46Hubbard&OBrienMoney,Banking,andtheFinancialSystem,FirstEdition

Chapter5
TheRiskStructureandTermStructure
ofInterestRates
.1

Brief Chapter Summary and Learning Objectives

5.1

TheRiskStructureofInterestRates(pages124134)
Explainwhybondswiththesamematuritycanhavedifferentinterestrates.
Bondsthathavethesamematuritymaydifferwithrespecttoothercharacteristicsthatinvestors
believeareimportant,suchasrisk,liquidity,informationcosts,andtaxation.
Bondswithmorefavorablecharacteristicshavelowerinterestratesbecauseinvestorsarewilling
toacceptlowerexpectedreturnsonthosebonds.

5.2

TheTermStructureofInterestRates(pages135147)
Explainwhybondswithdifferentmaturitiescanhavedifferentinterestrates.
Theliquiditypremiumtheory,themostcompletetheoryofthetermstructure,holdsthatthe
interestrateonalongtermbondisanaverageoftheinterestratesinvestorsexpectonshortterm
bondsoverthelifetimeofthelongtermbond,plusatermpremiumthatincreasesinvaluethe
longerthematurityofthebond.
Theslopeoftheyieldcurveshowstheshortterminterestratesthatbondmarketparticipants
expectinthefutureandcanbeusedtohelpforecastinflationandeconomicactivity.

.2

Key Terms and Concepts

BondratingAsinglestatisticthatsummarizesa
ratingagencysviewoftheissuerslikelyability
tomaketherequiredpaymentsonitsbonds.
Defaultrisk(orcreditrisk)Theriskthatthebond
issuerwillfailtomakepaymentsofinterestor
principal.
ExpectationstheoryAtheoryoftheterm
structureofinterestratesthatholdsthatthe
interestrateonalongtermbondisanaverageof
theinterestratesinvestorsexpectonshortterm
bondsoverthelifetimeofthelongtermbond.
Liquiditypremiumtheory(orpreferredhabitat
theory)Atheoryofthetermstructureofinterest

MunicipalbondsBondsissuedbystateandlocal
governments.
RiskstructureofinterestratesTherelationship
amonginterestratesonbondsthathavedifferent
characteristicsbutthesamematurity.
SegmentedmarketstheoryAtheoryoftheterm
structureofinterestratesthatholdsthatthe
interestrateonabondofaparticularmaturityis
determinedonlybythedemandandsupplyof
bondsofthatmaturity.
TermpremiumTheadditionalinterestinvestors
requireinordertobewillingtobuyalongterm
bondratherthanacomparablesequenceofshort

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47Hubbard&OBrienMoney,Banking,andtheFinancialSystem,FirstEdition

ratesthatholdsthattheinterestrateonalongterm
bondisanaverageoftheinterestratesinvestors
expectonshorttermbondsoverthelifetimeofthe
longtermbond,plusatermpremiumthatincreases
invaluethelongerthematurityofthebond.

termbonds.
TermstructureofinterestratesTherelationship
amongtheinterestratesonbondsthatareotherwise
similar,butthathavedifferentmaturities.

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Chapter5TheRiskStructureandTermStructureofInterestRates48

.3

Chapter Outline

WhyInvestinTreasuryBillsifTheirInterestRatesareSoLow?
ThethreelargestratingcreditratingagenciesareMoodysInvestorsService,Standard&PoorsCorporation,
andFitchRatings.TheU.S.governmentsprojectedlargebudgetdeficitscausedMoodystoannouncein
early2010thatthegovernmentsbondratingwouldbereduced.Table5.1onpage125summarizesthe
bondratingsforeachcreditagency.
5.1

The Risk Structure of Interest Rates (pages 124134)

LearningObjective:Explainwhybondswiththesamematuritycanhavedifferentinterestrates.
A. DefaultRisk
Bondswithahigherdefaultrisk,theriskthatthebondissuerwillfailtomakepaymentsofinterest
andprincipal,payhigherinterestrates.Thedefaultriskpremiumonabondisthedifference
betweentheinterestrateonthebondandtheinterestrateonaTreasurybondwiththesame
maturity.Anincreasedperceivedriskofdefaultleadstoadeclineinthedemandforabond,
resultinginalowerpriceandhigherinterestrate.Duringrecessions,investorsseeksafety,
leadingtoanincreaseinthedemandforU.S.Treasurybondsandadecreaseinthedemand
forcorporatebonds,resultinginahigherriskpremiumforcorporatebonds.

