Financial Markets and Institutions (2-downloads)

premium, and an increase in its default risk will raise the risk premium.

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Chapter 5 How Do Risk and Term Structure Affect Interest Rates?

91

Quantity of Corporate Bonds

Quantity of Treasury Bonds

Price of Bonds, P

Price of Bonds, P

(a ) Corporate bond market

(b) Default-free (U.S. Treasury) bond market

Risk

Premium

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F I G U R E   5 . 2

Response to an Increase in Default Risk on Corporate Bonds

Initially 

and the risk premium is zero. An increase in default risk on corporate bonds shifts the demand

curve from 

to 

. Simultaneously, it shifts the demand curve for Treasury bonds from 

to 

. The equilib-

rium price for corporate bonds falls from 

to  , and the equilibrium interest rate on corporate bonds rises to

. In the Treasury market, the equilibrium bond price rises from 

to 

and the equilibrium interest rate falls

to  . The brace indicates the difference between 

and  , the risk premium on corporate bonds. (Note that

because 

is lower than  , 

is greater than  .)

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www.federalreserve.gov/

Releases/h15/update/

Study how the Federal

Reserve reports the yields

on different quality bonds.

Look at the bottom of 

the listing of interest 

rates for AAA- and 

BBB-rated bonds.

G O   O N L I N E

---

92

Part 2 Fundamentals of Financial Markets

Because default risk is so important to the size of the risk premium, purchasers

of bonds need to know whether a corporation is likely to default on its bonds. This

information is provided by credit-rating agencies, investment advisory firms that

rate the quality of corporate and municipal bonds in terms of the probability of

default. Table 5.1 provides the ratings and their description for the two largest credit-

rating agencies, Moody’s Investor Service and Standard and Poor’s Corporation.

Bonds with relatively low risk of default are called investment-grade securities and

have a rating of Baa (or BBB) and above. Bonds with ratings below Baa (or BBB)

have higher default risk and have been aptly dubbed speculative-grade or junk

bonds. Because these bonds always have higher interest rates than investment-grade

securities, they are also referred to as high-yield bonds.

Next let’s look at Figure 5.1 at the beginning of the chapter and see if we can

explain the relationship between interest rates on corporate and U.S. Treasury

bonds. Corporate bonds always have higher interest rates than U.S. Treasury bonds

because they always have some risk of default, whereas U.S. Treasury bonds do

not. Because Baa-rated corporate bonds have a greater default risk than the

higher-rated Aaa bonds, their risk premium is greater, and the Baa rate there-

fore always exceeds the Aaa rate. We can use the same analysis to explain the huge

jump in the risk premium on Baa corporate bond rates during the Great Depression

years 1930–1933 and the rise in the risk premium after 1970 (see Figure 5.1).

The depression period saw a very high rate of business failures and defaults. As

we would expect, these factors led to a substantial increase in the default risk

for bonds issued by vulnerable corporations, and the risk premium for Baa bonds

reached unprecedentedly high levels. Since 1970, we have again seen higher lev-

els of business failures and defaults, although they were still well below Great

Depression levels. Again, as expected, both default risks and risk premiums for

corporate bonds rose, widening the spread between interest rates on corporate

bonds and Treasury bonds.

TA B L E   5 . 1

Bond Ratings by Moody’s and Standard and Poor’s