FIM

Chapter 3

Debt Security Yields and the Term Structure of Interest

The yield offered on debt securities varies due to several characteristics. Securities with
unfavorable characteristics must offer higher yields to attract investors. Even small yield
differences can significantly impact the issuer's interest expenses. For example, a 1% increase
in yield on a $30 million bond translates to an additional $300,000 in annual interest expenses
for the issuer.

Factors influencing debt security yields include:

● Credit (Default) Risk: Securities with higher credit risk must offer a higher yield,
known as a credit risk premium, to compensate investors. Investors can rely on bond
ratings from agencies like Moody's and Standard & Poor's to assess creditworthiness.
Higher-rated bonds have lower perceived credit risk and thus offer lower yields. For
example, an investor might choose a Zanstell Co. bond offering an 8% yield over a
risk-free Treasury bond with a 7% yield if they believe Zanstell has sufficient cash flow to
repay its debt despite a small risk of bankruptcy. The 1% difference in yield represents
the credit risk premium.
● Liquidity: Liquid securities can be easily converted to cash without losing value.
Securities with lower liquidity must offer a higher yield to compensate investors.
Debt securities with short-term maturity or an active secondary market are considered
more liquid.
● Tax Status: Investors prefer after-tax income. Taxable securities must offer a higher
before-tax yield compared to tax-exempt securities like municipal bonds. The required
compensation depends on the investor's tax bracket, with higher tax bracket investors
benefiting more from tax-exempt securities.
● Term to Maturity: The relationship between maturity and yield, known as the term
structure of interest rates, is complex and explained by several theories. The Treasury
yield curve visually represents this relationship for risk-free Treasury securities.

Modeling Debt Security Yields

To attract investors, companies issuing debt must determine an appropriate yield considering all
the factors mentioned above. A model for estimating the yield incorporates these factors:

Yn = Rf,n + DP + LP + TA

where:
 ● Yn = annualized yield of an n-year debt security
● Rf,n = annualized yield of an n-year risk-free Treasury security
● DP = credit risk premium
● LP = liquidity premium
● TA = adjustment due to tax status differences

This model matches the debt security's maturity with a comparable risk-free Treasury security to
control for term to maturity. Companies can apply a similar model for short-term debt securities
like commercial paper, using the prevailing risk-free yield of a short-term Treasury security. It is
crucial to remember that the appropriate yield can change over time due to fluctuations in the
risk-free rate, credit premium, liquidity premium, and tax adjustments.

Theories of the Term Structure of Interest Rates

Several theories attempt to explain the relationship between the maturity and yield of securities,
including:

● Pure Expectations Theory: This theory suggests that expectations of future interest
rates solely determine the term structure. An expected increase in interest rates
leads to an upward-sloping yield curve, while an expected decrease results in a
downward-sloping curve. For example, if investors anticipate rising interest rates, they
favor short-term securities to reinvest at higher rates later, pushing short-term yields
down and long-term yields up. Conversely, if investors expect interest rates to decline,
they prefer long-term securities to lock in current higher rates, leading to a
downward-sloping yield curve. This theory also implies that a security's return should
equal the compounded yield from a series of shorter-term investments over the same
period. The forward rate, calculated based on current yields of securities with different
maturities, is often used as an approximation of future interest rate expectations.
However, if forward rates are biased, they may not accurately predict future rates.
● Liquidity Premium Theory: This theory builds upon the pure expectations theory,
recognizing that investors prefer short-term liquid securities and require a premium
for holding less liquid long-term securities. This preference for liquidity adds upward
pressure on the yield curve's slope, regardless of interest rate expectations.
Consequently, the forward rate may overestimate future interest rate expectations when
considering the liquidity premium. A modified formula accounting for the liquidity
premium provides a more accurate estimate of the forward rate.
● Segmented Markets Theory: This theory proposes that investors and borrowers
choose securities based on their forecasted cash needs rather than interest rate
expectations. For example, pension funds might favor long-term investments aligned
with their long-term liabilities. This preference for specific maturities can influence the
yield curve. A limitation of this theory is that some investors and borrowers have
flexibility in choosing among maturity markets, contradicting the idea of strict
segmentation. However, the preferred habitat theory, a more flexible variant, suggests
that investors and borrowers might deviate from their natural market in certain events,
 acknowledging the influence of both natural maturity preferences and interest rate
expectations.

Integrating the Theories and Applications of the Term Structure

While research suggests validity in all three theories, the term structure is likely influenced by a
combination of interest rate expectations, investor preferences for liquidity, and the
specific needs of investors and borrowers in each maturity market. For example, if investors
expect rising interest rates, borrowers need long-term funds, and investors prefer liquidity, all
these factors contribute to an upward-sloping yield curve.

The term structure is used for:

● Forecasting Interest Rates: The yield curve's shape provides insights into market
expectations about future interest rates. An upward-sloping curve generally indicates
expectations of higher rates, while a downward-sloping curve suggests expectations of
lower rates. However, it's important to consider the influence of liquidity and maturity
preferences when interpreting these expectations.
● Forecasting Recessions: Some analysts believe a flat or inverted yield curve
signals a potential recession, suggesting expectations of lower interest rates and
reduced demand for loanable funds due to a weak economy.
● Making Investment and Financing Decisions: Investors can benefit from higher
yields on longer-term securities by "riding the yield curve," although this strategy
involves uncertainty in future selling prices. Financial institutions with mismatched asset
and liability maturities, like banks with short-term deposits and long-term loans, use the
yield curve to manage their interest rate spread. Firms consider the yield curve when
making financing decisions, potentially choosing short-term borrowing if they anticipate
refinancing at lower yields later.

International Considerations

The factors shaping the yield curve can differ across countries, resulting in varying shapes.
Each country's interest rate levels are influenced by the supply and demand for loanable funds
in its currency. However, interest rate movements across countries tend to be positively
correlated due to internationally integrated financial markets. Therefore, interest rate changes
in one country can impact rates in another.