■ describe how characteristics of debt securities cause their yields to vary - PowerPoint Presentation

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■ describe how characteristics of debt securities cause their yields to vary■ demonstrate how to estimate the appropriate yield for any particular debt security■ explain the theories behind the term structure of interest rates (relationship between the term to maturity and the yield of securities)

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Chapter Objectives

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Structure of Interest RatesSlide2

Why Debt Security Yields VaryThe yields on debt securities are affected by:Credit (default) riskLiquidityTax statusTerm to maturity

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Why Debt Security Yields VaryCredit (default) RiskInvestors must consider the creditworthiness of the security issuer.All else being equal, securities with a higher degree of default risk must offer higher yields.

Especially relevant for longer term securities.

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Why Debt Security Yields VaryCredit (default) Risk (cont.)In general, securities with a higher degree of default risk offer higher yields.Rating Agencies - Rating agencies charge the issuers of debt securities a fee for assessing default risk. (Exhibit 3.1).

Accuracy of Credit Ratings - The ratings issued by the agencies are useful indicators of default risk but they are opinions, not guarantees.

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.4Slide5

Exhibit 3.1 Rating Classification by Rating Agencies5Slide6

Why Debt Security Yields VaryLiquidityThe lower a security’s liquidity, the higher the yield preferred by an investor.Debt securities with a short-term maturity or an active secondary market have greater liquidity.

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Why Debt Security Yields VaryTax Status (Exhibit 3.2)Investors are more concerned with after-tax income.

Taxable securities must offer a higher before-tax yield.7Slide8

Exhibit 3.2 After-Tax Yields Based on Various Tax Rates and Before-Tax Yields8Slide9

Why Debt Security Yields VaryTax Status (cont.)Computing the Equivalent Before-Tax Yield: = after-tax yield

= before-tax yield

= Investor’s marginal tax rate 9Slide10

Tax examptTreasury bills (bonds, notes) are exempt from state and local income taxes.Municipal bonds are exempt from federal tax.In most states, interest income received from securities issued by governmental units within the state is also exempt from state and local taxes.

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Why Debt Security Yields VaryTerm to Maturity (Exhibit 3.3) Maturity dates will differ between debt securities.The term structure of interest rates defines the relationship between term to maturity and the annualized yield.

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Exhibit 3.3 Example of Relationship between Maturity and Yield of Treasury Securities (as of March 2013)12Slide13

Explaining Actual Yield DifferentialsThe yield differential is the difference between the yield offered on a security and the yield on the risk-free rate.They are sometimes measured in basis points where 1bp = 0.01%

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Explaining Actual Yield DifferentialsYield Differentials on Money Market Securities Yields on commercial paper and negotiable CDs are only slightly higher than T-bill rates to compensate for lower liquidity and higher default risk.Market forces cause the yields on all securities to move in the same direction.

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Explaining Actual Yield DifferentialsYield Differentials on Capital Market SecuritiesTreasury bonds have the lowest yield because of their low default risk and high liquidity.

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Estimating the Appropriate YieldYn = R

f,n + DP + LP + TAwhere:

Yn = yield of an n-day debt securityRf,n

= yield of an n-day Treasury (risk-free) securityDP = default premium to compensate for credit risk

LP

= liquidity premium to compensate for less liquidity

TA

= adjustment due to difference in tax status

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A Closer Look at the Term StructurePure Expectations Theory: Term structure reflected in the shape of the yield curve is determined solely by the expectations of interest rates.Impact of an Expected Increase in Rates leads to an upward sloping yield curve Impact of an

expected Decline in Rates leads to a downward sloping yield curve.

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A Closer Look at the Term StructureLiquidity Premium Theory: Investors prefer short-term liquid securities but will be willing to invest in long-term securities if compensated with a premium for lower liquidity. (Exhibit 3.6)18Slide19

Exhibit 3.6 Impact of Liquidity Premium on the Yield Curve under Three Different Scenarios19Slide20

A Closer Look at the Term StructureSegmented Markets Theory: Investors choose securities with maturities that satisfy their forecasted cash needs.20Slide21

Integrating the Theories of the Term StructureIf we assume the following conditions:Investors and borrowers currently expect interest rates to rise. (expectation)Most borrowers need long-term funds, while most investors have only short-term funds to invest.(segment)

Investors prefer more liquidity to less. (liquidity)Then all three conditions place upward pressure on long-term yields relative to short term yields leading to upward sloping yield curve. (Exhibit 3.7)

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Exhibit 3.7 Effect of Conditions in Example of Yield Curve22Slide23

Integrating the Theories of the Term StructureUse of the Term StructureForecasting Interest RatesThe shape of the yield curve can be used to assess the general expectations of investors and borrowers about future interest rates.

The curve’s shape should provide a reasonable indication (especially once the liquidity premium effect is accounted for) of the market’s expectations about future interest rates.Forecasting Recessions

- Some analysts believe that flat or inverted yield curves indicate a recession in the near future.23Slide24

Integrating the Theories of the Term StructureUse of the Term Structure (cont.)Making Investment Decisions - If the yield curve is upward sloping, some investors may attempt to benefit from the higher yields on longer-term securities even though they have funds to invest for only a short period of time. (p. 67)

Making Decisions about Financing - Firms can estimate the rates to be paid on bonds with different maturities. This may enable them to determine the maturity of the bonds they issue.

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Exhibit 3.9 Yield Curves at Various Points in Time25Slide26

Spot rate vs. Forward rate1. Spot rate a rate quoted at current time2. Forward rate

a rate to be quoted at some point in the future26Slide27

How to find Forward rate?If you deposit for 1-year, the annual interest rate is 8%.If you deposit for 2-years, the annual interest rate is 9%.What is the expected annual interest rate for 1-year deposit one year from now?27Slide28

Another ExampleTwo-year bonds offer yield-to-maturity of 6%, and three-year bonds have yields of 7%. What is the1-year forward rate for the third year?Verify that the forward rate is 9.03%28Slide29

FormulaIn general, we obtain the forward rate by equating the return on an n-period zero-coupon bond with that of an (n – 1)-period zero-coupon bond rolled over into a one-year bond in year n:(1 + yn)n = (1 + yn-1)

n-1(1 + fn)

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More PracticeHow to find the forward rates?30Slide31

A Closer Look at the Term StructureResearch on the Term Structure TheoriesInterest rate expectations have a strong influence on the term structure of interest rates. However, the forward rate derived from a yield curve does not accurately predict future interest rates, and this suggests that other factors may be relevant.

General Research Implications - Although the results differ, there is evidence that expectations, liquidity premium, and segmented markets theories all have some validity.

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Homework Assignment 3Chapter 3: Problems 1, 2, 3, 4, 532