Chapter 5

Factors Affecting Bond Yields and the Term Structure of Interest Rates

Introduction

We have spent a lot of time discussing the required yield (interest rate) on a bond. However there is an IMPORTANT point to remember: There is no single market yield. Every bond has its own yield. In this chapter, we learn about the factors that affect bond yields.

Two Ways to Get Money

1. Buy it: Earn it in productive activities (equity). 2. Rent it: An interest rate is the price of renting money (debt).

Like all other prices, interest rates reflect supply and demand.

That is, the supply and demand for renting money. There is an interest rate for each rental period.

Supply and Demand of Money

Interest rate (r)

S$

Why is D$ downward sloping? If r - less money demanded If r - more money demanded

D$
Quantity of money

U.S. Treasuries

Viewed as having zero default risk Largest and most liquid market Lowest rate (yield) Rate (yield) is the base or benchmark rate

Treasury yields

Minimum yield investors will accept Other bonds trade at spreads over the Treasury yield Examples of current U.S. Treasury rates

Bond Yield

All bond yields can be expressed as:

Bond yield = Base interest rate + Spread Bond yield = Base interest rate + Risk premium

Our first task is to understand the base rate (also called the benchmark rate) Then we move to the spread or risk premium.

Base Rate

Minimum rate an investor would ever accept for investing in non-Treasury securities.

It is measured as the YTM of a comparable on-the-run Treasury security.

Example: US Treasury yields on February 20, 2009:

1-Mo 0.19 3-Mo 0.27 6-Mo 0.48 1-Yr 0.64 2-Yr 0.96 3-Yr 1.30 5-Yr 1.81 10-Yr 2.78 30-Yr 3.56

Maturity Yield (%)

If you want to invest in a 10-year bond you would never accept less than a 2.78% yield.

Spread (Risk Premium)

Non-Treasury securities trade at a spread over a similar maturity Treasury security.

The spread is a risk premium that reflects the additional risks an investor faces by buying a bond riskier than a Treasury security. Basis points (difference in yields) [most important] Relative yield spread (% difference between yields) Yield ratio (one yield divided by another)

How do we measure spreads?

Example of Spreads

The current 10-year US Treasury Note yields 2.78%. A 10-year AAA rated corporate bond yields 4.96%. What is the spread on the AAA rated bonds?

Basis points: 4.96-2.78 = 2.18% or 218 bps Relative yield:

4.96 2.78 0.78% 2.78

Yield ratio:
4.96 1.78% 2.78

Factors Affecting Yield Spreads

Type of Issuer (market segments):

Different market segments (and sub-segments) have different ability to satisfy contractual obligations. e.g., Municipals, corporates, agencies, etc.

Factors Affecting Yield Spreads

Credit Worthiness of Issuer:

Spread between a Treasury and non-Treasury security that are identical in all respects except for credit quality is call a credit spread. Identical in all respects means identical in terms of embedded options, liquidity, taxability, etc. Otherwise the spread reflects the value of items other than default.

Factors Affecting Yield Spreads

Inclusion of Options (e.g., put and call provisions):

Callable bonds will have ________ spreads over Treasury rates. Putable bonds will have ________ spreads over Treasury rates.

Expected Liquidity of Issue:

Bonds with lower liquidity trade with higher yields because they are more difficult to sell quickly for a fair price (hence are more risky). Treasury securities have very high liquidity, although off-the-runs are less liquid than on-the-runs.

Financeability:

Treasury bonds can be used as collateral for loans. The more desirable a particular (usually on-the-run) T-bond is, the lower the rate the lender will charge for the loan.

Factors Affecting Yield Spreads

Term to Maturity:

Holding all other bond factors constant, the longer the time until maturity of the bond, the more risky (volatile) it will be when yields change. Coupon payments are taxable at federal and state level. Exception: Municipal bond interest is exempt at the federal level (and state level in some cases). This means municipal securities will pay lower coupon rate (why?)

