Chapter 6:

The Risk and Term Structure of Interest Rates

In previous chapter we analyzed the determination of "the interest
rate" as if there were only 1. YTM's, though, differ according to risk
and maturity, so in fact at any given time there are many interest
rates.
Risk Structure of Interest Rates
Question: - Why do bonds with the same maturities have different YTM's?
Answer: - They vary along at least three other dimensions
Default Risk
The perceived chance that the issuer will default
(i.e. fail to live up to repayment contract)
Note: U.S. Treasury bonds considered to have zero default risk
(a.k.a. default-free bonds) b/c Treasury can
always increase taxes or print money
Definition: "risk premium" -- the additional interest people
must earn in order to be willing to hold a risky bond
...the higher the default risk, the greater the risk
premium
Think of supply and demand analysis from last chapter
(flow of funds framework for bond pricing)

Note: Bonds are rated for their default risk

Bond rating agencies: Moodys, Standard & Poors, others

Risk Structure of Interest Rates (cont'd.)

Liquidity
The more widely traded, the more liquid.
Treasure bonds are most widely traded, ergo most liquid
Corporate bonds may face "thinner" trading markets,
therefore less liquid
(Note: "illiquidity" is a different kind of risk,
but risk nonetheless)
The more liquid, the greater the demand (ceteris paribus),
and hence the higher the price (and the lower the YTM)
Definition: liquidity premium -- the difference in YTM on a
bond relative to a Treasury bond of equal maturity, due
to the difference in liquidity.
Note: Treasury bonds are the benchmark both for low default
risk and for high liquidity. Thus it isn't easy to
distinguish the risk premium from the liquidity premium.
Usually when people say the "risk premium" they mean
a combination of the two:
"the risk and liquidity premium"
Income Tax Considerations
Recall that "Munis" are tax-free (i.e. generate no income tax liability)
If youre in the 40% tax bracket, and the yield is 10%, then your
take-home yield is just 6%.
So: risk and liquidity held constant, a person in the 40% tax bracket
would be just as happy with a municipal bond paying 6% as with a
non-municipal bond paying 10%

Yields on Different Instruments:

Note: liquidity AND risk AND tax differences between these

Most liquid: U.S. Treasuries
Least risky: U.S. Treasuries
Least taxed: Munis

Note:
1.
2.
3.
4.

rates tend to move together, though the spreads between different

interest rates are not constant
Munis have generally had the lowest nominal yields (higher after tax)
Surge in yields on all instruments after inflationary experience of the
70s
Connection between Muni spread and changes in income tax rates?

Treasury Yields 1960-2006

Note how the spreads expand and contract (and occasionally go negative)

The flight to quality in times of crisis

Term Structure of Interest Rates

Aside from differences in default risk, liquidity, and tax treatment,
bonds differ along another dimension: term to maturity
The "Yield Curve"
Definition: A graph illustrating YTM for bonds which are
comparable along all other dimensions except term to maturity.

Possible shapes of the yield curve

Upward sloping (normally the case)
Flat
Downward sloping, or "inverted" (unusual, but
important)
Three Stylized Facts about the yield curve, which a good
theory of interest rates must be able to explain
1. Rates tend to move together over time, even for
bonds of different maturities
2. The higher the short-term rate, the more likely
the yield curve is inverted
3. Yield curves almost always slope up
Three Theories which attempt an explanation:
1. Expectations Theory
2. Segmented Markets Theory
3. Liquidity Premium Theory

Expectations Theory
"The interest rate on a long-term bond will be the average of the shortterm interest rates that people expect to occur over the life of the
long-term bond"
For example,
If money needed after two years, you could either
a) buy a 2-year bond
b) buy a 1-year bond, and then after 1 year, buy another
1-year bond
If those two approaches are perfect substitutes,
then the yields must equate
Formally,
let
it = time t (today) yield on a 1-year bond
i2t = time t yield on a 2-year bond
iet+1 = expected yield on a 1-year bond starting
in t+1 (i.e. next year)
The expected return from investing $1 by strategy (a) above:
= (1+ i2t)*(1+ i2t) - 1
= 1 + 2*i2t + (i2t)2 - 1
= 2*i2t + (i2t)2
2*i2t

since (i2t)2 0

Meanwhile, the return from investing $1 by strategy (b) above:

