Chapter 11.Chapter 11.The Level & Structure of Interest The Level & Structure of Interest RatesRates

Chapter 11.Chapter 11.The Level & Structure of Interest The Level & Structure of Interest RatesRates

• Loanable funds market

• Risk Structure of Interest Rates• Loanable funds market

• Risk Structure of Interest Rates

I. Loanable Funds MarketI. Loanable Funds MarketI. Loanable Funds MarketI. Loanable Funds Market

• determine equilibrium interest rate

• overall level of interest rates but still many different interest

rates

• determine equilibrium interest rate

• overall level of interest rates but still many different interest

rates

Demand for LFDemand for LFDemand for LFDemand for LF

• behavior of issuers & borrowers

• interest rate is cost of borrowing it is the price of loanable funds

• demand is downward sloping

• behavior of issuers & borrowers

• interest rate is cost of borrowing it is the price of loanable funds

• demand is downward sloping

LF

i

DLF

what shifts demand?what shifts demand?what shifts demand?what shifts demand?

• tax rules favorable tax treatment for interest

payments increase demand mortgage interest deductible bond interest deductible for issuer

• tax rules favorable tax treatment for interest

payments increase demand mortgage interest deductible bond interest deductible for issuer

• expected profitability increases will encourage

investment & borrowing

-- increase demand increases w/ economic expansion,

decreases w/ recession

• expected profitability increases will encourage

investment & borrowing

-- increase demand increases w/ economic expansion,

decreases w/ recession

• government borrowing deficits increase demand surpluses decrease demand

• government borrowing deficits increase demand surpluses decrease demand

Supply of LFSupply of LFSupply of LFSupply of LF

• behavior of savers, lenders, bond buyers

• interest rate is reward for saving postpone present consumption

• supply curve is upward sloping

• behavior of savers, lenders, bond buyers

• interest rate is reward for saving postpone present consumption

• supply curve is upward sloping

LF

iSLF

DLF

what shifts supply?what shifts supply?what shifts supply?what shifts supply?

• tax rules favorable treatment of interest

income pensions tax exempt interest

• tax rules favorable treatment of interest

income pensions tax exempt interest

• income & wealth increases will increase amount and

% of saving

• rate of time preference people more/less willing to

postpone consumption

• income & wealth increases will increase amount and

% of saving

• rate of time preference people more/less willing to

postpone consumption

• FOMC policy if Fed buys Treasuries, increase

supply of LF

• FOMC policy if Fed buys Treasuries, increase

supply of LF

ExampleExampleExampleExample

• Fed sell Treasuries decrease SLF

• Federal gov’t runs a deficit increase DLF

• Fed sell Treasuries decrease SLF

• Federal gov’t runs a deficit increase DLF

LF

iSLF

DLF

interest raterises

What is i?What is i?What is i?What is i?

• benchmark interest rate

• or base interest rate

• minimum rate acceptable to lenders all other rates compared to

benchmark Treasury yield

-- default-free, highly liquid

• benchmark interest rate

• or base interest rate

• minimum rate acceptable to lenders all other rates compared to

benchmark Treasury yield

-- default-free, highly liquid

III. Risk Structure of Interest III. Risk Structure of Interest RatesRatesIII. Risk Structure of Interest III. Risk Structure of Interest RatesRates

• different interest rates on assets with same maturity

• why? assets have different

characteristics

• different interest rates on assets with same maturity

• why? assets have different

characteristics

measurementmeasurementmeasurementmeasurement

• difference between two interest rates spread

• measured in percentage points basis points 1 percentage pt. = 100 basis pts.

• difference between two interest rates spread

• measured in percentage points basis points 1 percentage pt. = 100 basis pts.

example 1example 1example 1example 1

• 3 mo. Tbill .95%

• 3 mo. Commercial paper 1.02 %

• spread

.07 percentage pts.

7 basis pts.

• 3 mo. Tbill .95%

• 3 mo. Commercial paper 1.02 %

• spread

.07 percentage pts.

7 basis pts.

example 2example 2example 2example 2

• 10 yr Tnote 3.85%

• 10 BAA corporate 5.02%

• spread 1.07 percentage pts. 107 basis pts.

