Money banking and the financial system 1e by hubbard and OBrien chapter 05

R. GLENN

HUBBARD
ANTHONY PATRICK

O’BRIEN
Money,
Banking, and
the Financial
System
© 2012 Pearson Education, Inc. Publishing as Prentice Hall


CHAPTER

5

The Risk Structure and Term
Structure of Interest Rates

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
5.1

Explain why bonds with the same maturity can have different interest rates

5.2

Explain why bonds with different maturities can have different interest rates

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

CHAPTER

5

The Risk Structure and Term
Structure of Interest Rates

WHY INVEST IN TREASURY BILLS IF THEIR INTEREST RATES ARE SO
LOW?
•In February 2010, Moody’s Investors Service hinted that large budget deficits
could affect the Aaa rating of government bonds.
•Also in 2010, Treasure bills offered very low interest rates, yet investors bought
them even though Treasury bonds offered much higher rates.
•In the corporate bond market, investors were also buying bonds with very low
yields.
•In this chapter, we study why these unusual situations occur.
•An Inside Look at Policy on page 148 describes the testimony before
Congress of rating agencies about the ratings of mortgage-backed securities.
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Key Issue and Question
Issue: During the financial crisis, the bond rating agencies were
criticized for having given high ratings to securities that proved to be
very risky.
Question: Should the government more closely regulate the credit
rating agencies?

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Learning
Objective
Explain why bonds with the same maturity can have different interest rates.
5.1

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Why might bonds that have the same maturities—for example, all the bonds
that will mature in 30 years—have different interest rates, or yields to maturity?
Four factors account for these differences:
•Risk
•Liquidity
•Information costs
•Taxation
Risk structure of interest rates The relationship among interest rates on
bonds that have different characteristics but the same maturity.

Default Risk
Bonds differ with respect to default risk (sometimes called credit risk), which
is the risk that the bond issuer will fail to make payments of interest or principal.

The Risk Structure of Interest Rates

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Default Risk
Bonds differ with respect to default risk (sometimes called credit risk), which
is the risk that the bond issuer will fail to make payments of interest or principal.
Measuring Default Risk
• The default risk premium on a bond is the difference between the interest
rate on the bond and the interest rate on a Treasury bond that has the same
maturity.
• Many investors rely on credit rating agencies to provide them with
information on the creditworthiness of corporations and governments that
issue bonds.
Bond rating A single statistic that summarizes a rating agency’s view of the
issuer’s likely ability to make the required payments on its bonds.
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Changes in Default Risk and in the Default Risk Premium

Determining Default Risk Premium in Yields
The initial default risk premium can be seen by comparing yields associated
with the prices P1T and P1C.
Because the price of the safer U.S. Treasury bond is greater than that of the
riskier corporate bond, we know that the yield on the corporate bond must be
greater than the yield on the Treasury bond to compensate investors for
bearing risk.
Figure 5.1 (1 of 2)

The Risk Structure of Interest Rates
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Changes in Default Risk and in the Default Risk Premium

Determining Default Risk Premium in Yields
As the default risk on corporate bonds increases, in panel (a), the demand for
corporate bonds shifts to the left.
In panel (b), the demand for Treasury bonds shifts to the right.
The price of corporate bonds falls to P2C, and the price of Treasury bonds rises
to P2T, so the yield on Treasury bonds falls relative to the yield on corporate
bonds. Therefore, the default risk premium has increased.•
Figure 5.1 (2 of 2)

The Risk Structure of Interest Rates
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Changes in Default Risk and in the Default Risk Premium

Rising Default Premiums during Recessions
The default premium typically rises during a recession.
For the 2001 recession, the figure shows a fairly typical pattern, with the
spread between the interest rate on corporate bonds and the interest rate on
Treasury bonds rising from about 2 percentage points before the recession to
more than 3 percentage points during the recession.
Figure 5.2 (1 of 2)

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Changes in Default Risk and in the Default Risk Premium

Rising Default Premiums during Recessions
For the 2007–2009 recession, the figure shows that the increase in the default
risk premium was much larger. It rose from less than 2 percentage points
before the recession began to more than 6 percentage points at the height of
the financial crises in the fall of 2008.•
Figure 5.2 (2 of 2)

