Outlines Why Debt Securities Yields Vary Explaining Actual Yield Differentials Estimating the Appropriate Yield Term Structure of Interest Rates
Introduction The annual interest rate offered by debt securities at a given point in time varies among debt securities. Debt securities offer different yields because they exhibit different characteristics that influence the yield to be offered. In general, securities with unfavorable characteristics will offer higher yields to entice investors. Yields on debt securities are affected by the following characteristics: (i) Credit risk; (ii) Liquidity; Tax status; and (iv) Term of maturity.
Why Debt Securities Yields Vary 1. Credit (Default) Risk If all other characteristics besides credit (default) risk are equal, securities with a higher degree of risk will offer higher yields. Rating Agencies 1.) Moody’s Investor Service 2.) Standard and Poor’s Corporation The higher the rating, the lower the perceived credit risk Accuracy of Credit Ratings Enron Scandal in 2001
Exhibit 3.1 Rating Classification by Rating Agencies
2. Liquidity The ease of conversion to cash without loss of value The lower a securities liquidity, the higher the yield preferred by investor3. Tax Status Investors are more concerned with after-tax income. Taxable securities must offer a higher before-tax yield
To compute the equivalent Before-Tax Yield: at bt (1 T )where τat = After-tax yield τbt = Before-tax yield T = Investor’s marginal tax rate
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
Explaining Actual Yield DifferentialsExplaining Actual Yield Differentials Small differentials can be significant Basis points (bp) are often quoted where 1bp = .01% = .0001
Yield Differentials of Money Market Securities Securities: commercial paper, certificates of deposit, bankers acceptances. Yields are just slightly higher than the risk-free T-billsYield Differentials of Capital Market Securities Municipal bonds have lowest before-tax yield Treasury bonds may have higher before-tax yield than municipal bonds but have lowest after-tax yield Corporate bonds may have highest yields
Exhibit 3.4 Yield Differences of Corporate Bonds
Estimating the Appropriate Yield Yn = Rf,n + DP + LP + TA where: Yn = yield of an n-day debt security Rf,n = yield of an n-day Treasury (risk-free) security DP = default premium to compensate for credit risk LP = liquidity premium to compensate for less liquidity TA = adjustment due to difference in tax status
Example 1: Suppose that the three-month Treasury bill’s annualized rate is 8% and Elizabeth Company plan to issue 90-day commercial paper. Assume that Elizabeth Company believes that a 0.7% default risk premium, a 0.2% liquidity premium and a 0.3% tax adjustment are necessary to sell its commercial paper to investors. Thus, the appropriate yield is Yn = Rf,n + DP + LP + TA = 8% + 0.7% + 0.2% + 0.3% = 9.2%
Term Structure of Interest RatesPure Expectations Theory: Term structure is determined solely by the expectations of future rates. Impact of an expected increase in interest rates: - Leads to an upward sloping yield curve Impact of an expected decline in interest rates: - Leads to a downward sloping yield curve The following figures show how interest rate expectations affect the yield curve.
Liquidity Premium Theory: Investors prefer short-term rather than long-term securities because a shorter maturity represents greater liquidity. However, they may be willing to invest in long-term securities only if compensated with a premium for lower liquidity. Liquidity may be a more critical factor to investors at particular points in time, and the liquidity premium will change over time accordingly.
Impact of Liquidity Premium on the Yield Curveunder Three Different Scenarios
Segmented Markets Theory: Investors choose securities with maturities that satisfy their forecasted cash needs Limitations of the theory: Some borrowers and savers have the flexibility to choose among various maturities
Integrating the Theories ofthe Term StructureIf we assume the following conditions Investors and borrowers currently expect interest rates to rise. (E) Most borrowers need long-term funds, while most investors have only short-term funds to invest. (S) Investors prefer more liquidity to less. (L) Then all three conditions place upward pressure on long- term yields relative to short term yields leading to upward sloping yield curve
Effect of Conditions in Example of Yield Curve
Use of the Term Structure Forecast interest rates Forecast recessions Investment decision
Why the Slope of the Yield CurveChanges If interest rate at all maturities are affected in the same manner by the existing conditions, the slope of the yield curve would remain the same. However, conditions may cause short-term yields to change in a manner that differs from the change in long-term yields.