CHAPTER A PP LI CATI O N The Risk and Term Structure of Interest Rates 117 The Subprime Collapse and the BAA-Treasury Spread in the United States Starting in August 2007, the collapse of the subprime mortgage market in the U.S led to large losses in American financial institutions (which will be discussed more extensively in Chapter 9) As a consequence of the subprime collapse, many investors began to doubt the financial health of corporations with low credit ratings, such as BAA, and even the reliability of the ratings themselves The perceived increase in default risk for BAA bonds made them less desirable at any given interest rate, decreased the quantity demanded, and shifted the demand curve for BAA bonds to the left As shown in panel (a) of Figure 6-2, the interest rate on BAA bonds should have risen, which is indeed what happened Interest rates on BAA bonds rose by 280 basis points (2.80 percentage points) from 6.63% at the end of July 2007 to 9.43% at the most virulent stage of the crisis in mid October 2008 But the increase in perceived default risk for BAA bonds after the subprime collapse made default-free U.S Treasury bonds relatively more attractive and shifted the demand curve for these securities to the right an outcome described by some analysts as a flight to quality Just as our analysis predicts in Figure 6-2, interest rates on U.S Treasury bonds fell by 80 basis points, from 4.78% at the end of July 2007 to 3.98% in mid-October 2008 The spread between interest rates on BAA and Treasury bonds rose by 360 basis points from 1.85% before the crisis to 5.45% afterward Liquidity Another attribute of a bond that influences its interest rate is its liquidity As we learned in Chapter 5, a liquid asset is one that can be quickly and cheaply converted into cash if the need arises The more liquid an asset is, the more desirable it is (holding everything else constant) Canada bonds are the most liquid of all long-term bonds because they are so widely traded that they are the easiest to sell quickly and the cost of selling them is low Corporate bonds are not as liquid because fewer bonds for any one corporation are traded; thus it can be costly to sell these bonds in an emergency because it may be hard to find buyers quickly How does the reduced liquidity of corporate bonds affect their interest rates relative to the interest rate on Canada bonds? We can use supply and demand analysis with the same figure that was used to analyze the effect of default risk, Figure 6-2, to show that the lower liquidity of corporate bonds relative to Canada bonds increases the spread between the interest rates on these two bonds Let us start the analysis by assuming that initially corporate and Canada bonds are equally liquid and all their other attributes are the same As shown in Figure 6-2, their equilibrium prices and interest rates will initially be equal: P c1 * P T1 and i c1 * i T1 If the corporate bond becomes less liquid than the Canada bond because it is less widely traded, then as the theory of asset demand indicates, its demand will fall, shifting its demand curve from D c1 to D c2, as in panel (a) The Canada bond now becomes relatively more liquid in comparison with the corporate bond, so its demand curve shifts rightward from D T1 to D T2 , as in panel (b) The shifts in the curves in Figure 6-2 show that the price of the less-liquid corporate bond falls and its interest rate rises, while the price of the more-liquid Canada bond rises and its interest rate falls