2. Outlines
Why Debt Securities Yields Vary
Explaining Actual Yield Differentials
Estimating the Appropriate Yield
Term Structure of Interest Rates
3. Introduction
The annual interest rate offered by debt securities at a
given point in time varies among debt securities.
Debt securities offer different yields because they
exhibit different characteristics that influence the
yield to be offered.
In general, securities with unfavorable characteristics
will offer higher yields to entice investors.
Yields on debt securities are affected by the following
characteristics: (i) Credit risk; (ii) Liquidity; Tax status;
and (iv) Term of maturity.
4. Why Debt Securities Yields Vary
1. Credit (Default) Risk
If all other characteristics besides credit (default) risk are
equal, securities with a higher degree of risk will offer higher yields.
Rating Agencies
1.) Moody’s Investor Service
2.) Standard and Poor’s Corporation
The higher the rating, the lower the perceived credit risk
Accuracy of Credit Ratings
Enron Scandal in 2001
6. 2. Liquidity
The ease of conversion to cash without loss of value
The lower a securities liquidity, the higher the yield
preferred by investor
3. Tax Status
Investors are more concerned with after-tax income.
Taxable securities must offer a higher before-tax yield
7. To compute the equivalent Before-Tax Yield:
at bt (1 T )
where τat = After-tax yield
τbt = Before-tax yield
T = Investor’s marginal tax rate
8. 4. Term to Maturity
Maturity dates will
differ between debt
securities
The term structure of
interest rates defines
the relationship
between term to
maturity and the
annualized yield
9. Explaining Actual Yield Differentials
Explaining Actual Yield Differentials
Small differentials can be significant
Basis points (bp) are often quoted where 1bp =
.01% = .0001
10. Yield Differentials of Money Market Securities
Securities: commercial paper, certificates of
deposit, bankers acceptances.
Yields are just slightly higher than the risk-free T-bills
Yield Differentials of Capital Market Securities
Municipal bonds have lowest before-tax yield
Treasury bonds may have higher before-tax yield than
municipal bonds but have lowest after-tax yield
Corporate bonds may have highest yields
12. Estimating the Appropriate Yield
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
TA = adjustment due to difference in tax status
13. Example 1:
Suppose that the three-month Treasury bill’s
annualized rate is 8% and Elizabeth Company plan to
issue 90-day commercial paper.
Assume that Elizabeth Company believes that a 0.7%
default risk premium, a 0.2% liquidity premium and a
0.3% tax adjustment are necessary to sell its
commercial paper to investors.
Thus, the appropriate yield is
Yn = Rf,n + DP + LP + TA
= 8% + 0.7% + 0.2% + 0.3%
= 9.2%
14. Term Structure of Interest Rates
Pure Expectations Theory:
Term structure is determined solely by the expectations of
future rates.
Impact of an expected increase in interest rates:
- Leads to an upward sloping yield curve
Impact of an expected decline in interest rates:
- Leads to a downward sloping yield curve
The following figures show how interest rate expectations
affect the yield curve.
15.
16. Liquidity Premium Theory:
Investors prefer short-term rather than long-term
securities because a shorter maturity represents greater
liquidity.
However, they may be willing to invest in long-term
securities only if compensated with a premium for lower
liquidity.
Liquidity may be a more critical factor to investors at
particular points in time, and the liquidity premium will
change over time accordingly.
17. Impact of Liquidity Premium on the Yield Curve
under Three Different Scenarios
18. Segmented Markets Theory:
Investors choose securities with maturities that satisfy their
forecasted cash needs
Limitations of the theory:
Some borrowers and savers have the flexibility to choose
among various maturities
19. Integrating the Theories of
the Term Structure
If we assume the following conditions
Investors and borrowers currently expect interest rates to
rise. (E)
Most borrowers need long-term funds, while most
investors have only short-term funds to invest. (S)
Investors prefer more liquidity to less. (L)
Then all three conditions place upward pressure on long-
term yields relative to short term yields leading to upward
sloping yield curve
21. Use of the Term Structure
Forecast interest rates
Forecast recessions
Investment decision
22. Why the Slope of the Yield Curve
Changes
If interest rate at all maturities are affected in the same
manner by the existing conditions, the slope of the
yield curve would remain the same.
However, conditions may cause short-term yields to
change in a manner that differs from the change in
long-term yields.
