Financial Markets and Institutions (2-downloads)

Rating

Moody’s

Standard

and Poor’s

Descriptions

Examples of Corporations with 

Bonds Outstanding in 2010

Aaa

AAA

Highest quality (lowest

default risk)

Microsoft, Johnson & Johnson, 

Mobil Corp.

Aa

AA

High quality

Shell Oil, Abbott Laboratories, 

General Electric

A

A

Upper-medium grade

Bank of America, Hewlett-Packard,

McDonald’s, Inc.

Baa

BBB

Medium grade

Best Buy, FedEx, Harley Davidson

Ba

BB

Lower-medium grade

Charter Communications, Colonial 

Penn, US Steel Corp.

B

B

Speculative

Rite Aid, Ford Motors, Delta

Caa

CCC, CC

Poor (high default risk)

Blockbuster, Century Indemnity, 

Everspan Financial Guarantee

C

D

Highly speculative

Citation Corp.

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

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C A S E

The Subprime Collapse and the 

Baa-Treasury Spread

Starting in August 2007, the collapse of the subprime mortgage market led to large

losses in financial institutions (which we will discuss more extensively in Chapter 8).

As a consequence of the subprime collapse, many investors began to doubt the

financial health of corporations with low credit ratings such as Baa and even the

reliability of the ratings themselves. The perceived increase in default risk for

Baa bonds made them less desirable at any given interest rate, decreased the quan-

tity demanded, and shifted the demand curve for Baa bonds to the left. As shown

in panel (a) of Figure 5.2, the interest rate on Baa bonds should have risen, which

is indeed what happened. Interest rates on Baa bonds rose by 280 basis points

(2.80 percentage points) from 6.63% at the end of July 2007 to 9.43% at the most

virulent stage of the crisis in mid-October 2008. But the increase in perceived default

risk for Baa bonds after the subprime collapse made default-free U.S. Treasury bonds

relatively more attractive and shifted the demand curve for these securities to the

right—an outcome described by some analysts as a “flight to quality.” Just as our

analysis predicts in Figure 5.2, interest rates on Treasury bonds fell by 80 basis points,

from 4.78% at the end of July 2007 to 3.98% in mid-October 2008. The spread

between interest rates on Baa and Treasury bonds rose by 360 basis points from

1.85% before the crisis to 5.45% afterward.

Liquidity

Another attribute of a bond that influences its interest rate is its liquidity. As we

learned in Chapter 4, a liquid asset is one that can be quickly and cheaply converted

into cash if the need arises. The more liquid an asset is, the more desirable it is (hold-

ing everything else constant). U.S. Treasury bonds are the most liquid of all long-term

bonds, because they are so widely traded that they are the easiest to sell quickly

and the cost of selling them is low. Corporate bonds are not as liquid, because fewer

bonds for any one corporation are traded; thus, it can be costly to sell these bonds

in an emergency, because it might be hard to find buyers quickly.

How does the reduced liquidity of the corporate bonds affect their interest rates

relative to the interest rate on Treasury bonds? We can use supply-and-demand analy-

sis with the same figure that was used to analyze the effect of default risk, Figure 5.2,

to show that the lower liquidity of corporate bonds relative to Treasury bonds increases

the spread between the interest rates on these two bonds. Let us start the analysis

by assuming that initially corporate and Treasury bonds are equally liquid and all their

other attributes are the same. As shown in Figure 5.2, their equilibrium prices and

interest rates will initially be equal: 

= 

and 

= 

. If the corporate bond becomes

less liquid than the Treasury bond because it is less widely traded, then (as the the-

ory of asset demand indicates) demand for it will fall, shifting its demand curve from

to 

as in panel (a). The Treasury bond now becomes relatively more liquid in

comparison with the corporate bond, so its demand curve shifts rightward from

to 

as in panel (b). The shifts in the curves in Figure 5.2 show that the price

D

T

2

D

T

1

D

c

2

D

c

1

i

T

1

i

c

1

P

T

1

P

c

1

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94

Part 2 Fundamentals of Financial Markets

of the less liquid corporate bond falls and its interest rate rises, while the price of

the more liquid Treasury bond rises and its interest rate falls.

The result is that the spread between the interest rates on the two bond types

has increased. Therefore, the differences between interest rates on corporate bonds

and Treasury bonds (that is, the risk premiums) reflect not only the corporate bond’s

default risk but also its liquidity. This is why a risk premium is more accurately a “risk

and liquidity premium,” but convention dictates that it is called a risk premium.

Income Tax Considerations

Returning to Figure 5.1, we are still left with one puzzle—the behavior of munici-

pal bond rates. Municipal bonds are certainly not default-free: State and local gov-

ernments have defaulted on the municipal bonds they have issued in the past,

particularly during the Great Depression and even more recently in the case of

Orange County, California, in 1994 (more on this in Chapter 25). Also, municipal

bonds are not as liquid as U.S. Treasury bonds.

Why is it, then, that these bonds have had lower interest rates than U.S. Treasury

bonds for at least 40 years, as indicated in Figure 5.1? The explanation lies in the fact

that interest payments on municipal bonds are exempt from federal income taxes,

a factor that has the same effect on the demand for municipal bonds as an increase

in their expected return.

Let us imagine that you have a high enough income to put you in the 35% income

tax bracket, where for every extra dollar of income you have to pay 35 cents to the gov-

ernment. If you own a $1,000-face-value U.S. Treasury bond that sells for $1,000 and

has a coupon payment of $100, you get to keep only $65 of the payment after taxes.

Although the bond has a 10% interest rate, you actually earn only 6.5% after taxes.

Suppose, however, that you put your savings into a $1,000-face-value munici-

pal bond that sells for $1,000 and pays only $80 in coupon payments. Its interest

rate is only 8%, but because it is a tax-exempt security, you pay no taxes on the

$80 coupon payment, so you earn 8% after taxes. Clearly, you earn more on the

municipal bond after taxes, so you are willing to hold the riskier and less liquid munic-

ipal bond even though it has a lower interest rate than the U.S. Treasury bond. (This

was not true before World War II, when the tax-exempt status of municipal bonds did

not convey much of an advantage because income tax rates were extremely low.)

Suppose you had the opportunity to buy either a municipal bond or a corporate bond, both

of which have a face value and purchase price of $1,000. The municipal bond has coupon

payments of $60 and a coupon rate of 6%. The corporate bond has coupon payments

of $80 and an interest rate of 8%. Which bond would you choose to purchase, assum-

ing a 40% tax rate?

Solution

You would choose to purchase the municipal bond because it will earn you $60 in coupon

payments and an interest rate after taxes of 6%. Since municipal bonds are tax-exempt,

you pay no taxes on the $60 coupon payments and earn 6% after taxes. However, you

have to pay taxes on corporate bonds. You will keep only 60% of the $80 coupon pay-

ment because the other 40% goes to taxes. Therefore, you receive $48 of the coupon

payment and have an interest rate of 4.8% after taxes. Buying the municipal bond would

yield you higher earnings.

E X A M P L E   5 . 1 Income Tax Considerations

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

95

Quantity of Treasury Bonds

Quantity of Municipal Bonds

Price of Bonds, P

Price of Bonds, P