Teaching Tips/Student Stumbling Blocks
• You may wish to review the material in Chapter 6 that introduced students to the idea that changes in risks can be seen as shifts in the demand for bonds. This concept is illustrated in Figure 7.1, which shows that increased risk results in a decreased demand for bonds, a lower bond price, and a higher yield.
• While the discussion of the tax implication for bonds (starts on page 159) is fairly straightforward, some students may have difficulty with the calculations. To reinforce the concept, have students compare a tax-free bond with a taxable bond and see if they can derive the implied tax rate. For example, as noted on page 160, the rule is:
Tax-Exempt Bond Yield = Taxable Bond Yield x (1
Tax Rate)
Suppose that a tax-exempt bond yields 5 percent and a taxable bond yields 7 percent. What is the implied tax rate? Plugging in theses values results in an implied tax rate of about .29. As a follow up, have students visit the website of Bloomberg.com (given below in the Virtual Tools section) for current data on taxable and tax-exempt bonds.
• Students are likely to have difficulty with the model of the Expectations Hypothesis. Use the numerical example on page 162 to illustrate the concept. Have students try the calculations with current data. A point for discussion: when purchasing a 30 year bond, do you have to be forecasting interest rates for the next 30 years?
Features in this Chapter
Lessons from the Crisis: Subprime Mortgages
The financial crisis of 2007–2009 initially was known as the subprime crisis because of the mortgage-backed securities that helped trigger the crisis in the United States. A residential mortgage is called subprime when it does not meet key standards of creditworthiness that apply to a conventional prime mortgage. Conventional prime mortgages are those that satisfy the rules for inclusion in a collection or pool of mortgages to be guaranteed by a U.S. government agency. For this reason, conventional prime mortgages also are called qualifying or conforming mortgages. Typically, a loan is subprime if it is made to someone with a low credit score or whose income may be low relative to the price of the home; or if the LTV is high; or if the borrower does not provide sufficient documentation of their ability to pay. Both conventional mortgages and subprime mortgages comes in two forms: fixed-rate and adjustable-rate mortgages (the latter are called ARMs Chapter 6). During the housing bubble, starting in 2002, the volume of subprime loans surged as mortgage lenders relaxed their lending standards. Borrowers could obtain loans with lower down payments (high LTVs) and ever-poorer documentation. A complacent belief that the rise in nationwide house prices that had continued since the 1930s would persist indefinitely encouraged lending to borrowers
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 07 - The Risk and Term Structure of Interest Rates 7-2
–
with progressively lower ability to pay. When house prices started to fall in 2006, home values fell to less than the amount of the mortgage and lenders became unwilling to refinance many subprime loans. A wave of defaults followed resulting in problems with MBSs.
Lessons from the Crisis: Rating Agencies
Ratings mistakes contributed significantly to the financial crisis of 2007-2009. Ratings that agencies had awarded to mortgage backed securities (MBS) were higher than they should have been. When US housing prices started to decline, MBS ratings were downgraded sharply, which reinforced the decline in MBS prices. Several things contributed to the rating errors, including the fact that issuers consulted (and paid for the consultation) with rating agencies to see which bond structure would yield the highest rating. When the agency actually rated the structure, there was a conflict of interest in rating what they had been consulted on. Further, agencies evaluating the mortgage debt estimated the risk of default using mathematical models, but these models did not have any period of time in which housing prices fell nationwide. Bond issuers also paid rating agencies, and the rating system had only one scale for every kind of default probability.
Your Financial World: Your Credit Rating
In this section students will find a brief discussion of credit scores, what influences them, and why they matter.
Lessons from the Crisis: Asset-Backed Commercial Paper
Asset-backed commercial paper (ABCP) is a short-term liability with a maturity of up to 270 days. The ABCP is collateralized assets in a special portfolio. In the housing boom that preceded the financial crisis of 2007-2009, some large banks created shadow banks to lower their costs and limit their own asset holding. These shadow banks issued ABCP and used the money to buy mortgages and other loans. The off-balance-sheet financing allowed the banks to boost leverage and take more risk. The long-term maturity of the assets and the short-term maturity of the liabilities (the ABCP) posed a roll-over risk to the ABCP issuers. That is, that issuers would be unable to borrow or sell the asset to be able to return the principle to the ABCP holders. When the value of some mortgages became highly uncertain in 2007, purchasers of ABCP grew anxious that their commercial paper might plunge in value. Firms that issued the ABCP faced an immediate threat to their survival. Some banks failed while other banks absorbed the loss on the commercial paper after they were unable to sell the mortgages.
