This chapter discusses several factors that influence interest rates: marketability, liquidity, default risk, call privileges, prepayment risk, convertibility, and taxation. It explains how each of these factors affects the promised and expected yields on different types of financial assets. The risk-free interest rate underlies all other interest rates, which are scaled upward depending on their degree of additional risk factors like default risk or prepayment risk.

2. Chapter 8 The Risk Structure of Interest Rates: Defaults, Prepayments, Taxes, and Other Rate-Determining Factors

3.  Learning Objectives  To see the effects of financial assets’ marketability, liquidity, default risk, call privileges, prepayment risk, convertibility and taxability upon their interest rates and prices. To understand why there are so many different interest rates within the global economy. To learn how the “structure of interest rates” is built and why it changes constantly.

4.  Learning Objectives  To see why it is so difficult to forecast interest rates and financial asset prices accurately.

5. Introduction In the preceding chapter, we examined how expected inflation and security maturity affect interest rates. In this chapter, we will look at how some other factors influence interest rates:  marketability,  default risk,  call privileges,  taxation of security income,  prepayment risk,  convertibility.

6. Marketability Marketability – Can an asset be sold quickly? Marketability is positively related to the size and reputation of the institution issuing the securities and to the number of similar securities outstanding. However, marketability is negatively related to yield.

7. Liquidity Liquidity – A liquid financial asset is readily marketable . Moreover, its price tends to be stable over time and it is reversible . Popular measures of liquidity include the bid-ask spread, trading volume, frequency of trades, and average trade size.

8. Default Risk and Interest Rates Default risk – The risk that a borrower will not make all the promised payments at the agreed-upon times. Promised yield on a risky asset = risk-free interest rate + default risk premium The promised yield on a risky debt security is the yield to maturity that will be earned by the investor if the borrower makes all promised payments when they are due.

9. Default Risk and Interest Rates

10. Default Risk and Interest Rates Among the leading U.S. bankruptcy filers in modern history are WorldCom, Enron, Conseco, Texaco, Global Crossing, UAL, Pacific Gas and Electric Company, Kmart, etc. Expected yield on a risky asset =  p i y i p i = probability that the i th possible yield, y i , occurs Anticipated default loss on a risky asset = promised yield – expected yield

11. Default Risk and Interest Rates Factors Influencing Default Risk Premiums Credit ratings by rating companies such as Moody’s and Standard & Poor’s Highly-rated securities are perceived as having negligible default risk.

12. Default Risk and Interest Rates Bond-Rating Categories

13. Default Risk and Interest Rates The Behavior of Interest Rates Source: Monetary Trends, Federal Reserve Bank of St. Louis, Dec 2003

14. Default Risk and Interest Rates Market Yield * Corporate bond ratings are from Moody’s Investors Service. ** 2004 interest rates are averages for January. Source: Board of Governors of the Federal Reserve System

15. Default Risk and Interest Rates Fluctuations (cycles) in business activity The yield spread between Aaa- and Baa-rated securities increases during economic recessions. For corporate securities, the period of time the firm has been in operation, variability in company earnings, and the amount of leverage employed Factors Influencing Default Risk Premiums

16. Default Risk and Interest Rates Inflation and Default Risk Premiums Default risk premiums tend to be higher and more volatile when inflation is high and volatile. Greater uncertainty about inflation tends to produce a “flight to quality” in the financial markets, and investors simply become more cautious about buying default-risk-exposed financial instruments.

17. Default Risk and Interest Rates Yield Curves for Risky Securities There is some evidence that the yield curves on high-default-risk instruments often have a downward (negative) slope or may have a significant bow or hump in them as maturity increases. Each required payment that is successfully made seems to lower the risk that subsequent payments will be missed.

18. Default Risk and Interest Rates The Volatile History of Junk Bonds Junk bonds are long-term debt securities whose full repayment is judged to be significantly less certain than that for bonds rated investment quality.

19. Default Risk and Interest Rates The Junk-Bond Spread and the Economy Junk bond spread = junk bond yields – Aaa corporate bond yields A rise in the junk bond spread indicates a growing fear among bond market investors that marginal-quality corporate borrowers are more likely to default on their debts (i.e. a weakening economy).

20. New Ways of Dealing with Default Risk: Credit Derivatives Credit derivatives are financial contracts that seek to protect lenders against default risk by shifting that risk to someone else willing to accept it for a fee. In a credit swap , two or more lenders agree to exchange a portion of their expected payments. A credit option may enable the lender to be reimbursed if a credit asset begins to lose value.

21. New Ways of Dealing with Default Risk: Credit Derivatives

22. Call Privileges and Call Risk A call privilege on a bond contract grants the borrower the option to retire all or a portion of a bond issue by buying back the securities in advance of maturity at a specified call price . A bond may be callable immediately, or the privilege may be deferred for a specified period of time.

23. Call Privileges and Call Risk The yield on called financial assets can be calculated by equating the security’s price (P) with the present value of all its future cash flows (I): n = the number of periods until maturity k = the time period in which the security is called, k < n C = call price i = the interest rate the call price is reinvested at h = holding period yield

24. Call Privileges and Call Risk Advantages and Disadvantages The call option is an advantage to the security issuer because it grants greater financial flexibility and the potential for reducing future interest costs. However, it is a disadvantage to the security buyer. The holding-period yield may decline if the security is called, and the potential for capital gains is limited.

