week 25 Fixed-Income Securities and Interest Rates

Market Interest Rates

• Required return on a bond:

  • r = r* + IP + RP

    • Where:

      • r* = real rate of return

      • IP = inflation premium

      • RP = risk premium

  • r* + IP = r_f (risk-free rate)

• Risk premium addresses default (credit) risk, liquidity, and call risks.

• Risk-free rate accounts for interest rate and purchasing power risk.

Keeping Tabs on Market Interest Rates

• Bond market consists of different sectors:

  • U.S. Treasury, municipal, and corporate bonds.

• Yield spreads: interest rate differences between market sectors.

• Municipal bonds: 20-30% lower rates than corporate bonds due to tax exemption.

• Revenue bonds: higher rates than general obligation bonds due to higher risk.

• Treasury bonds: lower rates than corporate bonds due to no default risk and state income tax exemption.

• Lower credit rating = higher interest rate.

• Longer maturities generally = higher yields (not always).

• Freely callable bonds = higher interest rates.

Determinants of Interest Rates

• Inflation is a key variable affecting market interest rates.

• Other economic variables:

  • Money Supply: Slow increase (decrease rates), Slow decrease (increase rates), Fast increase (increase rates), Fast decrease (decrease rates)

  • Federal Budget: Deficit (increase rates), Surplus (decrease rates)

  • U.S. Economic Activity: Recession (decrease rates), Expansion (increase rates)

  • Federal Reserve Policies: Expansionary (decrease rates), Contractionary (increase rates)

Term Structure of Interest Rates and Yield Curves

• Term structure: relationship between interest rates (yield) and time to maturity for similar-risk securities.

• Yield curve: graph depicting this relationship.

• Types of Yield Curves:

  • Upward-sloping: yields increase with longer maturities (most common).

  • Inverted: short-term rates higher than long-term rates.

  • Flat: rates for short- and long-term debt are similar.

• Treasury securities are commonly used to construct yield curves (no default risk, actively traded, homogeneous).

Explanations of the Term Structure

• Expectations Hypothesis: Yield curve reflects investor expectations about future interest rates.

  • Upward sloping: Investors expect rates to increase.

  • Downward sloping: Investors expect rates to decrease.

• Liquidity Preference Theory: Long-term bond rates are higher due to added risks.

  • Long-term bonds are less liquid and have greater interest rate risk.

  • Borrowers pay a premium for long-term funds.

• Market Segmentation Theory: Market segmented by maturity preferences.

  • Yield curve shaped by supply and demand within each maturity segment.

  • Supply > Demand (short-term): short-term rates low.

  • Demand > Supply (long-term): long-term rates high.

Using the Yield Curve in Investment Decisions

• Analyze changes in yield curves to gain insights into future interest rate movements.

• Rising yield curve (increasing inflation): investors expect rising interest rates, favor shorter or intermediate maturities.

• Steep yield curves (bullish sign): aggressive investors move into long-term securities.

• Flatter yield curves: less incentive to move to long-term maturities.