Tools of the Trade: Reading Charts
Using a Treasury yield curve chart from The Wall Street Journal, this section gives a step-by-step illustration of how to read charts. It provides a very good illustration of how changes in the vertical scale of a graph can be misleading for its interpretation.
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 07 - The Risk and Term Structure of Interest Rates 7-3
Applying the Concept: The Flight to Quality
Russia’s 1998 default on its bonds is used as an example of how dramatic changes in financial markets can occur as investors react to changing circumstances. The shock set off an “almost unprecedented flight to quality” which resulted in a more than doubling of the spread between U.S. Treasury bill and commercial paper rates. William McDonough, then President of the New York Federal Reserve Bank, called it “the most serious financial crisis since World War II” and worried that the problems in financial markets would spread to the wider economy.
In the News: Banks Decline Yield Curve Invitation to Party On
This article from Business Week, January 7, 2007, discusses how the occurrence of an “inverted” yield curve typically precedes a recession. The yield curve is considered to have predictive power because long-term interest rates represent the market’s expectations for future short-term rates. Prior to 2007, some predicted that the inverted yield curve was going to defy history this time. The article points out that the yield curve was right, it just took longer to get to recession this time.
Lessons of the article:
The slope of the yield curve can help predict the direction and speed of economic growth. At the beginning of 2010, the yield curve was unusually steep, pointing to a strong economic expansion (see Figure 7.9B, where the steep slope in 2010 is shown as a high value for the term spread). However, in the aftermath of the financial crisis of 2007-2009, lenders were especially cautious about extending credit to risky borrowers, even though risk spreads had narrowed sharply from crisis peaks (see Figure 7.8B). The author argues that it is only a matter of time until the steep yield curve encourages lenders to start lending again. However, the willingness to lend depends on how quickly intermediaries gain confidence that borrowers will repay. Even years later, many potential borrowers are still repairing their balance sheets that were damaged by the record plunge of U.S. housing prices.
Additional Teaching Tools
Credit scores are important for getting a loan and affect the cost of a loan in terms of the interest rate assessed (as pointed out in this chapter). However, paying attention to your credit report can also give you an edge in avoiding identity theft. In an article entitled “Safeguard Identity with Regular Checks of Credit Reports” (by Kim Komando with reporting by Ted Rybka, The Journal News, May 10, 2004) the author points out that credit reporting services “watch for early warning signs of identity theft. They let you know if a merchant has checked your address or if someone has submitted a change of address for you.” The credit reporting services may also be able to provide, for a fee, access to an identity theft specialist and insurance against losses incurred due to identity
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 07 - The Risk and Term Structure of Interest Rates 7-4
theft. The author points out that to really be safe a consumer would need to subscribe to all three credit-reporting services because a credit check could go to any one of them.
Virtual Tools
• Students may find it of interest to visit the web sites of the three credit-reporting services; they are TransUnion (www.transunion.com), Experian (www.experian.com), and Equifax (www.equifax.com).
• To find out more about identity theft and what to do if it happens to you. Visit the website of the Federal Trade Commission at http://www.ftc.gov/bcp/edu/microsites/idtheft/
• Bond market data is available on websites such as Bloomberg.com at http://www.bloomberg.com/markets/rates/
• The SmartMoney.com web site has current information about the bond market and the yield curve, and a number of interesting tools including a bond calculator and a “Living Yield Curve.” The “Living Yield Curve” section provides an excellent illustration of how the yield curve can be used to predict economic activity; it includes examples of a normal yield curve (from December 1984), a steep curve (April 1992), an inverted curve (August 1981) and a flat or humped curve (April 1989).
For More Discussion
In his “Economic Scene” column for The New York Times (Thursday, May 27, 2004), Alan B. Krueger reports that “James Carville once mused that instead of coming back as the president or the pope or a .400 baseball hitter if there were reincarnation, he would rather come back as the bond market because ‘you can intimidate everybody.’”
Chapter Outline
I. Ratings and the Risk Structure of Interest Rates
The risk of default (i.e., that a bond issuer will fail to make a bond’s promised payments) is one of the most important risks a bondholder faces, and it varies among issuers. Credit rating agencies have come into existence to assess the default risk of different issuers.
A. Bond Ratings
1. The best-known rating services are Moody’s and Standard & Poor’s.
2. Companies with good credit earn high ratings, suggesting that they will have little difficulty meeting the bond’s payment obligations.
3. The two companies have similar letter-based ratings systems; these are illustrated in Table 7.1.
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 07 - The Risk and Term Structure of Interest Rates
7-5
4. “Investment Grade” comprises the top four ratings; the next group is the noninvestment speculative grades, which are often referred to as “junk bonds”.
