Chapter 6

Factors Affecting Bond Yields

and the Term Structure of Interest
Rates

6-1
 Base Interest Rates
 Base or benchmark interest rate: the
minimum interest rate that investors demand
is the base interest rate or benchmark
interest rate.

 This rate is the yield to maturity on a

comparable maturity Treasury security.

6-2
U.S. Treasury Security Yields on 9/20/2024
Treasury Security Yield %
1-Month Bill 4.75
3-Month Bill 4.66
6-Month Bill 4.47
1-Year Bill 3.95
2-Year Note 3.61
3-Year Note 3.49
5-Year Note 3.51
7-Year Note 3.61
10-Year Note 3.74
30-Year Bond 4.08

6-3
 Yield Spread
 Yield spread: The difference between the yields of any two
bonds is called the yield spread:
Yield spread = Yield on bond A – Yield on bond B
 Yield spread reflects the difference in the risks between the
two bonds.
 This is typically quoted in basis points and referred to as the
absolute yield spread.
 Example: Yield spread between the 30-yr and 10-yr Treasury
bonds
Yield spread = 30-yr yield – 10-yr yield
= 4.08 – 3.74
= 0.34 or 34 basis points

6-4
 Benchmark Spread
 Benchmark spread: When bond B is a benchmark bond and
bond A is a non-benchmark bond, the yield spread is referred to
as a benchmark spread.
benchmark spread = yield on non-benchmark bond –
yield on benchmark bond
 The benchmark spread reflects the compensation that the
market is offering for bearing the risks associated with the non-
benchmark bond that do not exist for the benchmark bond.
 Thus, the benchmark spread represents a risk premium.
 Example: 10-yr corporate bond yield is 4.67% 10-yr Treasury
bond yield is 3.74%.
Benchmark spread = corporate bond yield – Treasury bond yield
= 4.67% – 3.74% = 0.93% or 93 basis points.

6-5
 Factors Affecting Benchmark Spreads
The factors that affect the yield spread
include:
 The type of issuer, the issuer’s perceived
credit worthiness
 Inclusion of options
 Taxability of the interest
 The expected liquidity of the security
 The financeability of an issue
 The term or maturity of the instrument

6-6
 Type of Issuer
 Types of Issuers
 The bond market is classified by the type of issuer,
including the U.S. government, U.S government agencies,
municipal governments, credit (domestic and foreign
corporations), and foreign governments.
 These classifications are referred to as market sectors.
 Different sectors have different risks and rewards.
 The spread between the interest rate offered in two sectors
of the bond market with the same maturity is called an
intermarket sector spread.
 The spread between two issues within a market sector is
called an intramarket sector spread.

6-7
 Type of Issuer
 Types of Issuers: Intermarket spreads

 Example: spread between corporate and mortgage

bonds
Corporate bond yield is 4.67% and mortgage-
back bond yield is 4.45%
Yield spread = 4.67% - 4.45% = 0.22% or 23
bps

6-8
 Credit Quality of the Issuer
 Perceived Credit Worthiness of Issuer
 Default risk or credit risk refers to the risk that the issuer
of a bond may be unable to make timely principal and/or
interest payments.
 Credit spread: the spread between Treasury securities
and non-Treasury securities that are identical in all
respects except for quality.
 Lower the credit rating, higher the credit spread.
 Example: spread between corporate and government
bonds
Corporate bond yield is 4.67% and 10-year
government bond yield is 3.74%
Credit spread = 4.67% - 3.74% = 0.93% or 93 bps

6-9
 Embedded Options
 Inclusion of Options
 Embedded options affect the spread of an issue
relative to a Treasury security and the spread
relative to otherwise comparable issues that do
not have an embedded option.
 Investors require a larger benchmark spread when
the option is favorable to the issuer (such as call
option).
 Investors require a smaller benchmark spread
when the option is favorable to the investor (such
as put and convertible options).