Teaching Tips
Attheheightofthefinancialcrisisinthefallof2008,thedefaultriskpremiumforbondsofcompanies
ratedBaabyMoodyssurpassed6%,higherthananytimesincethe1930s.Havestudentsdiscusshowthis
canbeusedasameasureoftheseverityofthefinancialcrisis(i.e.,difficultyofinvestmentgrade
corporationsinobtainingcredit).
B. LiquidityandInformationCosts
Anincreaseinabondsliquidityoradecreaseinthecostofacquiringinformationaboutthe
bondwillincreasethedemandforthebond,resultinginahigherpriceandalowerinterestrate.
C. TaxTreatment
Investorscareabouttheaftertaxreturnontheirinvestments;thatis,thereturntheinvestors
haveleftafterpayingtheirtaxes.Otherthingsequal,abondthatisnotsubjecttotaxespaysa
lowerinterestratethanonethatistaxable.Thecouponsonmunicipalbondsaretypicallynot
subjecttofederal,state,orlocaltaxes.ThecouponsonTreasurybondsaresubjecttofederaltax,
butnottostateorlocaltaxes.Thecouponsoncorporatebondscanbesubjecttofederal,state,
andlocaltaxes.
5.2

The Term Structure of Interest Rates (pages 135147)

LearningObjective:Explainwhybondswithdifferentmaturitiescanhavedifferentinterestrates.
A. ExplainingtheTermStructure
OnewaytoanalyzethetermstructureisbylookingattheTreasuryyieldcurve,whichisthe
relationshiponaparticulardayamongtheinterestratesonTreasurybondsofdifferentmaturities.
SeeFigure5.4onpage135fortheTreasuryyieldcurvefor2009and2010.Anyexplanationof
thetermstructureshouldbeabletoaccountforthreeimportantfacts:
Interestratesonlongtermbondsareusuallyhigherthaninterestratesonshorttermbonds.
Interestratesonshorttermbondsareoccasionallyhigherthaninterestratesonlongterm
bonds.
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49Hubbard&OBrienMoney,Banking,andtheFinancialSystem,FirstEdition

Interestratesonbondsofallmaturitiestendtoriseandfalltogether.

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Chapter5TheRiskStructureandTermStructureofInterestRates50

B. TheExpectationsTheoryoftheTermStructure
Theexpectationstheoryholdsthattheinterestratesonalongtermbondisanaverageoftheinterest
ratesinvestorsexpectonshorttermbondsoverthelifetimeofthelongtermbond.Sinceinterest
ratesonlongtermbondsareusuallyhigherthaninterestratesonshorttermbonds,theexpectations
theoryimpliesthatfutureshorttermratesaretypicallyexpectedtoriseatanyparticularpointin
time,whichisunrealistic.
C. TheSegmentedMarketsTheoryoftheTermStructure
Thesegmentedmarketstheoryassumesbondsofdifferentmaturityareinseparatemarkets.
FactorsthataffectthedemandforTreasurybillsorothershorttermbondswillhavenoeffect
onthedemandforTreasurybondsorotherlongtermbonds.Sincelongtermbondscarryhigher
interestrateriskandtendtobelessliquid,investorsneedtobecompensatedbyreceivinghigher
interestratesonlongtermbondsthanonshorttermbonds.Thesegmentedmarketstheoryfails
toexplainwhyshortterminterestratesaresometimeshigherthanlongterminterestratesas
wellaswhyinterestratestendtomovetogether.
D. TheLiquidityPremiumTheory
Theliquiditypremiumtheoryholdsthattheinterestrateonalongtermbondisanaverageof
theinterestratesinvestorsexpectonshorttermbondsoverthelifetimeofthelongtermbond,
plusatermpremiumthatincreasesinvaluethelongerthematurityofthebond.
E. UsingtheTermStructuretoForecastEconomicVariables
Theslopeoftheyieldcurveshowstheshortterminterestratesthatbondmarketparticipants
expectinthefuture.Iffluctuationsinexpectedrealinterestratesaresmall,theyieldcurve
containsexpectationsoffutureinflationrates.Theyieldcurvecanalsoindicatelikelyfuture
economicactivity.Withonlyoneexception,everytimetheyieldonthe3monthbillwas
higherthantheyieldonthe10yearnote,arecessionfollowedwithinayear.
Table5.4onpage145summarizesandcomparesthethreetheoriesoftermstructureofinterest
rates:expectationstheory,segmentedmarketstheory,andliquiditypremiumtheory.

