STRUCTURE OF INTEREST RATES

The yields on debt securities are affected:

Credit (default) risk
Liquidity
Tax status
Term to maturity

Credit (Default) Risk securities with a higher

degree of default risk offer higher yields.
a. Rating Agencies - Rating agencies charge the issuers
of debt securities a fee for assessing default risk.
(Exhibit 3.1).
b. Accuracy of Credit Ratings - The ratings issued by
the agencies are useful indicators of default risk but
they are opinions, not guarantees.
c. Oversight of Credit Rating Agencies - The Financial
Reform Act of 2010 established an Office of Credit
Ratings within the Securities and Exchange
Commission in order to regulate credit rating agencies.
Rating agencies must establish internal controls.

efault Risk (chance of not getting your $ back at

maturity)

Financial strength of the issuer

Business strengths of the issuer
Industry outlook
Term to maturity
Credit Agency Rating

iquidity (how easy is it to buy or sell at intrinsic

values?)
Size of the issue (float)
General market conditions
Characteristics of the secondary market in bonds
4

Computing the Equivalent Before-Tax Yield:

at bt (1 T )

= after-tax
atyield

= before-tax
yield
bt

= Investors marginal tax rate

Computing the Equivalent Before-Tax Yield:

at
bt
(1 T )
6

Yn = Rf,n + DP + LP + TA
where:
Yn

yield of an n-day debt security

Rf,n =

yield of an n-day Treasury (risk-free) security

DP =

default premium to compensate for credit risk

LP =

liquidity premium to compensate for less liquidity

TA

adjustment due to difference in tax status

ure Expectations Theory

Investor / borrower expectations and preferred maturities
Computing the forward rate (see page 54)

iquidity Premium Theory

S-T securities typically more marketable that L-T
Increase in marketability, ceteris paribus, should result in
lower YTM

egmented Markets Theory

Investor preferences for certain maturities investment

horizon
Nature of assets and liabilities (matching principle)
8

Algebraic Presentation:
(1 t i2 ) 2 (1 t i1 )(1 t 1 F1 )
i known annualized interest rate of a two - year security at time t

t 2

i known annualized interest rate of a one - year security at time t

t 1

t 1

F1 one - year interest rate that is anticipated as of time t 1

omprehensive Explanation for Term

Structure and Shape of the Yield Curve
The yield curve has much to do with investor
expectations about the economy.
Lenders prefer less risk and more liquidity.
Borrowers prefer longer terms.
Implications of flat and inverted yield curves

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Nov 14, 2000

11

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the implications of the following theories;

Briefly

describe

Pure Expectations Theory

Liquidity Premium Theory
Segmented Markets Theory

we consider when investing in bonds?

shape of the Yield Curve upward sloping to the right?
by a before-tax equivalent yield and why is it important?
influence interest rates?
rate and Why is it important?
conditions affect the risk premium?
Interpreting: a, b, c.

What
Why

factors do

is the normal

What

do we mean

What

factors

What

is a forward

How

do economic

Q&A:

1, 5, 6, 8, 17

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