economy is weaker and borrowers are more likely to have a hard time paying off their debts ● The risk that a borrower will default, which means the borrower will not make scheduled interest or principal payments, also affects the market interest rate on a bond: The greater the bond’s risk of default, the higher the market rate. Once again, we are assuming that Treasury securities have no default risk; hence, they carry the lowest interest rates on taxable securities in the United States
● For corporate bonds, bond ratings are often used to measure default risk. The higher the bond’s rating, the lower its default risk and, consequently, the lower its interest rate A “liquid” asset can be converted to cash quickly at a “fair market value.” Real assets are generally less liquid than financial assets, but different financial assets vary in their liquidity Liquidity Premium, LP: A premium added to the equilibrium interest rate on a security if that security cannot be converted to cash on short notice and at close to its “fair market value” ● Although it is difficult to measure liquidity premiums accurately, we can get some sense of an asset’s liquidity by looking at its trading volume. Assets with higher trading volume are generally easier to sell and are therefore more liquid. The average liquidity premiums also vary over time Interest Rate Risk: The risk of capital losses to which investors are exposed because of changing interest rates Maturity risk Premium: A premium that reflects the interest rate risk (which is higher the greater the years to maturity, is included in the required interest rate) ● The effect of maturity risk premiums is to raise interest rates on long-term bonds relative to those on short-term bonds ● This premium, like the others, is difficult to measure, but... ○ (1) It varies somewhat over time, rising when interest rates are more volatile and uncertain, and then falling when interest rates are more stable ○ (2) In recent years, the maturity risk premium on 20-year T-bonds has generally been in the range of one to two percentage points We should also not that although long term bonds are heavily exposed to interest rate risk, short term bills are heavily exposed to reinvestment rate risk ● Reinvestment Rate Risk: The risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested ● Investing short preserves one’s principle, the interest income however provided by short term T-bills is less stable than that on long term bonds (6-4) The Term Structure of Interest Rates Term Structure of Interest Rates: The relationship between bond yields and maturities ● The term structure is important to corporate treasurers deciding whether to borrow by issuing long- or short-term debt and to investors who are deciding whether to buy long- or short-term bonds ● Therefore, both borrowers and lenders should understand: ○ (1) How long- and short-term rates relate to each other and ○ (2) What causes shifts in their relative levels.