• 10 yr Tnote 3.85%

• 10 BAA corporate 5.02%

• spread 1.07 percentage pts. 107 basis pts.

3/5/20043/5/20043/5/20043/5/2004

• 3 mo Tbill .95%

• 3 mo Commerical Paper 1.02%

• 10 yr. Tnote 3.85%

• 10 yr. AAA corporate 4.31%

• 10 yr. BAA corporate 5.02%

• 10 yr. AAA muni 3.47%

• 30 yr. mortgage 5.36%

• 3 mo Tbill .95%

• 3 mo Commerical Paper 1.02%

• 10 yr. Tnote 3.85%

• 10 yr. AAA corporate 4.31%

• 10 yr. BAA corporate 5.02%

• 10 yr. AAA muni 3.47%

• 30 yr. mortgage 5.36%

PatternsPatternsPatternsPatterns

• Baa always the highest yield

• Municipal’s always the lowest (1940)

• Baa > AAA > U.S. > municipal size of the spread varies

• Baa always the highest yield

• Municipal’s always the lowest (1940)

• Baa > AAA > U.S. > municipal size of the spread varies

Risk premiumRisk premiumRisk premiumRisk premium

• base interest rate + risk premium

= interest rate on corporate debt

• base interest rate + risk premium

= interest rate on corporate debt

size of risk premiumsize of risk premiumsize of risk premiumsize of risk premium

• issuer

• default/credit risk

• liquidity

• maturity (chapter 12)

• options

• tax treatment

• issuer

• default/credit risk

• liquidity

• maturity (chapter 12)

• options

• tax treatment

IssuerIssuerIssuerIssuer

• spreads exist among different issuers

• but usually a function of other factors

• spreads exist among different issuers

• but usually a function of other factors

Default risk/ credit riskDefault risk/ credit riskDefault risk/ credit riskDefault risk/ credit risk

• risk of not receiving timely payment of principal and interest

• depends on creditworthiness of issuer structure of bond

• risk of not receiving timely payment of principal and interest

• depends on creditworthiness of issuer structure of bond

U.S. government debtU.S. government debtU.S. government debtU.S. government debt

• zero default risk

• backed by “full faith and credit”

of U.S. government

• why? power to tax largest economy power to issue stable currency

• zero default risk

• backed by “full faith and credit”

of U.S. government

• why? power to tax largest economy power to issue stable currency

Other issuersOther issuersOther issuersOther issuers

• private

• foreign

• municipal

• all have some default risk

• rated for default risk

• private

• foreign

• municipal

• all have some default risk

• rated for default risk

Bond ratingsBond ratingsBond ratingsBond ratings

• bond issuer pays rating agency Moody’s, S&P

• high credit rating low default risk

• bond ratings may change over time

• bond issuer pays rating agency Moody’s, S&P

• high credit rating low default risk

• bond ratings may change over time

default risk & yielddefault risk & yielddefault risk & yielddefault risk & yield

• investors are risk averse• investors are risk averse

higher default risk

lower credit rating

higher yield

• so default risk explains• so default risk explains

Treasuryyields

AAACorpyields

BAACorpyields

< <

default risk is not constant!default risk is not constant!default risk is not constant!default risk is not constant!

• varies over the business cycle higher in recessions lower in expansions

• Baa vs. Treasury bond yield 12/99 191 basis pts. 2/03 307 basis pts. 3/04 107 basis pts.

• varies over the business cycle higher in recessions lower in expansions

• Baa vs. Treasury bond yield 12/99 191 basis pts. 2/03 307 basis pts. 3/04 107 basis pts.

