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CHAPTER 3

Structure of Interest Rates

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CHAPTER 3 OVERVIEW

This chapter will:

A. Show how characteristics of debt securities cause their yields to vary

B. Demonstrate how to estimate the appropriate yield for any particular debt security

C. Explain the theories behind the term structure of interest rates

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A. Characteristics of Debt Securities that Cause Their Yields to Vary1. Debt (Default) Risk

a. Rating Agencies1.) Moody’s Investor Service

2.) Standard and Poor’s Corporation

b. Accuracy of Credit Ratings

c. Shifts in Credit Risk Premiums

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A. Characteristics of Debt Securities that Cause Their Yields to Vary

2. Liquidity

a. the ease of conversion to cash without loss of value.

b. the lower a securities liquidity, the higher the yield preferred by investor.

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A. Characteristics of Debt Securities that Cause Their Yields to Vary

3. Tax Status

Investors are more concerned with after-tax income.

Taxable securities must offer a higher before-tax yield

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A. Characteristics of Debt Securities that Cause Their Yields to VaryTo compute the equivalent Before-Tax Yield:

where τat = After-tax yield

τbt = Before-tax yield

T = Investor’s marginal tax rate

)1( Tbtat

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A. Characteristics of Debt Securities that Cause Their Yields to Vary

4. Term to Maturity maturity dates will differ between debt

securities The term structure of interest rates defines the

relationship between term to maturity and the annualized yield

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B. Estimating Debt Yield

1. Explaining Actual Yield Differentials

a. Small differentials can be significant

b. Basis points (bp) are often quoted where

1bp = .01% = .0001

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B. Estimating Debt Yield

2. Yield Differentials of Money Market Securities

a. Securities: commercial paper, certificates of deposit, bankers acceptances.

b. Yields are just slightly higher than the risk-free T-bills

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B. Estimating Debt Yield

3.Yield Differentials of Capital Market Securities

a. Municipal (munis) bonds have lowest before-tax yield

b. Treasury bonds may have higher before-tax yield than munis but have lowest

after- tax yield

c. Corporate bonds may have highest yields

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C. Term Structure of Interest Rates

1. Three prevailing theories:

a. Pure Expectations Theoryemphasizes the impact of an expected change in interest rates

b. Liquidity Premium Theory emphasizes estimation of the Forward Rate based on a Liquidity Premium

c. Segmented Markets Theory

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C. Term Structure of Interest Rates

2. Uses of the Term Structurea) Forecast Interest Rates

b) Forecast Recessions

c) Investment Decisions

d) Financing Decisions

3. Impact of Debt Management on Term Structure