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Fabozzi:Investment Management

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Learning Objectives

• You will understand why the yield on a Treasury

security is the base interest rate.

• You will study the factors that affect the yield spread

between two bonds.

• You will be able to describe what a yield curve is.

• You will learn what a spot rate and a spot rate curve

mean.

• You will calculate the theoretical spot rates from the

Treasury yield curve.

Learning Objectives

• You will explore what the term structure of interest

rates is.

• You will study why the price of a Treasury bond should

be based on spot rates.

• You will learn what is meant by a forward rate and be

able to calculate a forward rate.

• You will explore how long-term rates are related to the

current short-term rate and short-term forward rates.

• You will understand the different theories about the

determinants of the shape of the term structure: pure

expectations theory, the liquidity theory, the preferred

habitat theory, and the market segmentation theory.

Introduction

Bond yields depend on a variety of factors, including

the type of issuer, the characteristics of the bond issue,

and the state of economy. In this chapter we look at the

following factors

Treasury securities

•The difference in yields between a non- U.S. and a

U.S. Treasury security

•Bond maturity

The base interest rate

U.S. Treasury securities which are backed by the full faith

and credit of the U.S. government, are known throughout

the financial world as risk-free securities. Because of this,

the interest rate on Treasuries is the key interest rate in

world markets and the Treasury market is the most liquid

in the world.

•Minimum interest rate that investors will accept

•The yield on the most recently issued (on-the-run)

•Treasury security with a comparable maturity to the

investor’s potential bond purchase.

Risk premium

Risk premium – the spread between the rate on non-Treasury

securities and a particular on-the-run Treasury security. This is

the difference between the risk-free rate and the additional risk

inherent in other securities.

Or, base interest rate + risk premium

Factors affecting the spread

1.type of issuer

2.issuer’s perceived creditworthiness

3.term or maturity of the instrument

4.provisions that grant either issuer or investors the option

to do something

5.taxability of the interest received

6.expected liquidity of the security

Types of issuers

Market sectors (classifications of issuers)

-U.S. government and its agencies

-Municipal governments

-Corporations (foreign and domestic)

-Foreign governments

Types of issuers

Each sector has different risk/reward ratios as each

issuer (except the Treasury) has differing abilities to

meet their contractural obligations

offered by different sectors on security with same

maturity

within a market sector

Perceived creditworthiness of the

issuer

Default or credit risk

The risk that the issuer will be unable to make

timely interest or principal payments. This risk is

assessed by commercial rating companies

Spread between Treasuries and non-Treasuries that

are identical except for quality

Inclusion of options

Embedded options

Call provision – issuer can retire debt, in full or

partially, prior to maturity

Effect on spread

Investors require a larger spread on bonds with

embedded options comparable to Treasuries if the

option benefits the issuer

spread!) on bonds with embedded options

comparable to Treasuries if the option benefits the

investor.

Taxability of interest

Interest income is taxable at the federal level, as well as

possible taxes at the state and local level. The interest

from municipal bonds is exempt, which makes their

yields lower than similar Treasuries. The benchmark for

calculating spreads on tax-exempt bonds is a generic

AAA G.O. bond with specified maturity.

Taxability of interest

After-tax yield for taxable bond issues

After tax-yield = pretax yield x (1- marginal tax rate)

exempt issue

Equivalent taxable yield = tax exempt yield

(1- marginal tax rate)

Municipal bonds

General obligations

Revenue

Housing

Power

Hospitals

Insured

Expected liquidity of an issue and

term to maturity

Expected liquidity of an issue

The greater the expected liquidity, the lower required yield.

Term to maturity

The longer the term to maturity, the greater the bond price volatility

Short-term bonds – maturity between 1 and 5 years

Intermediate-term bonds – maturity between 5 and 12 years

Long-term bonds – maturity > 12 years

Term structure of interest rates – the relationship between yields on

identical bonds with different maturities

Yield curve

Insert Figure 25-1

bonds and setting yields in other areas of the debt

market. While this method has been used for a long time

due to the liquidity and creditworthiness of the Treasury

market, it has been inexact. That is, securities with the

same maturity may have different yields. How then

should we price bonds?

