
greater the risk premium.
Moody's and Standard & Poors are the two national bond rating services that do
financial analyses on companies and municipalities (cities, counties, states) and based