Chapter 3
Structure of Interest Rates
Chapter Objectives
Learn how characteristics of debt securities cause their
yields to vary.
Analyze & explain the theories that elucidate the
fluctuations in interest rates across various terms or
maturities, known as the term structure of interest rates.
Introduction
• Both individual and institutional investors need to understand why
quoted yields fluctuate*. This knowledge empowers them to evaluate
whether the increased yield offered by a specific security justifies any
associated risks or disadvantages.
• Similarly, Financial managers at companies or government agencies
looking for funds need to know why interest rates (quoted yields) on
debt securities vary at a given point in time. This helps them figure out
how much interest they should offer to sell new debt securities.
Factors Affecting Security Yields
Risk-averse investors demand higher yields for added riskiness.
Risk is associated with variability of returns.
Increased riskiness generates lower debt security prices leading to
higher investors’ required rates of return.
Factors Affecting Debt Security Yields
Debt security yields and prices are affected by levels and
changes in:
a) Credit Risk (also called Default Risk)
b)Liquidity
c) Tax Status
d)Term to Maturity
e)Special Contract Provisions (such as embedded options of those
bonds)
Credit (Default) Risk
Benchmark: Risk-free Treasury Securities for given maturity
Default Risk Premium = Risky Security Yield – Treasury Security Yield of
same maturity
Default Risk Premium = market expected default loss rate
Use of Rating Agencies to Assess Credit Risk: Rating agencies set default
risk ratings based on a financial assessment of the issuing corp.*
Anticipated or actual ratings changes impact security prices and yields.
Rating Agencies
Liquidity
The Liquidity of a security affects the yield and or price of the security.
A liquid investment is easily converted to cash at minimum transactions
cost (i.e. without a loss in value).
Investors pay more (lower yield) for liquid investment.
If all other characteristics are equal, securities with less liquidity must
offer a higher yield to attract investors.
Liquidity is associated with short-term maturity and low default risk
marketable securities.
Tax Status
• Tax status of income or gain on debt security impacts the security
yield.
• Investors are more concerned with after-tax return or yield earned on
securities.
• Investors require higher yields for higher taxed securities.
• If all other characteristics are similar, taxable securities must offer a
higher before-tax yield than do tax-exempt securities. The extra
compensation required for taxable securities depends on the tax rates
of individual and institutional investors.
• Investors in high tax brackets benefit most from tax-exempt securities.
Tax Status (Cont ….)
When assessing the expected yields of various securities with similar risk
and maturity, it is common to convert them into an after-tax form, as
follows:
Yat = Ybt(1 – T)
Where:
Yat = after-tax yield
Ybt = before-tax yield
T = investor’s marginal tax rate
Investors retain only a percentage (1 – T) of the before-tax yield once
taxes are paid.
Tax Status (Cont ….)
Example:
A taxable security offers a before-tax yield of 14 percent. The investor’s
tax rate is 20 percent. Calculate the after-tax yield.
Yat = Ybt(1 – T)
Yat = 14% (1 – 0.2)
= 11.2%
Computing the Equivalent Before-Tax Yield
This can be done by rearranging the terms of the previous equation:
Ybt = Yat / (1 – T)
The fully taxable pre-tax equivalent corporate bond for a 11.2%
municipal bond is:
Ybt = 11.2% / (1 – 0.2) = 14%
Term to Maturity
• The annualized yield that a corporation has to offer when issuing its debt
securities is influenced by the maturity of the debt securities.
• The term structure of interest rates, also known as the yield curve defines the
relationship between terms to maturity and the annualized yield (interest rate)
for a debt security at a specific moment in time while holding other factors
constant.*
• The Yield Curve is the plot of current interest yields versus time to maturity.
Yield (in %)
An upward-sloping yield
curve indicates that
Treasury Securities with
longer maturities offer
higher annual yields
Time to Maturity
Term to Maturity (Cont….)
Yield Curve Shapes
Special Contract Provisions
• Call Feature enables borrower to buy back the bonds before
maturity at a specified price.
• Call features are exercised when interest rates have declined.
• Investors demand higher yield on callable bonds, especially when rates are
expected to fall in the future.
• Convertible bonds allow investors to convert the bond into a
specified number of common stock shares.
• Investors will accept a lower yield for convertible bonds because investor
returns include expected return on equity participation.
Estimating the Appropriate Yield
The appropriate yield to be offered on a debt security is based on the
risk-free rate, credit premium, liquidity premium, and tax adjustment
factors.