6-10
 Taxability of Interest
 Taxability of Interest
 Income from bonds issued by state, city, and local
governments (municipal bonds, or munis) is free from federal
taxes.
 Because of the tax-exempt feature of municipal bonds, the
yield on municipal bonds is less than Treasuries with the same
maturity.
 To compare munis with taxable bonds, we compare the
municipal bond yield with after-tax yields of taxable bonds.
 The yield on a taxable bond issue after federal income taxes
are paid is called the after-tax yield:
after-tax yield = pretax yield × (1 – marginal tax rate)

6-11
 Taxability of Interest
 Example: the yield on taxable corporate bonds is 5%. The
marginal income tax rate is 35%.
After-tax yield = 5% × (1 – 0.35) = 3.25%
 Alternatively, we can determine the yield that must be offered
on a taxable bond issue to give the same after-tax yield as a
tax-exempt issue.
• This yield is called the equivalent taxable yield and is:
Equivalent Taxable Yield =
tax-exempt yield / (1 – marginal tax rate)
 Example: the yield on a municipal bond is 3%. The marginal
income tax rate is 35%.
Equivalent Taxable Yield = 3/(1-0.35) = 4.62%

6-12
 Liquidity of an Issue
 Expected Liquidity of an Issue
 Bonds trade with different degrees of liquidity.
 Bonds with greater expected liquidity will have
lower yields.
 Treasury securities are the most liquid securities
in the world.
 The lower yield offered on Treasury securities
relative to non-Treasury securities partly reflects
the difference in liquidity.

6-13
 Financeability of an Issue
 Financeability of an Issue
 A portfolio manager can use an issue as collateral for
borrowing funds so as to create leverage.
 The typical market used by portfolio managers to borrow
funds using a security as collateral for a loan is the
repurchase agreement (repo) market.
 When a portfolio manager wants to borrow funds via a repo
agreement, a dealer provides the funds.
 The interest rate charged by the dealer is called the repo
rate.
 There are times when dealers are in need of particular
issues to cover a short position.
 When a dealer needs a particular issue, that dealer will be
willing to offer to lend funds at a lower repo rate than the
general repo rate in the market.
6-14
 Term to Maturity
 Term To Maturity
 The volatility of a bond’s price is dependent on its term to
maturity.
 All other factors constant, the longer the term to maturity of
a bond, the greater the price volatility resulting from a
change in market yields.
 Therefore, longer maturity bonds have to compensate the
investor for the higher interest rate risk associated with
them.
 This extra compensation is called the maturity spread or
term spread or term premium.
 Maturity spread is the difference in yield between otherwise
comparable securities with different maturities.

6-15
 Term to Maturity
 Example: 30-year government bond yield is 4.08.
10-year government bond yield is 3.74%

Maturity spread or premium = 4.08% - 3.74%

= 34 basis points

6-16
 Term Structure of Interest Rates
 The relationship between yield and term to maturity on securities
that differ only in length of time to maturity.
 Yield Curve
 The yield curve is the graphical representation of the term
structure of interest rates.
 Investors typically construct yield curves from prices and
yields in the Treasury market for two reasons:
1) First, Treasury securities are free of default risk, and
differences in credit worthiness do not affect yields.
Therefore, these instruments are directly comparable.
2) Second, as the largest and most active bond market, the
Treasury market offers the fewest problems of illiquidity
or infrequent trading.

6-17
 Yield Curve Patterns

Positive
Yield

(Normal)

Yield
Inverted

Maturity
Maturity
(a)
(b)
Yield

Flat

Maturity (c)

6-18
 Yield Curve
 The shape of the yield curve shows the market’s
expectations of future interest rates.
 An upward sloping yield curve suggests that market
expects that interest rates will increase in the future
and higher economic activity or economic expansion.
 A downward sloping yield curve suggests that market
expects that interest rates will decrease in the future
and that the economic growth will be slower or there
will be a recession.