Why the yield curve should not be

used to price a bond

Recall that the price of a bond = PV of its cash flows and that one

interest rate (derived from a Treasury security) is used to discount all

cash flows.

Problems

Different cash flow patterns require different discount rates

Each bond should be viewed as package of zero-coupon

instruments, with each coupon date being its own maturity.

Finding the spot rate - Take the yield on a zero-coupon Treasury for

each maturity

Spot rate curve – graphical description of the rate and its maturity

All zero-coupon Treasuries maturities < 1 year, so we find

the theoretical spot rate curve.

Constructing the theoretical spot

rate curve for Treasuries

This curve is constructed from the yield on the following

Treasury securities:

1.on-the-run Treasury issues

2.on-the-run Treasury issues and selected off-the-run

Treasury issues

3.all Treasury coupon securities and bills

4.Treasury coupon strips

The methodology depends on which securities are used.

Bootstrapping occurs when on-the-run Treasury issues with or

without selected off-the-run Treasury issues are used.

On-the-run Treasury issues

These include the most recently auctioned issues of a given

maturity with each having an observed yield. Estimated yield is

used in the analysis when the issue is not trading at par. The

resulting yield curve is the par coupon curve.

semiannual spot rates – 6 month rate to 30 year rate. Seven

maturity points are available, with the rest extrapolated. This

yield is found by

Number of semiannual periods between the two maturity points

On-the-run Treasury issues

Then, the yield for intermediate points is found by adding

to the yield at the lower maturity the amount from the

computation above.

•Large gap between maturity points resulting in

misleading yields for those maturities estimated

•Yields for on-the-run issues may be misleading since the

true yield tends to be > quoted yield.

Estimating the theoretical spot rate curve

Insert Table 25-6

Use the 6 month Treasury bill with an annualized yield of 5.25% = spot

rate and 1 year Treasury with yield of 5.5% as the 1 year spot rate.

Coupon rate for a 1.5 year Treasury is 5.75%. Compute the spot rate for

a theoretical 1.5 year zero-coupon Treasury.

$100 = par

Cash flows are: 0.5 year 0.575 x $100 x 0.5 = $ 2.875

1.0 year 0.075 x $100 x 0.5 = $ 2.875

1.5 years 0.575 x $100 x 0.5 + 100 =$102.875

and given:

z1= one-half the annualized 6 month theoretical spot rate

z2= one-half the 1 year theoretical spot rate

z3= one-half the annual value of the 1.5 year theoretical spot rate

Estimating the theoretical spot rate curve

We know that

z1 = 0.02625 (0.0525/2)

z2 = 0.0275 (0.055/2)

therefore,

100 = 2.801461 + 2.723166 + 102.875

(1 + z3)3

94.47537 = 102.875

(1 + z3)3

We double this yield to find the bond-equivalent yield of 5.76%.

This procedure can be used to find the theoretical spot rates for all

maturities. See Table 25-7. Insert Table 25-7

On-the-run Treasury issues and

selected off-the-run Treasury issues

To lessen the problem of gaps between maturities, some

dealers use selected off-the-run Treasury issues (i.e. 20

year and 25 year issues). The linear extrapolation method

is used to fill in the gaps and bootstrapping is used to

construct the theoretical spot rate curve.

All Treasury coupon securities

and bills

Even when using only on-the-run issues with a few off-the-

run issues, information is embodied in Treasury prices is lost

to the analysis.

and bills to construct the theoretical spot rate curve.

Using the theoretical spot rate curve

Insert Table 25-9

What forces a Treasury to be price based on the spot

rates? Arbitrage.

By viewing the bond as a package of zero-coupon

instruments and applying the appropriate interest

rates, we avoid underpricing the bond relative to

its theoretical value, creating an arbitrage

opportunity.

Base interest rate = theoretical Treasury spot rate for

that maturity

Forward rates

Alternative 1: An investor buying a one-year instrument will

realize the on-year spot rate, a certain amount.

Alternative 2: An investor buying a six-month instrument and

then replacing it with another at maturity, will realize an

unknown amount. The logic is that in six months rates may be

higher. The value of f denotes some rate on a six month

instrument six months from now that will make the investor

indifferent between alternatives 1 and 2.