Teaching Tips
Inthesummerof2010,somecommentatorsexpressedfearofrapidlyincreasinginflationinthenextfew
years.Meanwhile,interestratesarelongtermbonds,suchasthefiveyearandtenyearTreasurybonds,
wereabout1.5%and3%,respectively.Havestudentsdiscusswhatthisimpliesaboutthebondmarkets
viewoffutureinflation.Arelowinterestratesonbondsconsistentwithexpectationsofrapidlyincreasing
inflation?

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51Hubbard&OBrienMoney,Banking,andtheFinancialSystem,FirstEdition

.4

Solutions to the End-of-Chapter Questions and Problems

Answers to Thinking Critically Questions

1.

Thedowngradingofthecreditratingsincreasedthedefaultriskontheaffectedsecurities.Information
costswerealsoaffected;solongastheratingagenciesarepaidfortheirservicesbythefirmsthat
issuesecurities,investorsarelikelytospendmoreresourcesevaluatingsecuritiesratherthanto
simplytrusttheratings.Bondyieldsriseasdefaultriskandinformationcostsrise.

2.

Althoughtheconflictofinterestwasinplaceinthe1970s,itwasnotuntilthe2000sthatthepopularity
ofcreditratingsofmortgagebackedsecuritiesbecamewidespread.Thesesecuritiesweremore
difficulttoevaluatethantraditionalbonds.Thereweresubstantialfinancialrewardsforgranting
thesecuritiesinvestmentgraderatings.Ratherthandevelopnew,moreaccurateratingsmodels,
firmssuccumbedtothepressuretogivetheirclientstheratingstheywanted.

5.1 The Risk Structure of Interest Rates

Learningobjective:Explainwhybondswiththesamematuritycanhavedifferentinterestrates.
Review Questions
1.1

Theriskstructureofinterestratesistherelationshipamongtheinterestratesonbondsthathave
differentcharacteristicsbutthesamematurity.Thedifferencesbetweeninterestratesamong
bondswiththesamematuritiesexistsbecauseofdifferentdefaultrisk,liquidity,information
costs,andtaxation.

1.2

Defaultriskistheriskthatthebondissuerwillfailtomakepaymentsofinterestandprincipal.
Thedefaultriskismeasuredasthedifferencebetweentheinterestrateonthebondandthe
interestrateonaU.S.Treasurybondwiththesamematurity.

1.3

Abondissuerscreditworthinessistheprojectedratingofacompanysoragovernments
abilitytopayoffthebond.Abondratingisaratingassignedtoacompanyoragovernment
thatratesitscreditworthiness.ThemajorcreditratingagenciesareMoodysInvestorsService,
StandardandPoorsCorporation,andFitchRatings.

1.4

Whenacompanysratingislowered,thereislessdemandforthebond,shiftingthedemand
curvetotheleft.Thislowerspriceandincreasestheyield.