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Making the Connection

Do Credit Rating Agencies Have a Conflict of Interest?
• John Moody began the modern bond rating business by publishing Moody’s
Analyses of Railroad Investments in 1909.
• By the 1920s, the work of rating agencies expanded to cover an increasing
number of industries.
• In the post-World War II period, prosperity diminished the role of rating
agencies, but by the late 1970s, recession, inflation, and government
regulations once again expanded the work of rating agencies.
• When the rating agencies began charging firms and governments—rather
than investors—for their services, a conflict of interest emerged.
• During the financial crisis, rating agencies came under increased scrutiny. In
July 2010, Congress passed the Dodd-Frank Wall Street Reform and
Consumer Protection Act, and a new Office of Credit Ratings was created
within the Securities and Exchange Commission (SEC) to oversee the work
of credit rating agencies.
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Liquidity and Information Costs
• Investors care about liquidity, so they are willing to accept a lower
interest rate on more liquid investments than on less liquid—or illiquid—

investments, all other things being equal.
• Similarly, investors care about the costs of acquiring information on a
bond.
• An increase in a bond’s liquidity or a decrease in the cost of acquiring
information about the bond will increase the demand for the bond.
• During the financial crisis of 2007–2009, homeowners were defaulting
on many of the mortgages contained in the bonds. To make matters
worse, investors came to realize that they did not fully understand these
bonds and had difficulty finding information contained in the mortgagebacked bonds.

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Tax Treatment
• Investors care about the after-tax return on their investments—that is, the
return the investors have left after paying their taxes.
How the Tax Treatment of Bonds Differs
Municipal bonds Bonds issued by state and local governments.

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How the Tax Treatment of Bonds Differs
• The coupons on corporate bonds can be subject to federal, state, and

local taxes. The coupons on Treasury bonds are subject to federal tax
but not to state or local taxes. The coupons on municipal bonds are
typically not subject to federal, state, or local taxes.
• It is important to recall that bond investors can receive two types of
income from owning bonds:
(1) interest income from coupons and
(2) capital gains (or losses) from price changes on the bonds.
• Interest income is taxed at the same rates as wage and salary income.
Capital gains are taxed at a lower rate than interest income. Capital
gains are also taxed only if they are realized, which means that the
investor sells the bond for a higher price than he or she paid for it.
Unrealized capital gains are not taxed.
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The Effect of Tax Changes on Interest Rates

The Effect of Changes in Taxes on Bond Prices
If the federal income tax rate increases, tax-exempt municipal bonds will be more
attractive to investors, and Treasury bonds will be less attractive.
In panel (a), the demand curve for municipal bonds shifts to the right, from DMuni1
to DMuni2, increasing the price from PM1 to PM2 and lowering the interest rate.
In panel (b), the demand curve for Treasury bonds shifts to the left, from DTreas1 to
DTreas2, lowering the price from PT1 to PT2 and raising the interest rate.•

Figure 5.3

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Solved Problem

5.1

How Would a VAT Affect Interest Rates?
Suppose the federal government eliminates the federal income tax and
replaces it with a VAT. Explain the effect of this policy change on the
interest rates on municipal bonds, corporate bonds, and Treasury bonds.
Draw three graphs, one for each market, to illustrate your answer.

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Solved Problem

5.1

How Would a VAT Affect Interest Rates?
Solving the Problem
Step 1 Review the chapter material.
Step 2 Analyze the effect of the tax policy change on the interest rate on
municipal bonds.

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Solved Problem

5.1

How Would a VAT Affect Interest Rates?
Solving the Problem (continued)
Step 3 Analyze the effect of the tax
policy change on the interest
rate on corporate bonds.

Step 4 Analyze the effect of the tax
policy change on the interest
rate on Treasury bonds.

Step 5 Summarize your findings.
Replacing the federal income tax with a VAT would increase the interest rate on municipal
bonds and lower the interest rates on corporate bonds and Treasury bonds.
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Making the Connection

Is the U.S. Treasury Likely to Default on Its Bonds?
• Bonds issued by governments are called sovereign debt. Recent examples
of sovereign debt defaults include Russia and Argentina. In the nineteenth
century, many U.S. states also defaulted on their bonds. Circa 2010,
investors feared that several European countries might default on their debt.
• Investors typically consider U.S. Treasury bonds to be default-risk free, but
rating agencies worry that very large projected budget deficits will increase
the volume of Treasury bonds issued and that the resulting interest
payments will take an ever increasing fraction of the federal budget.
• Governments can raise taxes or create money to make the interest
payments, but these two alternatives can be painful.
• In 2010, investors in the United States and elsewhere didn’t seem to think
that the U.S. Treasury would default on its bonds because they were willing
to buy them at interest rates that were too low to include a default premium.
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Learning
Objective

Explain why bonds with different maturities can have different interest rates.
5.2

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Term structure of interest rates The relationship among the interest rates on
bonds that are otherwise similar but that have different maturities.

• The Treasury yield curve shows the relationship on a particular day among
the interest rates on Treasury bonds with different maturities.
• When short-term rates are lower than long-term rates, we have an upwardsloping yield curve.
• Infrequently, there are times when short-term interest rates are higher than
long-term interest rates, resulting in a downward-sloping yield curve.

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Figure 5.4

The Treasury Yield Curve
This figure shows the
Treasury yield curves for
June 22, 2009, and June
22, 2010.•

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