Double this to give the bond-equivalent yield for the 6 month

rate, 6 months from now.

Forward rates: an example

Given:

6 month spot rate = 0.0525, z1 = 0.02625

1 year spot rate = 0.0550, z2 = 0.02750

That is, the annual rate for f on a bond equivalent basis = 5.75%

If the 6 month rate 6 months from now < 5.75%, then the investor

should go with alternative one since the total value will be higher.

It is important to understand that expectations of future rates are

built into the rates offered on investments with different maturities.

Forward rate – future interest rate calculated from spot rates or the

yield curve

Relationship between six-month

forward rates and spot rates

Given a t-period spot rate, the current spot rate and six

month forward rates (ft), the formula for the relationship is

Other forward rates

We can calculate the forward rates for any time in the

future for any investment horizon by using spot rates.

But do forward rates do a good job at predicting future

interest rates?

predict rates well, forward rates show how an investor’s

expectations must differ from the market consensus to

choose the correct alternative.

Determinants of the shape of the

term structure

Four typical term structure shapes

Insert Figure 25-3

Two theories have evolved to explain these structures:

1.Expectations theories

-Pure expectations

-Liquidity

-Preferred habitat

2.Market segmentation theory

The pure expectations theory

Forward rates exclusively represent the expected future rates.

The entire term structure reflects the market’s expectations of future

short-term rates. Therefore, a normal curve indicates a rising trend in

short-term rates for the near future, a flat term structure indicates

constant rates, and a falling structure indicates declining rates.

Looking at the normal structure, the following scenario could exist:

1.Long-term horizon investors would shy away from long-term bonds

since an increase in rates would lower bond prices. They would buy

short-term bonds.

2.Speculators would sell long-term bonds before prices fell and short-

sell others. They would reinvest proceeds in short-term debt

instruments.

3.Borrowers would tend to borrow now, rather than wait, as lending

rates are expected to increase.

The pure expectations theory

Long-term bonds would be sold and demand for short-

term debt instruments would rise, making long-term

yields rise. That is, the behavior initiated by expectations

would affect the predicted result.

The pure expectations theory: a

problem

This theory ignores the inherent risks of bonds brought on

by the uncertainty of future interest rates. More

specifically, the risks are:

1.Price risk

Uncertainty about the price of a bond at the end

of an investment horizon due to dependence on

future interest rates; it may be lower than

expected.

2.Reinvestment risk

Uncertainty about the rate at which proceeds can

be reinvested

The pure expectations theory:

interpretations

1.Investors expect the return for any investment horizon to be the

same regardless of maturity strategy. However, due to the price risk

associated with investing in bonds with a maturity greater than the

investment horizon, expected returns will differ significantly.

different maturities will be the same over a short-term investment

horizon. This interpretation can be sustained given equilibrium.

return an investor will realize by rolling over short-term bonds to

some investment horizon will be the same as holding zero-coupon

bond with a maturity equal to that investment horizon. There is much

doubt about this interpretation.

The liquidity theory

Investors will hold longer-term maturities if they are

offered a forward rate that reflects both interest rate

expectations and a liquidity (or risk) premium.

implied forward rates will not be an unbiased estimate of

expectations of future interest rates because there is a

liquidity premium built in. It also assumes that the risk

premium rises uniformly with maturity.

The preferred habitat theory

Given mismatched demand and supply for funds in a maturity

range, lenders and borrowers will need to shift to maturities

showing the opposite imbalances. They will require a risk

premium reflecting the extent of aversion to price or

reinvestment risk.

The shape of the yield curve, under this theory, is

determined by both expectations of future interest rates

and the risk premium that will coax investors to shift out

of their preferred habitat.

Determination of shape

Upward and downward sloping as well as humped are

possible.

Market segmentation theory

This theory states that the shape of the yield curve is

affected by the asset/liability constraints and/or creditors

(borrowers) restricting their lending (financing) to specific

maturity sectors.

Assumes neither investors nor borrowers are willing

to shift maturity sectors to take advantage of forward

rate or expectations opportunities.

Supply and demand for securities within each

maturity sector

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