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Chapter5TheRiskStructureandTermStructureofInterestRates52

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53Hubbard&OBrienMoney,Banking,andtheFinancialSystem,FirstEdition

1.5 Investorsfavorliquidity,soabondthatisnotliquidwouldhavelessdemandcomparedto
anequivalentbondwithmoreliquidity.Thiswouldmeanalowerpricefortheilliquidbondand
ahigheryield.Abondwithhighinformationcostswouldhavelowerdemandthananequivalent
bondthathaslowerinformationcosts.Investorsfavorfullinformation,sothiswouldpushthe
priceofthehighinformationcostbonddownandtheyieldup.
1.6

Interestincomefromcouponsandcapitalgains/lossesfrompricechanges.Capitalgainsare
taxedattheincometaxrate(withinoneyear)andatalowerrate(capitalgainstax)ifheldfor
morethanoneyear.Couponpaymentsaretaxedattheincometaxrate.

1.7

ThebondissuedbyHoustonisamunicipalbondanditscouponsarenotsubjecttofederal,state,
orlocaltaxes.ThebondissuedbyGEisacorporatebondanditscouponsaresubjecttofederal
taxes,andtypicallytostateandlocaltaxes.ThecouponsoftheU.S.Treasurybondaresubject
tofederaltax,butnotstateorlocaltaxes.

Problems and Applications

1.8

a Obligationsreferstotheobligationthebondissuerhastopaythebondholder.
b. Creditriskistheriskofdefault.

1.9. a. Amunicipalbondisabondissuedbyastateorlocalgovernment.
b. Municipalbondshavedifferenttaxtreatmentsanddifferentwaysofmeasuringdefaultrisk.
1.10

TheprofitabilityofRepublicServices30yearsfromnowismoreuncertainthanitsprofitability
10yearsfromnow.

1.11

Thebondratingsmodelreliesontheratingagenciestoratebondsandtochargefirmsforthe
serviceofviewingthebondratings.Thiscreatesaconflictofinterestbecausealargefirmthat
paystheratingagenciesmayhavealargeinvestmentinacompanythattheratingagenciesare
supposedtodowngrade.Theratingagencies,becauseofthefeeforservicemodel,havean
incentivetoprovideratingsthattheircustomersthelargefirmswant.

1.12

Managersoffirmsmayhavemoreincentivetotakeriskthanthebondholderwoulddesire.The
managermayhaveabonustiedtoperformanceandmayvaluehigherriskthanthebondholder
values.Ratingagenciesbridgetheinformationasymmetrygapbetweeninvestorsandfirm
managers.

1.13

Taxingthecouponreducestheaftertaxcouponpaidtothebondpurchaser.Thismakesthebond
lessdesirable.Thiswouldreducethepriceandincreasetheyield.

1.14

Theriseinthetopmarginaltaxrateonthefederalpersonalincometaxwouldincreasethe
desirabilityofholdingmunicipalbonds.Asaresult,thedemandcurveformunicipalbonds
willshifttotheright,increasingtheirprice.ThetaxonincomefromU.S.Treasurybonds
willincrease.ThiswillcausethedemandcurveforU.S.Treasurybondstoshifttotheleft,
decreasingtheirprice.

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Chapter5TheRiskStructureandTermStructureofInterestRates54

1.15 a. Thepriceofthebondstumbledbecauseoftheriskofdefault.
b. BecausetheRomaniangovernmentcouldnottakestepstosolvetheirbudgetcrisis,theriskof
defaultontheirbondsincreased.
1.16

Withhigherbudgetdeficits,debtaccumulatesandthepotentialfordefaultincreases.Alower
ratingwouldlowerTreasurybondpricesandraiseyields.

1.17

AnincreaseinriskofdefaultwouldshiftdemandforTreasurybondstotheleftpushingprice
downandyieldup.