Taxability of Interest:

Taxability of Bonds

To compare the yields on municipals with yields on taxable bonds, we need to look at after-tax yields:
after-tax yield = pretax yield (1 marginal tax rate)

Example:

A 10-year A-rated corporate bond has a yield of 5.26% and a 10-year A-rated municipal bond has a yield of 3.73%. If your federal tax rate is 35% which bond would you prefer? (assuming all other features of the bonds are equal). After-tax muni yield is 3.73%. After-tax corporate yield is 3.42% [= 5.26 (1 0.35)]

Answer:

Taxability of Bonds

We can also determine the yield that must be offered on a taxable bond to give the same after-tax yield as a tax-exempt issue. This is called the equivalent taxable yield:
tax-exempt yield equivalent taxable yield = 1 marginal tax rate

From the previous example, what taxable yield would offer the same after-tax yield as 3.73% at 35% tax rate:
3.73 5.74% 1 0.35

Term Structure of Interest Rates

The relationship between yield and maturity on bonds that are identical in every way except maturity. The term structure is an important tool in valuing bonds. A graphical representation of the term structure is called the yield curve.

Term Structure of Interest Rates

r
Flat Notice: (1) Term structure can change over time. (2) Short-term rates more volatile than long-term rates.

Downward sloping

Upward sloping (most common)

Maturity (term)

Where Do We Get A Yield Curve?

It may seem a logical first step to use the YTM from bonds of different maturities:
C C P 2 (1 y ) (1 y) C Face Value N (1 y) (1 y) N

However, YTM is accurate for yield curve construction only if:

Coupons can be reinvested at a rate equal to YTM.

Otherwise YTM is incorrect.

Getting Yields for Yield Curve

A bond is a portfolio of zero-coupon bonds:

C C P 2 (1 y1 ) (1 y2 ) C Face Value N (1 y N ) (1 y N ) N

If each coupon is sold as a zero-coupon bond, then each should be discounted at a different rate (reflecting the maturity of the cash flow)

1 year coupon should be discounted at 1-year rate. 2 year coupon should be discounted at 2-year rate. and so on.

Such rates are called spot rates.

These are rates on zero-coupon bonds.

Theoretical Spot Rate Curve

Treasury Bond valuation:

portfolios of zero coupon securities. Each cash flow should be discounted by the appropriate yield Cannot use yields on coupon bonds. Need a zero coupon yield curve.

There are no zero coupon Treasuries with maturities > 1 year so a curve must be constructed

Constructing the Spot Rate Curve

Which securities?

On the run Treasuries On the run and selected off the run Treasuries All Treasuries Treasury coupon strips

Must use increasingly rigorous methods as securities are added

What Characteristics Should Spot Rates Have?

Spot rates should reflect the required yield for a single cash flow (i.e., a single maturity).
Therefore,

bonds from which spot rates are determined ideally should have no intermediate cash flows. rates should reflect the pure supply and demand of loanable funds, not default risk.

Be default risk free:

Spot

Where do we get these rates?

From

risk-free zero-coupon bonds. The spot rate curve comes from risk-free zero-coupon rates.

Where Do We Get Risk-Free Zeros?

Treasury coupon strips (logical starting point!):

Coupons are stripped from the bond and sold off separately as individual zero-coupon bonds. Resulting securities are called STRIPS (Separate Trading of Registered Interest and Principal of Securities). Liquidity of strips is less than the liquidity of the original Treasury securities. Thus, yields on strips reflect a liquidity risk premium. Tax treatment of strips is different from that of original treasury securities. Accrued interest on strips is taxed.

Problems with strips:

Where Else Can We Get Risk-Free Zeros?

1.
2. 3.

On-the-run Treasury issues. On-the-run issues along with selected off-the-run Treasury issues. All Treasury coupon securities and bills.
The securities above are coupon paying bonds, not zero-coupon bonds! So we will need some techniques to create the spot (zero-coupon) yield curve from coupon-paying bonds. The resulting yield curve is called the theoretical spot rate curve.

On-The-Run Treasury Issues

We need to extract 60 spot (zero) rates from couponbearing Treasury bonds.