= (1+ it)*(1+iet+1) - 1
= 1 + it + iet+1 + it* iet+1 - 1
= it + iet+1 + it* iet+1
it + iet+1

since it* iet+1 0

If these two bonds are perfect substitutes then their yields must equate
(else one or the other won't be held), i.e.
2*i2t = it + iet+1
or
i2t = (it + iet+1)/2
In other words: the two-period (annualized) YTM must be equal to
the average of the expected 1-period YTMs
In the general, n-period case, the arbitrage condition would be
int = (it + iet+1 + iet+2 + ... + iet+(n-1))/n
Which says simply: "the interest rate on an n-period bond must be
equal to the average of the expected 1-period rates over the relevant
time horizon"

Problem: Calculate the yield curve for 1- to 5-year bonds if a) the

Expectations Theory is correct, and b) the expected trajectory of 1year interest rates is the following
it=5%
iet+1=7%
iet+2=8%
iet+3=7.5%
iet+4=7%
Solution:
2-year bond: i2t = (5%+7%)/2 = 6%
3-year bond: i3t = (5%+7%+8%)/3 = 6.67%
4-year bond: i4t = (5%+7%+8%+7.5%)/4 = 6.875%
5-year bond: i5t = (5%+7%+8%+7.5%+7%) = 6.9%

(Graph)
Insight: As long as "interest rates are expected to increase" the yield
curve will be upward sloping
More exactly: as long as the marginal (expected) interest rate
is above the average (expected) interest rate, the yield curve
will be upward sloping

So, which of the stylized facts can this Expectations Theory model
explain?
1. Rates move together
Yes. b/c a change in short-rate gets averaged into longer rates
2. Yield curve slopes up when short rates are low
and down when short-rates are high
Yes. b/c mean reversion
3. Yield curves almost always slope upwards
No. b/c short-rates are equally likely to be above mean as
below. Hence expected rates should be falling as often
as rising, and yield curve therefore downward sloping as
often as upward sloping.

Segmented Markets Theory

Holds that "bonds of different maturities are not substitutes"
(or perhaps that they are such imperfect substitutes that their relative
yields matter little to investors)
For example, if investors want to completely avoid interest
rate risk, they must hold a bond to maturity. Hence those who
need their money in 10 years have no use for a 5-year or a 30year bond, etc.
Assume there are more people with need for their money in the shortterm than in the long term.
Demand for the short bond will be higher than demand for
the long bond
The price of short bond will be higher
The yield on the short bond will be lower

So: This theory can explain stylized fact 3

("yield curves almost always slope up")
But it fails to explain stylized fact 1
("rates move together")
{ or does it ...?)
And it certainly fails to explain stylized fact 2
("upward sloping when short rate is low,
downward sloping when short rate is high")

Liquidity Premium Theory

Expectations Theory
assumes perfect substitutability between maturities
Segmented Markets Theory
assumes no substitutability between maturities
Liquidity Premium Theory
assumes imperfect substitutability
(but substitutability nonetheless)

LPT
"The interest rate on a long-term bond will equal an average of shortterm expected rates, plus a liquidity premium ('term premium'), which
is a positive function of time to maturity"
The term premium captures the following:

higher interest rate risk embedded in longer term bonds

investor preference for shorter terms

Thus, according to LPT:

int = (it + iet+1 + iet+2 + ... + iet+(n-1))/n + lnt
where lnt term premium on an n-year bond at time t
(and lnt is increasing in n)

(graph lnt )What can we explain with this theory?

Stylized fact

Explained?

1. rates move together

2. inverted yield curve

at high short rates

3. y-curve almost always

slopes up