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55Hubbard&OBrienMoney,Banking,andtheFinancialSystem,FirstEdition

1.18 a. Junkstatusisalowcreditratingfromthecreditagencies.GreekdebtarebondsthatGreecesells
tofinanceitsbudgetdeficits.
b. Thespreadisthedifferenceinyield(6.71%)fromasafebond(Germany)andthebondin
question(Greece).Thespreadrepresentstheriskpremium.
1.19

Bobsbondwouldbebetterbecauseonlythe3%interestincomeistaxed,notthe4%capital
gain.Bobsaftertaxreturnwouldequal0.03(10.33)0.040.0601or6.01%.Juanitas
aftertaxreturnwouldequal0.08(10.33)0.0536or5.36%.

1.20

Thecoupononthestatebondwillnotbesubjecttotax,soitspretaxyieldwillalsobe8%.
Thepretaxyieldonthefederalperpetuityequals0.08/(10.396)0.1325or13.25%.

1.21

Ajunkbondisabondwithahighlevelofdefaultrisk.Theyieldsofjunkbondswillriseatthe
bottomofabusinesscyclebecauseoftheincreaseindefaultriskthataneconomicdownturn
brings.Theyieldswillfallastheeconomyrecoversanddefaultislesslikely.

5.2 The Term Structure of Interest Rates

Learningobjective:Explainwhybondswithdifferentmaturitiescanhavedifferentinterestrates.
Review Questions
2.1

Thetermstructureofinterestratesistherelationshipamongtheinterestratesonbondsthatare
otherwisesimilar,butdifferinmaturity.TheTreasuryyieldcurvegraphicallyillustratesthe
termstructureofinterestratesbyillustratingforaparticulardaytheinterestratesontreasury
bondsofdifferentmaturities.

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Chapter5TheRiskStructureandTermStructureofInterestRates56

2.2

Thethreekeyfactsaboutthetermstructureare1)interestratesonlongtermbondsareusually
higherthaninterestratesonshorttermbonds;2)interestratesonshorttermbondsareoccasionally
higherthaninterestratesonlongtermbonds;and3)interestratesonbondsofallmaturitiestend
toriseandfalltogether.

2.3

Thethreetheoriesofthetermstructureare:1)Segmentedmarkettheory:Holdsthatthemarket
forbondsofdifferentmaturitiesarecompletelyseparatedfromeachother.2)Liquiditypremium
theory:Holdsthatinterestratesonlongtermbondsareaveragesoftheexpectedinterestrateson
shorttermbondsplusatermpremium.3)Expectationstheory:Holdsthatinterestratesonlong
termbondsareanaverageoftheinterestratesinvestorsexpectonshorttermbondsoverthe
lifetimeofthelongtermbond.

Problems and Applications

2.4

Considerwhata$1investmentineachoptionwouldequalafterthreeyears:
Option(a)(1.08)(1.11)(1.07)$1.282
Option(b)(1.1)(1.1)(1.07)$1.295
Option(c)(1.085)31.277.
Option(b)offersthehighestreturn.

2.5

a.
b.
c.
d.

$1,000(1.064)$1262.48
$1,000(1.0553)(1.09)$1,279.92
$1,000(1.052)(1.07)(1.09)$1,285.85
$1,000(1.04)(1.065)(1.07)(1.09)$1,291.79.

Youshouldchooseoption(d).
2.6

2year:(34)/23.5%
3year:(345)/34%
4year:(3453)/43.75%

2.7

InvestorswouldbuyaTreasurybillinsteadofaTreasurybondbecauseofthepotentialdefault
risk(whichincreasesthelongerthematurity),thethreatofpricedepreciationifinterestrates
rise,andthedesireforliquidity.

2.8

Acarrytrade(interestcarrytrade)referstoborrowingatalowshortterminterestrateandusing
theborrowedfundstoinvestatahigherlongterminterestrate.Withtheexpectationstheory,the
averageoftheexpectedshortterminterestratesoverthelifeofthelongterminvestmentshould
beroughlyequaltotheinterestonthelongterminvestment,whichwouldwipeoutanypotential
profitsfromtheinterestcarrytrade.Moreover,ifinterestratesrisemorethanexpected,theprice
ofthelongterminvestmentwilldecline,andtheinvestorwillsufferacapitalloss.