Why 60? There are 60 semi-annual coupon payments in 30 years. Complication: There are usually only 6 or so on-the-run Treasuries available. Construct par yield curve yield curve constructed from 6 couponbearing Treasuries assuming the bonds are priced at par (yield equal to the coupon rate). Use linear interpolation to fill in gaps. Convert the par yield curve to theoretical zero coupon curve using a technique called bootstrapping.

How do we estimate the remaining 54 yields?

1.

2.

Par Yield Curve Construction

Suppose we have par yields for two on-the-run Treasuries:

2-year: 6.0% 5-year: 6.6%

From these par yields we can interpolate the 2, 3, 3, 4, and 4 year par yields using the following formula:
Yield at longer maturity Yield at shorter maturity 6.6% 6.0% 0.10 Number of semi-annual periods between maturity points 6

Interpolated yields are:

2 -year: 6.00% + 0.10 = 6.10% 3-year: 6.10% + 0.10 = 6.20% 3-year: 6.20% + 0.10 = 6.30% 4-year: 6.30% + 0.10 = 6.40% 4-year: 6.40% + 0.10 = 6.50%

Problems With Interpolation

There are large gaps between the 5-year and 10-year bonds and 10-year and 30-year bonds.

Using such long distances between maturities can reduce the accuracy of interpolation.

On-the-runs may be special in that they are desirable as collateral for loans. This can distort yields. Solution?

In addition to the on-the-runs, use some selected off-the-run Treasuries to help fill in the gaps. Usually the 20 and 25-year off-the-runs are used.

Bootstrapping

Bootstrapping enables us to take (par) yields from coupon bonds and generate a spot yield curve. Bootstrapping uses the concept that a coupon-bearing bond is a portfolio of zero-coupon bonds and should be priced accordingly. Best illustrated by an example.

Example of Bootstrapping

Suppose we have the following on-the-run Treasury securities (coupons paid semi-annually):
Bond A B C D Maturity (in years) 0.50 1.00 1.50 2.00 Yield/ Coupon Rate 5.25 5.50 5.75 6.00
All bonds have a face value of $100. The first 2 bonds are zero coupon bonds (why?).

Our goal: Extract zero-coupon yields.

Bond A B C D

Solution

Maturity (in years) 0.50 1.00 1.50 2.00

Yield/ Coupon Rate 5.25 5.50 5.75 6.00

Since the first 2 bonds are zero-coupon bonds (i.e., T-bills) their par rates are spot rates. The next spot rate we need is the 1 year rate:

Since it has a 5.75% coupon rate, the coupon on this bond should be $2.875 every six months. The value of this bond is $100 since it is based on par yields.

$100 $100

2.875 2.875 102.875 2 (1 z1 ) (1 z2 ) (1 z3 )3

2.875 2.875 102.875 (1.02625) (1.0275) 2 (1 z3 )3

Solving for z3 we get: 0.028798

Double the yield to get an annual spot yield: 0.0576 (or 5.76%).

Bond A B C D

Solution

Maturity (in years) 0.50 1.00 1.50 2.00

Yield/ Coupon Rate 5.25 5.50 5.76 6.00

Now we find the spot yield for the 2-year maturity:

Since it has a 6.0% coupon rate, the coupon on this bond should be $3.00 every six months. So, we can now find z4:

$100 $100

3.00 3.00 3.00 103.00 (1 z1 ) (1 z2 ) 2 (1 z3 )3 (1 z4 ) 4

3.00 3.00 3.00 103.00 (1.02625) (1.0275) 2 (1028798)3 (1 z4 ) 4

Solving for z4 we get: 0.030095

Double the yield to get an annual spot yield: 0.062 (or 6.02%).

Comments On Bootstrapping

This process continues until the entire spot yield curve is constructed. The bootstrapped yields are yields the market would apply to zero-coupon Treasury bonds, if such securities existed.