25. Call Privileges and Call Risk The Call Premium & Interest Rate Expectations Issuers of callable securities must pay a call premium in the form of a higher interest rate. The call premium is higher if the market expects interest rates to fall (such that the call risk is higher), the call deferment period is shorter, and the call price is lower.

26. Call Privileges and Call Risk Research Evidence Research studies generally support the expected inverse relationship between interest rate expectations and the value of the call privilege. Research also suggests that calling in bonds to save on interest costs may be a “zero sum game” between the bondholders and stockholders of a company.

27. Prepayment Risk and the Yields on Loan-Backed Securities Prepayment risk is the risk that the purchaser may receive higher-than-expected repayments of principal early in the life of loan-backed securities. Prepayment risk is especially valid for the investors in securities that are backed by home mortgage loans, as many home loans will be retired early due to loan refinancing and home-owner turnover.

28. Prepayment Risk and the Yields on Loan-Backed Securities Since prepayments may lower the investor’s return, loan-backed securities with greater prepayment risks are priced lower.

29. Prepayment Risk and the Yields on Loan-Backed Securities One of the most popular devices today to reduce prepayment risk is to divide the loan-backed security issue into classes or tranches . Each tranche promises a different rate of return based on a different maturity and risk profile.

30. Taxation of Returns on Financial Assets Taxes imposed by the federal, state, and local governments can have a profound effect on the returns earned by investors on financial assets. Thus, governments can use their taxing power to encourage the investment in certain financial assets, thereby redirecting the flow of savings and investment toward areas of critical social need.

31. Taxation of Returns on Financial Assets In particular, governments may vary the income brackets and tax rates tie the applicable tax rates to the length of time that securities were held grant certain amounts of tax exemptions for various categories enable the deduction of capital losses (up to specified limits) change the permissible annual contributions to educational or retirement accounts

32. Taxation of Returns on Financial Assets Tax-exempt securities represent a subsidy to induce investors to support local governments. The exemption privilege shifts the burden of federal taxation from buyers of municipal bonds to other taxpayers. However, the privilege lowers the interest rates at which municipals can be sold in the open market relative to comparable taxable bonds.

33. Taxation of Returns on Financial Assets After-tax yield = (1 – t )  Before-tax yield where t is the investor’s marginal tax rate An investor will be indifferent between taxable and tax-exempt securities when Tax-exempt yield = (1 – t )  Taxable yield To make valid comparisons between taxable and tax-exempt issues, the taxed investor should convert all expected yields to an after-tax basis.

34. Taxation of Returns on Financial Assets Recent Marginal Federal Income Tax Rates

35. Convertible Securities Convertible (or hybrid) securities are special issues of corporate bonds or preferred stock that can be exchanged for a specific number of shares of the issuing firm’s common stock. Convertibles offer the investor the prospect of a stable interest or dividend income, as well as capital gains on common stock on conversion. Hence, investors are generally willing to pay a premium for convertibles.

36. Convertible Securities For the corporate bond issuer, the advantages of convertible bonds is a significantly lower interest cost and being able to avoid issuing more common stock. Interest on convertible bonds is often a tax-deductible expense in many countries too. Note that the issuer may call in the securities early, forcing conversion.

37. The Structure of Interest Rates The risk-free interest rate underlies all interest rates and is a component of all rates. All other interest rates are scaled upward by varying degrees from the risk-free rate, depending on such factors as inflation, the term (maturity) of a loan, the risk of borrower default, the risk of prepayment, and the marketability, liquidity, convertibility, and tax status of the financial assets to which those rates apply.

38. The Structure of Interest Rates

39. Markets on the Net Duff & Phelps Credit Rating Company at www.duffllc.com / Federal Reserve Bank of Cleveland at www.clevelandfed.org / Federal Reserve System at www.federalreserve.gov /releases/ Fitch Ratings at www.fitchratings.com High Yield or “Junk” Bonds at www.finpipe.com/bndjunk.htm

40. Markets on the Net Moody’s Investor Service at www.moodys.com Standard & Poor’s Corporation at www.standardpoor.com The Bond Market Association at www.investinginbonds.com Thomson Bank Watch at www.bankwatch.com

41. Chapter Review Introduction Marketability Liquidity

42. Chapter Review Default Risk and Interest Rates The Premium for Default Risk The Expected Rate of Return or Yield on a Risky Asset Anticipated Loss and Default-Risk Premiums Factors Influencing Default Risk Premiums Inflation and Default-Risk Premiums Yield Curves for Risky Securities The Volatile History of Junk Bonds The Junk-Bond Spread and the Economy

43. Chapter Review New Ways of Dealing with Default Risk: Credit Derivatives Call Privileges and Call Risk Calculating the Yields on Called Financial Assets Advantages and Disadvantages of the Call Privilege The Call Premium and Interest Rate Expectations Research Evidence on Call Privileges and Call Risk

44. Chapter Review Prepayment Risk and the Yields on Loan-Backed Securities Taxation of Returns on Financial Assets Recent Changes in Tax Laws Treatment of Capital Losses Tax-Exempt Securities

45. Chapter Review Convertible Securities Advantages for the Corporate Bond Issuer Advantages for the Investor in Convertible Bonds The Structure of Interest Rates in the Financial System