The appropriate yield to be offered on the debt security can be
determined by:
Yn = Rf,n + DP + LP + TA + CALLP + COND
Where:
Yn = yield of an n-day security
Rf,n = yield on an n-day Treasury (risk-free) security
DP (CP) = default premium (credit risk)
LP = liquidity premium
TA = adjustment for tax status
CALLP = call feature premium
COND = convertibility discount
The Term Structure of Interest Rates
Various theories have been proposed to explain the relationship between
the maturity of securities and their annualized yield, known as the term
structure of interest rates.
Presented below are three prominent theories:
1. Pure Expectation Theory
2. Liquidity Premium Theory
3. Segmented Market Theory
Pure Expectation Theory
Pure Expectations Theory (Unbiased Expectations Theory)
According to the Pure Expectations Theory, the term structure of interest
rates is determined solely by expectations of future short-term interest
rates (assumes that investor has no maturity preferences and transaction costs are low) .
According to this theory, long-term interest rates are derived from the
geometric average of current short-term interest rates and expected
future short-term interest rates over the same period*.
Investors select maturity based on expectations.
Pure Expectation Theory (Cont’d)
Let’s understand Pure Expectation Theory through:
• Demand-Supply Perspective
• Impact of an Expected Increase in Interest Rates
• Impact of an Expected Decline in Interest Rates
Downward-
Upward- Sloping
Sloping Yield Curve
Yield Curve
Expected higher interest rate Expected lower interest rate
levels levels
Expansive monetary policy Tight monetary policy
Expanding economy Recession soon?
Pure Expectation Theory (Cont’d)
Demand-Supply Perspective (Impact of an Expected Increase in Interest Rates)
Assume that the annualized yields for short term and long term securities are similar.
Now assume that the investors are believing that the interest rate will increase in
future.
What will be their response?
• Invest in short-term securities and later invest in long-term securities.
What will be the impact of such situation on the demand and supply curves?
• The Investors’ supply of fund in short-term securities will increase.
• The investors’ supply of fund in long-term securities will decrease.
How this rate increase will impact the expectations of the borrowers (issuers)?
• The borrowers will issue long-term securities in order to lock-in the current yield.
What will be the impact on the demand-supply curve?
• The demand of long-term borrowing will increase by the borrower.
• The demand for short-term borrowing will decrease by the borrower.
• The overall curve will be a decrease in short term and increase in long-term (normal yield curve).
Pure Expectation Theory (Cont’d)
Demand-Supply Perspective (Impact of an Expected Increase in Interest Rates)
Pure Expectation Theory (Cont’d)
Demand-Supply Perspective (Impact of an Expected Decrease in Interest Rates)
• Now assume that the investors believe that the interest rate will decrease in future.
• The investors will prefer long-term investment to lock-in the current interest rate.
What will happen to demand and supply curve?
• The supply will increase for long-term funds.
• The supply will decrease for short-term funds.
• However, the borrowers will demand funds for short-term so that they can borrow at
lower cost in future.
what will happen to the demand curve?
• The demand for short-term funds will increase.
• The demand for long-term funds will decrease.
• Therefore, the overall yield curve will be downward sloping.
Pure Expectation Theory (Cont’d)
Demand-Supply Perspective (Impact of an Expected Decrease in Interest Rates)
Pure Expectation Theory (Cont’d)
Let’s understand Pure Expectation Theory through:
• Algebraic Presentation
• Let’s suppose that an investor has two options to invest.
• Invest in two years security with x% of interest rate.
• Invest in one year security with y% of interest rate and reinvest the proceeds in one year
security with z% of interest rate.
The investor will choose one of the above strategies with the higher interest rate.
• The theory assumes that if the investor is indifferent to the maturity, they will be
indifferent to investing in either a two year security or two one year securities
because in both cases they will get the same return.
where
i = known annualized interest rate of a two-year security as of time
i 2
i = known annualized interest rate of a one-year security as of time
t 1
t+1 2 i = one-year interest rate that is anticipated as of time 1 (one year ahead)
Pure Expectation Theory (Cont’d)
• This theory is based on premise that the forward rates are unbiased estimators of
future interest rates (Unbiased Expectations Theory).
• Suppose, that the forward rate is biased and underestimated.
• Then the investors would invest in two years security rate that 1+1.
• This will increase the demand of two year security and the price will move up
whereas demand for 1 year security will go down and the price will also go down.
• Due to inverse relationship between price and yield, the bias will be eliminated.