2.9

TheTreasurywouldbesubjecttoborrowingrisk,inthataftertheshorttermbillshave
matured,theinterestonnewshorttermbillsmayhaverisen.Themuchhigherinterest
ratesonTreasurynotesandbondsarebecausethemarketexpectsfutureshortterm
interestratestorise.

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57Hubbard&OBrienMoney,Banking,andtheFinancialSystem,FirstEdition

2.10

Expectedrealinterestrate=nominalinterestrateminusexpectedinflationrate.The
nominalyieldis1%,theinflationrateisnegative2%,hencetheexpectedrealreturn
shouldbe1%.

2.11

InvestorsexpectedtheoneyearinterestrateonTreasurybillsintwoyearstobe2.33%.
TheyexpectedtheoneyearinterestrateonTreasurybillsinoneyeartobe1.4%.

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Chapter5TheRiskStructureandTermStructureofInterestRates58

2.12 a. Itwouldmatterbecauseinthepastinvertedyieldcurveshadveryhighshortterm
interestrates,whichhaveanegativeeffectoneconomicgrowth.Inthisperiodwhenthe
yieldcurveisinverted,shorttermratesarelow.
b. Thestructuralfallinthetermpremiumreferstothefallintheadditionalinterestan
investorrequirestopurchasealongtermbondratherthanashorttermbond.A
structuralfallinthetermpremiumwouldflattentheyieldcurveitself,independentof
anyeffectofanexpectedrecession.
c. No,ChairmanBernankesinterpretationwaswronginthesensethatasevererecession
startedDecemberof2007.
2.13. a. Aninvertedyieldcurve.
b. Becausethemarketmustexpectfutureshortterminterestratestofallandlongterm
bondsincludeatermpremium.
2.14

Thereisariskofdefault,buttreasurybondscomparedtoanyotherinvestmentarethe
safestpossibleasset.Othertypesofriskareaprobablecauseinthisarticleandinclude
interestraterisk,theriskofpricesfalling,andtheopportunitycostofbeinginbonds
whenothermarkets(equities)rally.

2.15

Theshortendoftheyieldcurveshiftsup,andthelongendoftheyieldcurveshifts
down,asshowninthegraphbelow.

2.16 Anupwardslopingyieldcurveimplieshealthyeconomicconditions.Accordingto
expectationstheory,anupwardslopingyieldcurveindicatesthatinvestorsexpect
interestratestorise.Theexpectationthatinterestrateswillrisemeansthatpeople
expectstrongereconomicconditions,andhencenorecession.
2.17 a. Proxymeansinplaceof.Generallyspeaking,thetwoyearTreasurynotemarketwill
reflectthecurrentthinkingabouteconomicconditions.Thiswillprovideevidencefor
whattheFederalReservewilldototheFedFundsrate.

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59Hubbard&OBrienMoney,Banking,andtheFinancialSystem,FirstEdition

b. BondtradersbidthepriceofbondstoadjusttowhattheexpectationoftheFedFunds

ratewillbe.Thiscreatesarbitrageprofitsbecauseastradersbuyandsellbondsbasedon
theexpectationsofwhattheFederalReservewilldo,theywillcapturethecapitalgains
whentheFederalReserveactuallymakesitsmove.

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Chapter5TheRiskStructureandTermStructureofInterestRates60

Data Exercises
D5.1

Shorttermrateswerehigherthanlongtermratesinthemid1970s,aswellastheearly
1980s.

D5.2 OnNovember24,2010,theyieldcurvehadasteepslopewiththeoneyear
Treasurybillyieldof0.25andthe30yearTreasurybondyieldof4.22.Concernsabout
inflationandgovernmentbudgetdeficitskeptexpectedfutureshortterminterestrates
relativelyhighpushingupcurrentlongtermrates.

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