1 Chapter 3 Structure of Interest Rates Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline  Characteristics of debt securities that cause their yields to vary  Explaining actual yield differentials  Estimating the appropriate yield  A closer look at the term structure  International structure of interest rates 3 Characteristics of Debt Securities  Credit (default) risk  Securities with a higher degree of risk have to offer higher yields to be chosen  Credit risk is especially relevant for longer-term securities  Investors must consider the creditworthiness of the security issuer  Can use bond ratings of rating agencies  The higher the rating, the lower the perceived credit risk  Ratings can change over time as economic conditions change  Ratings for different bond issues by the same issuer can vary 4 Characteristics of Debt Securities (cont’d)  Credit (default) risk (cont’d)  Rating agencies  Moody’s Investor Service and Standard and Poor’s Corporation are the most popular  Agencies use different methods to assess the creditworthiness of firms and state governments  A particular bond issue could have different ratings from each agency, but differences are usually small  Financial institutions may be required to invest only in investment-grade bonds rated Baa or better by Moody’s and BBB or better by Standard and Poor’s 5 Characteristics of Debt Securities (cont’d)  Ratings Assigned by: Description of Security Moody’s Standard and Poor’s Highest quality Aaa AAA High quality Aa AA High-medium quality A A Medium quality Baa BBB Medium-low quality Ba BB Low quality (speculative) B B Poor quality Caa CCC Very poor quality Ca CC Lowest quality (in default) C DDD, D 6 Characteristics of Debt Securities (cont’d)  Credit (default) risk (cont’d)  Shifts in credit risk premiums  The risk premium corresponding to a particular bond rating can chance over time  Accuracy of credit ratings  In general, credit ratings have served as reasonable indicators of the likelihood of default  Credit rating agencies do not always detect financial problems of firms 7 Characteristics of Debt Securities (cont’d)  Liquidity  Liquid securities can be easily converted to cash without a loss in value  Short-maturity securities with an active secondary market are liquid  Securities with lower liquidity have to offer a higher yield to be preferred 8 Characteristics of Debt Securities (cont’d)  Tax status  Investors are more concerned with after-tax income than before-tax income  Taxable securities have to offer a higher before-tax yield to be preferred  The after-tax yield is equal to: )1( TYY btat −= 9 Characteristics of Debt Securities (cont’d)  Tax status  Computing the equivalent before-tax yield  The before-tax yield necessary to match the after-tax yield on a tax-exempt security is:  State taxes should be considered along with federal taxes )1( T Y Y at bt − = 10 Computing the Equivalent Before-Tax Yield Assume a firm in the 30 percent tax bracket is aware of a tax-exempt security that pays a yield of 9 percent. To match this after-tax yield, taxable securities (with similar maturity and risk) must offer a before-tax yield of: %86.12 )3.1( %9 )1( = − = − = T Y Y at bt