6-19
 Spot and Forward Rates
 Spot Rates
 The yields on a zero-coupon security for some maturity.
 Example: Treasury bill yields
 Spot rates beyond one-year are not observable and need to be
estimated using the coupon paying Treasury bonds.

 Forward Rate
 The interest rate for a future period implied by the difference in
a short‐term spot rate and a longer‐term spot rate.

6-20
 Forward Rates
 Forward Rate
 The relationship between a n-period spot rate (rn), the
current n-1 period spot rate (rn-1), and the forward rate for
year n (fn) is given by the following equation:

(1+ rn)n = (1 + rn-1)n-1 (1 + fn)

6-21
 Forward Rates
 Forward Rate
 Example: 2-year spot rate is 5%. one-year spot rate is 4%. Then,
the one-year spot rate for year 2 is:
𝑟2
𝑟1 𝑓 2

Today 1-year 2 years

(1.05)2 = (1.04) (1 + f2)
f2 = (1.05)2 / (1.04) – 1
= 0.0601 = 6.01%
6-22
 Forward Rates
 Forward Rate
Assume the following spot rates. What are the forward rates
for years 3 and 4?
Year Spot Rate
1 4%
2 5%
3 6%
4 5%
Year 3 forward rate:
(1.06)3 = (1.05)2 (1 + f3)
f3 = (1.06)3 / (1.05)2 – 1
= 1.1910/1.1025 -1 = 0.0803 = 8.03%
Year 4 forward rate:
(1.05)4 = (1.06)3 (1 + f4)
f4 = (1.05)4 / (1.06)3 – 1
= 1.2125 /1.1910 -1 = 0.0181 = 1.81%
6-23
 Term Structure Theories

 Pure Expectations theory

 Liquidity premium theory

 Preferred habitat theory

 Market segmentations theory

6-24
 Pure Expectations Theory
 The entire term structure at a given time reflects the market’s
current expectations of future short-term rates.
 An upward sloping yield curve suggests that market expects
the short-term interest rates to rise in the future.
 A downward sloping yield curve suggests that market
expects short-term interest rates to fall in the future.
 The forward rates represent the expected future short-term
rates.
 It can explain different yield curve patterns based on
investor expectations.
 However, it cannot explain why yield curves usually slow
upward.

6-25
 Liquidity Premium Theory
 Short‐term bonds provide greater marketability (more
secondary market liquidity) and have smaller price
fluctuations (price risk) than long‐term securities.
 As a result, long‐term bonds must offer a positive liquidity
premium (also called term premium) to induce investors to
hold them.
 The liquidity premium increases as maturity increases
because the longer the maturity of a security, the greater the
price risk and lower the marketability.
 While the yield curve reflects expectations about future
interest rates, a liquidity premium should be added to such
rates.
 This theory can explain different yield curve patterns as well
as why the yield curve usually slopes upward.

6-26
 Preferred Habitat Theory
 Investors prefer for one maturity over another – they have a
preferred habitat (maturity preference).
 Investors will not hold debt securities outside their
preferred habitat without an additional reward in the form
of a risk premium.
 The yield curve reflects the expectation of the future path of
interest rates as well as a risk premium.
 This theory also can explain different yield curve patterns
as well as why the yield curve usually slopes upward.

6-27
 Market Segmentation Theory
 Market participants have strong preferences for securities of a
particular maturity and that they buy and sell securities consistent
with these maturity preferences.
 As a result, the yield curve is determined by the supply of and the
demand for securities for a particular maturity.
 Investors who desire short‐term securities, such as commercial banks,
determine the short‐term yield curve; investors with preferences for
intermediate maturities determine the intermediate‐term yield curve;
and investors who prefer long‐term securities, such as pension funds
and life insurance companies, determine the long‐term yield curve.
 The market segmentation theory differs from the preferred habitat
theory in that it assumes that neither investors nor borrowers are
willing to shift from one maturity sector to another to take advantage
of opportunities arising from differences between expectations and
forward rates.

6-28