1 Chapter 3 Structure of Interest Rates Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline Characteristics of debt securities that cause their yields to vary Explaining actual yield differentials Estimating the appropriate yield A closer look at the term structure International structure of interest rates 3 Characteristics of Debt Securities Credit (default) risk Securities with a higher degree of risk have to offer higher yields to be chosen Credit risk is especially relevant for longer-term securities Investors must consider the creditworthiness of the security issuer Can use bond ratings of rating agencies The higher the rating, the lower the perceived credit risk Ratings can change over time as economic conditions change Ratings for different bond issues by the same issuer can vary 4 Characteristics of Debt Securities (cont’d) Credit (default) risk (cont’d) Rating agencies Moody’s Investor Service and Standard and Poor’s Corporation are the most popular Agencies use different methods to assess the creditworthiness of firms and state governments A particular bond issue could have different ratings from each agency, but differences are usually small Financial institutions may be required to invest only in investment-grade bonds rated Baa or better by Moody’s and BBB or better by Standard and Poor’s 5 Characteristics of Debt Securities (cont’d) Ratings Assigned by: Description of Security Moody’s Standard and Poor’s Highest quality Aaa AAA High quality Aa AA High-medium quality A A Medium quality Baa BBB Medium-low quality Ba BB Low quality (speculative) B B Poor quality Caa CCC Very poor quality Ca CC Lowest quality (in default) C DDD, D 6 Characteristics of Debt Securities (cont’d) Credit (default) risk (cont’d) Shifts in credit risk premiums The risk premium corresponding to a particular bond rating can chance over time Accuracy of credit ratings In general, credit ratings have served as reasonable indicators of the likelihood of default Credit rating agencies do not always detect financial problems of firms 7 Characteristics of Debt Securities (cont’d) Liquidity Liquid securities can be easily converted to cash without a loss in value Short-maturity securities with an active secondary market are liquid Securities with lower liquidity have to offer a higher yield to be preferred 8 Characteristics of Debt Securities (cont’d) Tax status Investors are more concerned with after-tax income than before-tax income Taxable securities have to offer a higher before-tax yield to be preferred The after-tax yield is equal to: )1( TYY btat −= 9 Characteristics of Debt Securities (cont’d) Tax status Computing the equivalent before-tax yield The before-tax yield necessary to match the after-tax yield on a tax-exempt security is: State taxes should be considered along with federal taxes )1( T Y Y at bt − = 10 Computing the Equivalent Before-Tax Yield Assume a firm in the 30 percent tax bracket is aware of a tax-exempt security that pays a yield of 9 percent. To match this after-tax yield, taxable securities (with similar maturity and risk) must offer a before-tax yield of: %86.12 )3.1( %9 )1( = − = − = T Y Y at bt