R GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER The Risk Structure and Term Structure of Interest Rates LEARNING OBJECTIVES After studying this chapter, you should be able to: 5.1 Explain why bonds with the same maturity can have different interest rates 5.2 Explain why bonds with different maturities can have different interest rates © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER The Risk Structure and Term Structure of Interest Rates WHY INVEST IN TREASURY BILLS IF THEIR INTEREST RATES ARE SO LOW? •In February 2010, Moody’s Investors Service hinted that large budget deficits could affect the Aaa rating of government bonds •Also in 2010, Treasure bills offered very low interest rates, yet investors bought them even though Treasury bonds offered much higher rates •In the corporate bond market, investors were also buying bonds with very low yields •In this chapter, we study why these unusual situations occur •An Inside Look at Policy on page 148 describes the testimony before Congress of rating agencies about the ratings of mortgage-backed securities © 2012 Pearson Education, Inc Publishing as Prentice Hall Key Issue and Question Issue: During the financial crisis, the bond rating agencies were criticized for having given high ratings to securities that proved to be very risky Question: Should the government more closely regulate the credit rating agencies? © 2012 Pearson Education, Inc Publishing as Prentice Hall of 50 Learning Objective Explain why bonds with the same maturity can have different interest rates 5.1 © 2012 Pearson Education, Inc Publishing as Prentice Hall of 50 Why might bonds that have the same maturities—for example, all the bonds that will mature in 30 years—have different interest rates, or yields to maturity? Four factors account for these differences: •Risk •Liquidity •Information costs •Taxation Risk structure of interest rates The relationship among interest rates on bonds that have different characteristics but the same maturity Default Risk Bonds differ with respect to default risk (sometimes called credit risk), which is the risk that the bond issuer will fail to make payments of interest or principal The Risk Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall of 50 Default Risk Bonds differ with respect to default risk (sometimes called credit risk), which is the risk that the bond issuer will fail to make payments of interest or principal Measuring Default Risk • The default risk premium on a bond is the difference between the interest rate on the bond and the interest rate on a Treasury bond that has the same maturity • Many investors rely on credit rating agencies to provide them with information on the creditworthiness of corporations and governments that issue bonds Bond rating A single statistic that summarizes a rating agency’s view of the issuer’s likely ability to make the required payments on its bonds The Risk Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall of 50 The Risk Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall of 50 Changes in Default Risk and in the Default Risk Premium Determining Default Risk Premium in Yields The initial default risk premium can be seen by comparing yields associated with the prices P1T and P1C Because the price of the safer U.S Treasury bond is greater than that of the riskier corporate bond, we know that the yield on the corporate bond must be greater than the yield on the Treasury bond to compensate investors for bearing risk Figure 5.1 (1 of 2) The Risk Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall of 50 Changes in Default Risk and in the Default Risk Premium Determining Default Risk Premium in Yields As the default risk on corporate bonds increases, in panel (a), the demand for corporate bonds shifts to the left In panel (b), the demand for Treasury bonds shifts to the right The price of corporate bonds falls to P2C, and the price of Treasury bonds rises to P2T, so the yield on Treasury bonds falls relative to the yield on corporate bonds Therefore, the default risk premium has increased.• Figure 5.1 (2 of 2) The Risk Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall 10 of 50 Solved Problem 5.2a Is There Easy Money to Be Made from the Term Structure? The term interest carry trade is sometimes used to refer to borrowing at a low short-term interest rate and using the borrowed funds to invest at a higher long-term interest rate a How would you advise an investor who is thinking of following a carry trade strategy? What difficulties would you point out in the strategy? b If the yield curve was inverted, or downward sloping, would a carry trade strategy still be possible? Briefly explain The Term Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall 36 of 50 Solved Problem 5.2a Is There Easy Money to Be Made from the Term Structure? Solving the Problem Step Review the chapter material Step Use the expectations theory of the term structure to answer the questions in part (a) If the expectations theory is correct, the average of the expected short-term interest rates over the life of a long-term investment should be roughly equal to the interest rate on the long-term investment, which would wipe out any potential profits from the interest carry trade Moreover, if interest rates rise more rapidly than expected, the price of the long-term investment will decline, and the investor will suffer a capital loss Step Answer part (b) by explaining whether the interest carry trade would still be possible if the yield curve were inverted If the yield curve were inverted, with long-term rates lower than short-term rates, an institutional investor could borrow long term and invest the funds at the higher short-term rates In this case, the investor would be subject to reinvestment risk, or the risk that after the short-term investment has matured, the interest rate on new short-term investments will have declined The Term Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall 37 of 50 The Segmented Markets Theory of the Term Structure Segmented markets theory A theory of the term structure of interest rates that holds that the interest rate on a bond of a particular maturity is determined only by the demand and supply of bonds of that maturity The segmented markets theory addresses the shortcomings of the expectations theory by making two related observations: Investors in the bond market not all have the same objectives Investors not see bonds of different maturities as being perfect substitutes for each other •Markets for bonds of different maturities are separated from each other, or segmented Investors who participate in the market for bonds of one maturity not participate in markets for bonds of other maturities The Term Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall 38 of 50 The Segmented Markets Theory of the Term Structure • Relative to short-term bonds, long-term bonds have two shortcomings: • They are subject to greater interest-rate