Bond ratings (p. 400)Bond ratings (p. 400)Bond ratings (p. 400)Bond ratings (p. 400)

AAA

AA

A

Aaa

Aa

A

BBB

BB

B

Baa

Ba

B

CCC

CC

C

Caa

Ca

C

Moody’sS&P

Investmentgrade

High Yield

B. LiquidityB. LiquidityB. LiquidityB. Liquidity

• how quickly/cheaply can bond be sold for cash?• how quickly/cheaply can bond be

sold for cash?

higher liquidity

lower yield

liquidity is not ratedliquidity is not ratedliquidity is not ratedliquidity is not rated

• Treasuries most liquid

• depends on size of issuer

• related to default risk bonds in default very illiquid higher-rated bonds tend to be

more liquid

• Treasuries most liquid

• depends on size of issuer

• related to default risk bonds in default very illiquid higher-rated bonds tend to be

more liquid

Embedded OptionsEmbedded OptionsEmbedded OptionsEmbedded Options

• special rights granted to holder or issuer of bond

• affect on yield spread depends on option beneficial to issuer? beneficial to holder?

• special rights granted to holder or issuer of bond

• affect on yield spread depends on option beneficial to issuer? beneficial to holder?

options for issueroptions for issueroptions for issueroptions for issuer

• increase yield relative to option-free bond

• call provision issuer has right to pay off bond

early issuer often calls bonds when

interest rate falls

• increase yield relative to option-free bond

• call provision issuer has right to pay off bond

early issuer often calls bonds when

interest rate falls

options for holderoptions for holderoptions for holderoptions for holder

• decrease yield relative to an option-free bond

• put provision holder has right to sell back bond

early holder more likely to exercise right

at higher interest rates

• decrease yield relative to an option-free bond

• put provision holder has right to sell back bond

early holder more likely to exercise right

at higher interest rates

• issuer options must offer higher yield to get

special rights

• holder options must accept lower yield in

exchange for special rights

• issuer options must offer higher yield to get

special rights

• holder options must accept lower yield in

exchange for special rights

Tax treatmentTax treatmentTax treatmentTax treatment

• depends on the issuer municipal Treasury corporate

• depends on the issuer municipal Treasury corporate

municipal bond interestmunicipal bond interestmunicipal bond interestmunicipal bond interest

• exempt from federal income tax

• possibly exempt from state income tax if issuer & bondholder are in same

state

• exempt from federal income tax

• possibly exempt from state income tax if issuer & bondholder are in same

state

Treasury bond interestTreasury bond interestTreasury bond interestTreasury bond interest

• exempt from state income tax• exempt from state income tax

Corporate bond interestCorporate bond interestCorporate bond interestCorporate bond interest

• fully taxable• fully taxable

morefavorabletax treatment

lowerbefore-tax yield

tax treatment explainstax treatment explainstax treatment explainstax treatment explains

Treasuryyields

muniyields

Corpyields< <

example 1example 1example 1example 1

• 10 yr. municipal Baa bond, 6%

• 10 yr. corporate Baa bond, 8%

• tax rate 28%

• after tax yield?

muni = 6%

corporate = 8%(1-.28) = 5.76%

• 10 yr. municipal Baa bond, 6%

• 10 yr. corporate Baa bond, 8%

• tax rate 28%

• after tax yield?

muni = 6%

corporate = 8%(1-.28) = 5.76%

example 2example 2example 2example 2• 10 yr. municipal Baa bond, 6%

• tax rate 28%

• what corporate yield would make investors indifferent?

corp. yield (1-.28) = 6%

corp. yield = 8.33%

equivalent taxable yield

• 10 yr. municipal Baa bond, 6%

• tax rate 28%

• what corporate yield would make investors indifferent?

corp. yield (1-.28) = 6%

corp. yield = 8.33%

equivalent taxable yield

example 3example 3example 3example 3

• 10 yr. municipal Baa bond, 6%

• 10 yr. corporate Baa bond, 8%

• what tax rate makes investor indifferent?

8% (1- t) = 6%

t = 25%

• 10 yr. municipal Baa bond, 6%

• 10 yr. corporate Baa bond, 8%

• what tax rate makes investor indifferent?

8% (1- t) = 6%

t = 25%

impact of tax ratesimpact of tax ratesimpact of tax ratesimpact of tax rates

• higher tax brackets derive more benefit from muni’s

• changing tax rates will affect the corporate-municipal yield spread

• IRS rulings could make muni debt taxable

• higher tax brackets derive more benefit from muni’s

• changing tax rates will affect the corporate-municipal yield spread

• IRS rulings could make muni debt taxable