Financial Markets and Institutions (2-downloads)

(a) Market for municipal bonds

( b) Market for Treasury bonds

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F I G U R E   5 . 3

Interest Rates on Municipal and Treasury Bonds

When the municipal bond is given tax-free status, demand for the municipal bond shifts right-

ward from 

to 

and demand for the Treasury bond shifts leftward from 

to 

. The equi-

librium price of the municipal bond rises from 

to 

so its interest rate falls, while the

equilibrium price of the Treasury bond falls from 

to 

and its interest rate rises. The result is

that municipal bonds end up with lower interest rates than those on Treasury bonds.

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In contrast to corporate bonds, Treasury bonds are exempt from state and local income taxes.

Using the analysis in the text, you should be able to show that this feature of Treasury bonds provides

an additional reason why interest rates on corporate bonds are higher than those on Treasury bonds.

Another way of understanding why municipal bonds have lower interest rates

than Treasury bonds is to use the supply-and-demand analysis depicted in Figure 5.3.

We assume that municipal and Treasury bonds have identical attributes and so have

the same bond prices as drawn in the figure: 

and the same interest rates.

Once the municipal bonds are given a tax advantage that raises their after-tax

expected return relative to Treasury bonds and makes them more desirable,

demand for them rises, and their demand curve shifts to the right, from 

to 

.

The result is that their equilibrium bond price rises from 

to 

and their equi-

librium interest rate falls. By contrast, Treasury bonds have now become less desir-

able relative to municipal bonds; demand for Treasury bonds decreases, and 

shifts to 

. The Treasury bond price falls from 

to 

, and the interest rate rises.

The resulting lower interest rates for municipal bonds and higher interest rates

for Treasury bonds explain why municipal bonds can have interest rates below

those of Treasury bonds.

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Summary

The risk structure of interest rates (the relationship among interest rates on bonds

with the same maturity) is explained by three factors: default risk, liquidity, and

the income tax treatment of a bond’s interest payments. As a bond’s default risk

increases, the risk premium on that bond (the spread between its interest rate and

the interest rate on a default-free Treasury bond) rises. The greater liquidity of

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Term Structure of Interest Rates

We have seen how risk, liquidity, and tax considerations (collectively embedded in

the risk structure) can influence interest rates. Another factor that influences the

interest rate on a bond is its term to maturity: Bonds with identical risk, liquidity, and

tax characteristics may have different interest rates because the time remaining to

maturity is different. A plot of the yields on bonds with differing terms to maturity

but the same risk, liquidity, and tax considerations is called a yield curve, and it

describes the term structure of interest rates for particular types of bonds, such as

government bonds. The Following the Financial News box shows several yield curves

for Treasury securities that were published in the Wall Street Journal. Yield curves

can be classified as upward-sloping, flat, and downward-sloping (the last sort is often

referred to as an inverted yield curve). When yield curves slope upward, the most usual

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Part 2 Fundamentals of Financial Markets

Treasury bonds also explains why their interest rates are lower than interest rates on

less liquid bonds. If a bond has a favorable tax treatment, as do municipal bonds,

whose interest payments are exempt from federal income taxes, its interest rate

will be lower.

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