All Treasury Securities

Using only on-the-run issues (even with selected off-therun issues) fails to recognize all the information contained in Treasury security prices. Some argue that all Treasury securities and T-bills should be used to construct the theoretical spot yield curve. If all securities are used, methodologies other than bootstrapping must be used because there may be more than one yield for each maturity:

The most common methodology is exponential spline fitting.

Revisiting the Theoretical Spot Curve

Lets return to the base rate in the formula:

Bond yield = Base interest rate + Spread

Earlier, we said the base rate came from the YTM of an on-the-run Treasury security.

We have to modify that explanation.

The base rate comes from the theoretical spot rate curve that we just learned to construct.

Example using theoretical spot rates (exhibit 5-7)

Period 1 2 3 4 Year 0.5 1 1.5 2 Cash Flow 5 5 5 5 Spot Rate (%) 5.25 5.5 5.76 6.02 PV of $1 at 0.974421 0.947188 0.918351 0.888156 PV of CF 4.872107 4.735942 4.591756 4.440782

5
6 7

2.5
3 3.5

5
5 5

6.28
6.55 6.82

0.856724
0.824206 0.790757

4.283619
4.12103 3.953783

8
9 10 11 12 13 14 15 16 17 18 19 20

4
4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 10

5
5 5 5 5 5 5 5 5 5 5 5 105

6.87
7.09 7.2 7.26 7.31 7.43 7.48 7.54 7.67 7.8 7.79 7.93 8.07

0.763256
0.730718 0.701952 0.675697 0.650028 0.622448 0.597889 0.573919 0.547625 0.521766 0.502665 0.477729 0.453268

3.81628
3.653589 3.509758 3.378483 3.250138 3.112238 2.989446 2.869594 2.738125 2.608831 2.513325 2.388643 47.59317

Theoretical Value = 115.4206

Forward Interest Rates

Borrowers and lenders often enter into agreements to make loans in the future. This creates a need for a forward interest rate.

Forward rates are interest rates implied by current spot rates of interest. A forward rate is often viewed as the markets consensus for future interest rates.

Example of Forward Rates

Consider the following zero rates:

Period (n) 1 2 3 4 5 Zero Rate z1 = 5.25 z2 = 5.50 z3 = 5.76 z4 = 6.02 z5 = 6.28

zT = The current T-period spot (zero) interest rate (i.e., annual interest rate that prevails from T0 to time T).

Forward Interest Rates

Period (n) 1 2 3 4 5

Spot Rate z1 = 5.25 z2 = 5.50 z3 = 5.76 z4 = 6.02 z5 = 6.28

Consider the following two strategies: (1) Invest $100 at 2.75% for 1 year (i.e., 2 six-month periods:

$100(1.0275)2 = $105.5756.

(2) Invest $100 at 2.625% for 6 months and then reinvest the funds for 6 more months at the prevailing rate:

At the end of 6 months we would have: $100(1.02625) = $102.625 At the end of 1 year we would have: $102.625(1 + f) = ?

These must be equal

We dont know what f is (its a forward rate). However

100(1.0275)2 = 100(1.02625)(1 + f):

Solving for f we get: f = 2.875% To annualize, multiply: 5.75%

5.75% is the markets consensus for the six-month rate six months from now.

How to use the forward rate

If the six-month rate six months from now is less (greater) than 5.75%, then the total dollars at the end of one year would be higher (lower) by investing in the one-year instrument.

Forward rates cont

In general:

(1 zt 1 )t 1 ft 1 t (1 zt )

where ft is the 6-month forward rate beginning t 6-month periods from now.

Generalizing Our Result

The relationship between the t-period spot rate, current six-month spot rate, and the six-month forward rates is:
(1 zt )t (1 z1 )(1 f1 )(1 f 2 ) (1 f t 1 )

zt t (1 z1 )(1 f1 )(1 f 2 )
t=0 t=1 t=2

(1 ft 1 ) 1
t=3 t=4

where ft is the 6-month forward rate beginning t 6-month periods from now.