risk, and they are often less liquid • The reason why the yield curve is typically upward sloping is that more investors are in the market for short-term bonds, causing their prices to be higher and their interest rates lower, and fewer investors are in the market for long-term bonds, causing their prices to be lower and their interest rates higher • The segmented markets theory, however, cannot explain why short-term interest rates would ever be greater than long-term interest rates (a downward-sloping yield curve), or why interest rates of all maturities tend to rise and fall together The Term Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall 39 of 50 The Liquidity Premium Theory Liquidity premium theory (or preferred habitat theory) A theory of the term structure of interest rates that holds that the interest rate on a long-term bond is an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond, plus a term premium that increases in value the longer the maturity of the bond Term premium The additional interest investors require in order to be willing to buy a long-term bond rather than a comparable sequence of short-term bonds The Term Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall 40 of 50 The Liquidity Premium Theory • In effect, then, the liquidity premium theory adds a term premium to the expectations theory’s equation linking the interest rate on a long-term bond to the interest rate on short-term bonds where is the term premium on a two-year bond Or, more generally, the interest rate on an n-period bond is equal to: The Term Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall 41 of 50 Solved Problem 5.2b Using the Liquidity Premium Theory to Calculate Expected Interest Rates? Using the table above, what did investors expect the interest rate to be on the one-year Treasury bill two years from that time if the term premium on a two-year Treasury note was 0.05% and the term premium on a threeyear Treasury note was 0.10%? The Term Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall 42 of 50 Solved Problem 5.2b Using the Liquidity Premium Theory to Calculate Expected Interest Rates? Solving the Problem Step Review the chapter material Step Use the liquidity premium equation that links the interest rate on a long-term bond to the interest rates on short-term bonds to calculate the interest rate that investors expected on the one-year Treasury bill one year from February 19, 2010 Step Answer the problem by using the result from step to calculate the interest rate investors expected on the one-year Treasury bill two years from February 19, 2010 The Term Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall 43 of 50 The Term Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall 44 of 50 Using the Term Structure to Forecast Economic Variables • The slope of the yield curve shows the short-term interest rates that bond market participants expect in the future • In addition, if fluctuations in expected real interest rates are small, the yield curve contains expectations of future inflation rates • For example, If the real interest rate is expected to remain constant, you can interpret an upward-sloping yield curve to mean that inflation is expected to rise, leading investors to expect higher nominal interest rates • Economists and market participants also look to the slope of the yield curve to predict the likelihood of a recession • Models of the term structure reveal that in every recession since 1953, the term spread has narrowed significantly That is, the yield on the 10-year Treasury note has declined significantly relative to the yield on the 3-month Treasury bill The Term Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall 45 of 50 Using the Term Structure to Forecast Economic Variables Figure 5.7 Interpreting the Yield Curve Models of the term structure, such as the liquidity premium theory, help analysts use data on the Treasury yield curve to forecast the future path of the economy. The Term Structure of Interest Rates â 2012 Pearson Education, Inc Publishing as Prentice Hall 46 of 50 Using the Term Structure to Forecast Economic Variables • During recessions, interest rates typically fall, and short-term rates tend to fall more than long-term rates • In this situation, the liquidity premium theory of the term structure predicts that long-term rates should fall relative to short-term rates, making the yield curve inverted The Term Structure of Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall 47 of 50 Answering the Key Question At the beginning of this chapter, we asked the question: “Should the government more closely regulate credit rating agencies?” Like other policy questions we will encounter in this book, this question has no definitive answer During the financial crisis of 2007–2009, many bonds had much higher levels of default risk than the credit rating agencies had indicated Some observers argued that the rating agencies had a conflict of interest in being paid by the firms whose bond issues they rate Other observers, though, argued that the ratings may have been accurate when given, but the creditworthiness of the bonds declined rapidly following the unexpected severity of the housing bust and the resulting financial crisis © 2012 Pearson Education, Inc Publishing as Prentice Hall 48 of 50 AN INSIDE LOOK AT POLICY Executives from Moody’s, Standard and Poor’s Describe Pressure to Grant High Ratings LOS ANGELES TIMES, Credit Rating Executives Say They Were Pressured to Give Good Ratings Key Points in the Article • In 2008, Congress investigated allegations of pressure on the rating agencies to grant investment-grade ratings to certain financial instruments • The conflict of interest started back in the 1970s, when rating agencies switched from selling ratings to investors to selling ratings to the firms whose bonds they rated • Credit agencies provided the Congressional subcommittee with evidence of extensive downgrading of mortgage-backed securities between 2004 and 2007 • After downgrading those securities, their price fell and the yields rose Investors increased their demand for safer Treasury bonds, causing their prices to rise and yields to fall © 2012 Pearson Education, Inc Publishing as Prentice Hall 49 of 50 AN INSIDE LOOK AT POLICY © 2012 Pearson Education, Inc Publishing as Prentice Hall 50 of 50 ... maturities tend to rise and fall together Economists have advanced three theories to explain these facts: the expectations theory, the segmented markets theory, and the liquidity premium theory or preferred... understand is that under the assumptions of the expectations theory, the returns from the two strategies must be the same Arbitrage should result in the returns from the two strategies being the. .. Yields As the default risk on corporate bonds increases, in panel (a), the demand for corporate bonds shifts to the left In panel (b), the demand for Treasury bonds shifts to the right The price