Liquidity Premium Theory
Some investors may prefer to own short-term rather than long-term securities because
short-term securities represents greater liquidity.
• The longer the maturity the more sensitive the price is to the interest rate changes.
• Hence, the chances of losses in the short-term securities are less.
• If it is so, then they would want premium for holding long-term securities.
Liquidity Premium Theory (Cont’d)
Estimating Forward Rate based on a Liquidity Premium
Combing expectation theory with liquidity theory – the yield may not be necessarily
equal to the two consecutive one year securities.
LP2 represents the liquidity premium for a two-year security.
A two year security yield should exceed the yield of two consecutive one year
securities by a premium that compensate the investor for less liquidity.
If the liquidity influences the yield curve then the forward rate overestimates the
market’s expectation of the future interest rate.
This could be found by shuffling the equation.
Segmented Market Theory
According to the Segmented Markets Theory, investors and borrowers choose
securities with maturities that satisfy their forecasted cash needs.*
• The market is divided into different segments.
• There are some investors who wish to invest in long term securities to match their
long term liabilities, while others prefer to invest in short-term securities to
coincide with their short term liabilities.
• Hence, the supply-demand curves in each segment will dictate the overall yield
curve.
• Some borrowers and savers have flexibility to choose among various maturity
markets.
• If the maturity markets were completely segmented then adjustment in interest
rate in one market will have no impact on the other markets. However, the interest
rates moves in tandem.
Segmented Market Theory (Cont’d)
Although, markets are not completely segmented, therefore, this theory does not
completely explain the yield curve*, however, the segmentation on the basis of
maturity may somehow affect the yield curve because of the preference of particular
maturity.
Preferred Habitat Theory provides a more flexible explanation to the segmented
market theory.
Explains that, each investor has its own habitat (e.g. short-term investment).
However, they may invest in medium or long term securities if the anticipated interest
rates goes down.
Research on Term Structure Theories
• Interest rate expectation has strong influence on term structure of interest rate.
• Forward rates are not the perfect predictors of future interest rate.
• Studies found variation in yield maturity relationship that cannot be explained by
interest rate expectation or liquidity.
• Variation might be because of supply and demand conditions for the particular
maturity segments.
• There is some relevance of all the theories.
• Therefore if PET is used for predicting future interest rates, investors should net
out the liquidity premium and any unique market conditions for various maturity
segments.
Integrating the Term Structure Theories
Assume the following conditions:
• Investors and borrowers who select security maturities based on anticipated
interest rate movements currently expect interest rates to rise.
• Most borrowers are in need of long-term funds, while most investors have only
short-term funds to invest.
• Investors prefer more liquidity to less.
There can be offsetting conditions sometimes. Where one condition will put an
downward pressure and other upward pressure.
If LPT and SMT have upward pressure and dominates the PET. There will be an
upward pressure overall.
Use of the Term Structure
The term structure of interest rates is used;
• to forecast interest rates, (The market provides a consensus forecast of
expected future interest rates)
• to forecast recessions, (Flat or inverted yield curves have been a good
predictor of recessions), and
• to make investment and financing decisions, (Lenders/borrowers attempt
to time investment/financing based on expectations shown by the yield
curve)
Forecasting Interest Rate
• While forecasting interest rates, the investors have their own interest rate
projections.
• They may compare the yield curve based on PET and LPT with their own
projections to capitalize on the differences.
• If their projections reflect a stable interest rate and PET reflects an upward yield
curve, the investor can craft their future strategy i.e. invest in long-term securities.
Forecasting Recessions
Inverted and flat curve give a prediction about recession in future.
Forecasting Interest Rate (Cont’d)
Investment Decisions
• Riding on Yield Curve – have short term funding but invest in long term securities
to capitalize on the interest rate difference.
Suitable for investors who thinks that the expectation of increase interest rate is
wrong.
Investment Decisions
• The yield curve helps the firms that plans to issue bonds.
By assessing the interest rate on different maturity securities, they can estimate
the rate paid on different maturity bonds they may want to issue.
International Structure of Interest Rates
• Each country has a different currency with its own interest rate levels for
various maturities, and each country’s interest rates are based on conditions
of supply of and demand for loanable funds in its own currency.
• Nevertheless, interest rate movements across countries tend to be positively
correlated as a result of internationally integrated financial markets.
• Consequently, interest rate changes in one country may affect interest rates in
another country.
• Because a foreign interest rate may affect domestic interest rates, some
investors estimate the forward interest rate in a foreign country in an attempt
to predict the future interest rate in that country