z1

f1

f2

f3

Example

Suppose we have the following rates:

z1 = 0.0250 f1 = 0.0237 f2 = 0.0255 f3 = 0.0262 We can see how the 2-year spot rate is related to the various sixmonth forward rates:

z4 [(1.0250)(1.0237)(1.0255)(1.0262)]1/ 4 1 0.0251 (or 5.02%)

Calculating forward rates

Invest $100 in each strategy Alternative 1 payoff at end of year

$100(1 + z2)2 $100(1 + z1)(1+f) $100 (1 + z2)2 = $100(1 + z1)(1+f) f = ((1 + z2)2 /(1 + z1)) -1

Alternative 2 payoff at end of year

Investors are indifferent if:

Theories of the Term Structure

If we plot the yield curve, what will it look like? Typical patterns are:

Upward sloping (called normal or positive yield curve) Downward sloping (called inverted yield curve) Flat

We want a theory that explains two things:

What explains the shape of the yield curve? What explains two empirical regularities we observe:

1. Most of the time the yield curve is upward sloping. 2. Sometimes the yield curve is downward sloping

Expectations-Based Theories

Expectations Theories:

Three theories: (1) pure, (2) liquidity, (3) preferred habitat Assume that forward rates are related to the markets expectations about future short-term rates. The various theories differ in whether other factors also affect forward rates.

Market Segmentation Theory.

Pure Expectations Theory

Under the Pure Expectations Theory, forward rates equal expected future spot rates. [ft = E(zt)] Thus, the yield curve reflects the markets current expectations of future short-term rates:

Rising yield curve market expects ST rates to rise in the future. Flat yield curve market expects rates to be mostly constant. Declining yield curve market expects ST rates to decline.

The shape of the yield curve results from bond prices adjusting to investor expectations about the future level of interest rates.

Example of How Expectations Affect Shape of Yield Curve

Suppose the yield curve is flat at 5% and investors expect interest rates to increase over the next year to 7%. An investor with a two-year horizon would weigh two investing strategies:
1.
2.

Buy a two-year bond and hold it for two years (earning 5%) Buy a one-year bond now and a 7% bond in one year (earning about 6% over two years) 1-year bond prices would increase, pushing down 1-year yields. 2-year bond prices would decline, pushing up 2-year yields. The yield curve would go from flat to upward sloping.

Investors would choose alternative #2 and ignore #1:

Strengths and Weaknesses of PET

Strengths:

PET is consistent with the observation that yields tend to move together in the yield curve.

Weaknesses:

PET does not explain the persistent upward slope of the yield curve. Risk factors are ignored in PET, but seem to play a role in shaping the yield curve.

What risk factors are ignored by PET?

Reinvestment risk Price risk Liquidity (term) risk.

Liquidity Theory

Investors are averse to risk. LTB > STB, so investors demand the less volatile ST bonds unless compensated for buying LT bonds. Therefore, liquidity theory says investors must be paid a risk premium for investing in LT bonds:

And, the risk premium rises uniformly with maturity. LT bond yields > ST bond yields and the yield curve will be upward sloping.

Strength of Liquidity Theory:

Consistent with the persistent positive slope of the yield curve.

Preferred Habitat Theory

Suggests that different investors have a different maturity preference for investing in bonds.

e.g., Insurance companies prefer to invest in long-term bonds whereas banks prefer shorter-term instruments.

However, investors will leave their maturity habitat if compensated (i.e., paid a risk premium) for doing so. Firms issuing bonds in an undesirable maturity range will have to offer a risk premium to attract investors. Shape of yield curve is based on expectations as well as risk premiums offered in different maturity habitats.

Market Segmentation Theory

Similar to the Preferred Habitat Theory except investors are not willing to leave their preferred maturity segment. Each maturity segment of the yield curve has its own supply and demand for funds that is not related to any other segment.

Reality

What are the main influences of the shape of the Treasury yield curve? Research shows there are three main influences:

Expectations of future interest rate changes. Bond risk premiumsdemand for long-term bonds pushes up prices and reduces yields relative to what we would expect from expectations alone. Convexity biasattractive convexity properties of LT bonds pushes LT bond prices up (and yields down) relative to a pure expectations driven yield curve.