Chapter The Risk and Term Structure of Interest Rates © 2005 Pearson Education Canada Inc Risk Structure of Long-Term Bonds in Canada © 2005 Pearson Education Canada Inc 6-2 Increase in Default Risk on Corporate Bonds © 2005 Pearson Education Canada Inc 6-3 Analysis of Figure 6-2: Increase in Default Risk on Corporate Bonds Corporate Bond Market Re on corporate bonds , Dc , Dc shifts left Risk of corporate bonds , Dc , Dc shifts left Pc , ic Canada Bond Market Relative Re on Canada bonds , DT , DT shifts right Relative risk of Canada bonds , DT , DT shifts right PT , iT Outcome: Risk premium, ic – iT, rises © 2005 Pearson Education Canada Inc 6-4 Bond Ratings © 2005 Pearson Education Canada Inc 6-5 Corporate Bonds Become Less Liquid Corporate Bond Market Less liquid corporate bonds Dc , Dc shifts left Pc , ic Canada Bond Market Relatively more liquid Canada bonds, DT , DT shifts right PT , iT Outcome: Risk premium, ic – iT, rises Risk premium reflects not only corporate bonds’ default risk, but also lower liquidity © 2005 Pearson Education Canada Inc 6-6 Tax Advantages of Municipal Bonds in the United States © 2005 Pearson Education Canada Inc 6-7 Analysis of Previous Figure: Tax Advantages of Municipal Bonds Municipal Bond Market in the United States Tax exemption raises relative RETe on U.S. municipal bonds, Dm , Dm shifts right Pm , im U.S. Treasury Bond Market Relative RETe on Treasury bonds , DT , DT shifts left PT , iT Outcome: im