STRUCTURE OF INTEREST RATES
1
The yields on debt securities are affected:
Credit (default) risk
Liquidity
Tax status
Term to maturity
2
Credit (Default) Risk – securities with a higher degree of
default risk offer higher yields.
a. Rating Agencies - Rating agencies charge the issuers of
debt securities a fee for assessing default risk. (Exhibit 3.1).
b. Accuracy of Credit Ratings - The ratings issued by the
agencies are useful indicators of default risk but they are
opinions, not guarantees.
c. Oversight of Credit Rating Agencies - The Financial Reform
Act of 2010 established an Office of Credit Ratings within
the Securities and Exchange Commission in order to
regulate credit rating agencies. Rating agencies must
establish internal controls.
3

Default Risk (chance of not getting your $ back at
maturity)






Financial strength of the issuer
Business strengths of the issuer
Industry outlook
Term to maturity
Credit Agency Rating
Liquidity (how easy is it to buy or sell at intrinsic values?)
 Size of the issue (float)
 General market conditions
 Characteristics of the secondary market in bonds
4
5
Computing the Equivalent Before-Tax Yield:
 at   bt (1  T )
 at
 bt
T
= after-tax yield
= before-tax yield

= Investor’s marginal tax rate
Computing the Equivalent Before-Tax Yield:
 at
 bt 
(1  T )
6
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
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TA = adjustment due to difference in tax status

Pure Expectations Theory
 Investor / borrower expectations and preferred maturities
 Computing the forward rate (see page 54)

Liquidity Premium Theory
 S-T securities typically more marketable that L-T
 Increase in marketability, ceteris paribus, should result in
lower YTM

Segmented Markets Theory
 Investor preferences for certain maturities investment
horizon
 Nature of assets and liabilities (matching principle)
8
Algebraic Presentation:
(1 t i2 ) 2  (1 t i1 )(1 t 1 F1 )
i  known annualized interest rate of a two - year security at time t
t 2
i  known annualized interest rate of a one - year security at time t
t 1
t 1
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F1  one - year interest rate that is anticipate d as of time t  1

Comprehensive Explanation for Term Structure
and Shape of the Yield Curve
 The yield curve has much to do with investor expectations about
the economy.
 Lenders prefer less risk and more liquidity.
 Borrowers prefer longer terms.
 Implications of flat and inverted yield curves
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Nov 14, 2000
11
12

Briefly describe the implications of the following theories;
 Pure Expectations Theory
 Liquidity Premium Theory
 Segmented Markets Theory
What factors do we consider when investing in bonds?

Why is the normal shape of the Yield Curve upward
sloping to the right?

What do we mean by a before-tax equivalent yield and why
is it important?

What factors influence interest rates?

What is a forward rate and Why is it important?

How do economic conditions affect the risk premium?

Q&A: 1, 5, 6, 8, 17 Interpreting: a, b, c.

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