5. There are two types of junk bonds: “fallen angels” which were once investment grade but the companies’ situations have changed, and “original issue” junk bonds which are bonds for which little is known about the risk of the issuer.
6. The ratings companies continually monitor the situations of firms and announce rating changes; a lowering of the rating is a “downgrade” and an improvement is an “upgrade”.
B. Commercial Paper Ratings
1. Commercial paper is a short-term version of a bond, issued both by corporations and governments.
2. This is unsecured debt because the borrower offers no collateral.
3. Commercial paper is issued on a discount basis, and most of it has a maturity of between 5 to 45 days.
4. Moody’s and Standard & Poor’s provide rations of commercial paper issuers in the same way they do bonds. The lowest default risk issues are now termed “prime” grade or investment grade.
C. The Impact of Ratings on Yields
1. The lower a bond’s rating the lower its price and the higher its yield.
2. A bond yield can be thought of as the sum of two parts: the yield on the U.S. Treasury bond (called “benchmark bonds” because they are close to being risk-free) and a risk spread or default risk premium.
3. The default risk premium should increase as the bond rating decreases.
4. Considering yield this way also allows us to see that when U.S. Treasury bond yields change all other yields will change in the same direction.
5. Data on the risk structure of interest rates supports these predictions; this is illustrated in Figure 7.2 on page 155.
6. The difference of a couple of points in yield has a big affect on the cost of debt. For instance, as noted on page 156, the difference between a 5 percent rate and a 7 percent rate is a 40% difference.
II. Differences in Tax Status and Municipal Bonds
1. The second important factor that affects the return on a bond is taxes.
2. Bondholders must pay income tax on the interest income they receive from privately issued bonds, but government bonds are treated differently.
3. Interest payments on bonds issued by state and local governments, called “municipal” or “tax-exempt” bonds are specifically exempt from taxation.
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 07 - The Risk and Term Structure of Interest Rates 7-6
4. The general rule in the United States is that one level of government does not tax the interest income from bonds issued by another level of government (although the issuing government may tax it).
5. A tax exemption affects a bond’s yield because it affects how much of the return the bondholder gets to keep.
6. The yield on a tax-exempt bond equals the taxable bond yield times one minus the tax rate.
III.The Term Structure of Interest Rates
1. A third factor that affects a bond’s yield is its maturity.
2. The relationship among bonds with the same risk characteristics but different maturities is called the term structure of interest rates. A plot of this, the yield curve, is shown in Figure 7.4
3. Three conclusions can be drawn from studying the data:
a. Interest rates of different maturities tend to move together.
b. Yields on short-term bonds are more volatile than those on long-term bonds.
c. Long-term yields tend to be higher than short-term yields.
4. There are two explanations for these relationships, the Expectations Hypothesis and the Liquidity Premium Theory.
A. The Expectations Hypothesis
1. The hypothesis begins with the observation that the risk-free interest rate can be computed, assuming that there is no uncertainty about the future.
2. This means that an investor would be indifferent between holding a two-year bond or a series of two one-year bonds because certainty means that bonds of different maturities are perfect substitutes for each other.
3. Therefore, when interest rates are expected to rise long-term rates will be higher than short-term rates and the yield curve will slope up (and vice versa); if interest rates are expected to remain unchanged, the yield curve will be flat
4. From this we can construct investment strategies that must have the same yield. Assuming the investor has a two-year horizon, the investor can:
a. Invest in a two-year bond and hold it to maturity.
b. Invest in a one-year bond today and a second one a year from now when the first one matures.
5. The hypothesis tells us that investors will be indifferent between the two strategies, so the strategies must have the same return.
6. Therefore the rate on the two-year bond must be the average of the current one-year rate and the expected future one-year rate.
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 07 - The Risk and Term Structure of Interest Rates 7-7
7. The implications are the three conclusions we noted above (IV, 3).
8. However, in order to explain why the yield curve normally slopes upward, we need to extend the hypothesis to include risk.
B. The Liquidity Premium Theory
1. Risk is the key to understanding the slope of the yield curve.
2. The upward slope is due to long-term bonds being riskier than short-term bonds.
3. The longer the term the greater the inflation and interest-rate risk.
a. Inflation risk increases over time because investors, who care about the real return, must forecast inflation over longer periods.
b. Interest-rate risk arises when an investor’s horizon and the bond’s maturity do not match. If holders of long-term bonds need to sell them before maturity and interest rates have increased, the bonds will lose value.
4. Including risk in the model means that we can think of yield as having two parts: one that is risk-free and one that is a risk premium.
