Financial Markets and Institutions (2-downloads)

State and Local Government

(Municipal)

U.S. Government

Long-Term Bonds

Corporate Baa Bonds

Annual

 Yield (%)

Corporate Aaa Bonds

1940

1930

1920

F I G U R E   5 . 1

Long-Term Bond Yields, 1919–2010

Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970;

Federal Reserve: 

www.federalreserve.gov/releases/h15/data.htm

.

In addition, the spread between the interest rates on Baa corporate bonds (riskier than

Aaa corporate bonds) and U.S. government bonds is very large during the Great

Depression years 1930–1933, is smaller during the 1940s–1960s, and then widens again

afterward. Which factors are responsible for these phenomena?

Default Risk

One attribute of a bond that influences its interest rate is its risk of default, which

occurs when the issuer of the bond is unable or unwilling to make interest payments

when promised or pay off the face value when the bond matures. A corporation suf-

fering big losses, such as the major airline companies like United, Delta, US Airways,

and Northwest in the mid-2000s, might be more likely to suspend interest payments

on its bonds. The default risk on its bonds would therefore be quite high. By contrast,

U.S. Treasury bonds have usually been considered to have no default risk because

the federal government can always increase taxes to pay off its obligations. Bonds

like these with no default risk are called default-free bonds. The spread between

the interest rates on bonds with default risk and default-free bonds, both of the same

maturity, called the risk premium, indicates how much additional interest people

must earn to be willing to hold that risky bond. Our supply-and-demand analysis of

the bond market in Chapter 4 can be used to explain why a bond with default risk

always has a positive risk premium and why the higher the default risk is, the larger

the risk premium will be.

To examine the effect of default risk on interest rates, let us look at the supply-

and-demand diagrams for the default-free (U.S. Treasury) and corporate long-term

bond markets in Figure 5.2. To make the diagrams somewhat easier to read, let’s

assume that initially corporate bonds have the same default risk as U.S. Treasury

bonds. In this case, these two bonds have the same attributes (identical risk and

---

maturity); their equilibrium prices and interest rates will initially be equal (

and 

), and the risk premium on corporate bonds (

) will be zero.

If the possibility of a default increases because a corporation begins to suffer large

losses, the default risk on corporate bonds will increase, and the expected return

on these bonds will decrease. In addition, the corporate bond’s return will be more

uncertain. The theory of asset demand predicts that because the expected return

on the corporate bond falls relative to the expected return on the default-free

Treasury bond while its relative riskiness rises, the corporate bond is less desirable

(holding everything else equal), and demand for it will fall. Another way of think-

ing about this is that if you were an investor, you would want to hold (demand) a

smaller amount of corporate bonds. The demand curve for corporate bonds in panel

(a) of Figure 5.2 then shifts to the left, from 

to 

At the same time, the expected return on default-free Treasury bonds increases

relative to the expected return on corporate bonds, while their relative riskiness

declines. The Treasury bonds thus become more desirable, and demand rises, as

shown in panel (b) by the rightward shift in the demand curve for these bonds

from to .

As we can see in Figure 5.2, the equilibrium price for corporate bonds falls from 

to 

, and since the bond price is negatively related to the interest rate, the equilibrium

interest rate on corporate bonds rises to  . At the same time, however, the equilibrium

price for the Treasury bonds rises from 

to 

, and the equilibrium interest rate

falls to  . The spread between the interest rates on corporate and default-free bonds—

that is, the risk premium on corporate bonds—has risen from zero to 

–  . We can

now conclude that a bond with default risk will always have a positive risk