5. Again, we arrive at the same three conclusions about the term structure of interest rates.
IV.The Information Content of Interest Rates
1. The risk and term structure of interest rates contain useful information about overall economic conditions.
2. These indicators are helpful in evaluating both the present health of the economy and its likely future course.
3. Risk spreads provide one type of information, the term structure another.
Information in the Risk Structure of
Interest Rates
1. An impending recession raises the risk premium on privately issued bonds because of the increasing risk that corporations cannot meet their obligations.
2. An economic slowdown or recession does not affect the risk of holding government bonds.
3. Recessions do not affect all companies equally, and the impact on those with high ratings is likely to be small. Therefore the spread between U.S. Treasuries and highly rated bonds is not likely to move by much.
4. For firms with lower ratings, the situation is quite different; the lower the initial grade of the bond, the more the default risk premium rises as general economic conditions deteriorate.
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 07 - The Risk and Term Structure of Interest Rates 7-8
A. Information in the Term Structure of Interest Rates
1. Information on the term structure also helps us to forecast general economic conditions.
2. The yield curve usually slopes upward, but on rare occasions it can be inverted and slope downward (short-term rates exceed long-term yields).
3. An inverted yield curve predicts an economic slowdown because it signals a fall in short-term interest rates. Figure 7.8 on page 167 illustrates this.
Using FRED: Codes for Data in This Chapter
Data Series
Moody’s Aaa corporate bond yield
Moody’s Baa corporate bond yield
FRED Data Code
AAA
BAA
BofA Merrill Lynch US corporate BBB effective yield BAMLC0A4CBBBEY
BofA Merrill Lynch US high‐yield BB effective yield
BAMLH0A1HYBBEY
BofA Merrill Lynch US high‐yield B effective yield BAMLH0A2HYBEY
BofA Merrill Lynch US high‐yield CCC or below BAMLH0A3HYCEY effective yield
10‐year Treasury yield
3‐month Treasury bill rate
3‐month AA nonfinancial commercial paper rate
Consumer price index
Real GDP (chained 2005 dollars)
Brazil Treasury bill rates
GS10
TB3MS
CPN3M
CPIAUCSL
GDPC1
INTGSTBRM193N
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 07 - The Risk and Term Structure of Interest Rates 7-9
Terms Introduced in Chapter 7
benchmark bond commercial paper expectations hypothesis of the term structure
fallen angel
flight to quality interest-rate spread inverted yield curve
investment-grade bond
junk bond
liquidity
premium theory of the term structure municipal bonds
prime-grade commercial paper rating ratings downgrade ratings upgrade
risk spread
risk structure of interest rates spread over Treasuries
tax-exempt bond
taxable bond term spread
term structure of interest rates yield curve
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 07 - The Risk and Term Structure of Interest Rates 7-10
Lessons of Chapter 7
1. Bond ratings summarize the likelihood that a bond issuer will meet its payment obligations.
a. Highly rated investment-grade bonds are those with the lowest risk of default.
b. If a firm encounters financial difficulties, its bond rating may be downgraded.
c. Commercial paper is the short-term version of a privately issued bond.
d. Junk bonds are high-risk bonds with very low ratings. Firms that have a high probability of default issue these bonds.
e. Investors demand compensation for default risk in the form of a risk premium. The higher the risk of default, the lower a bond’s rating, the higher its risk premium, and the higher its yield.
2. Municipal bonds are usually exempt from income taxes. Because investors care about the after-tax returns on their investments, these bonds have lower yields than bonds whose interest payments are taxable.
3. The term structure of interest rates is the relationship between yield to maturity and time to maturity. A graph with the yield to maturity on the vertical axis and the time to maturity on the horizontal axis is called the yield curve.
a. Any theory of the term structure of interest rates must explain three facts:
i. Interest rates of different maturities move together
ii. The yields on short-term bonds are more volatile than the yields on long-term bonds
iii. Long-term yields are usually higher than short-term yields.
b. The expectations hypothesis of the term structure of interest rates states that longterm interest rates are the average of expected future short-term interest rates. This hypothesis explains only the first two facts about the term structure of interest rates.
c. The liquidity premium theory of the term structure of interest rates, which is based on the fact that long-term bonds are riskier than short-term bonds, explains all three facts described in 3a.
4. The risk structure and the term structure of interest rates both signal financial market’s expectations of future economic activity. Specifically, the likelihood of a recession will be higher when
a. The risk spread, or the range the between low- and high-grade bond yields, is wide
b. The yield curve slopes downward, or is inverted, so that short-term interest rates are higher than long-term interest rates.
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 07 - The Risk and Term Structure of Interest Rates 7-11
Solution manual for Money,Banking and Financial Markets Cecchetti Schoenholtz 4th edition Visit TestBankBell.com to get complete for all chapters
