Chapter 6 The Economics of Interest-Rate Spreads and Yield Curves Notes
The 1930s, the Great Depression, dried up profit opportunities for businesses and hence shifted the supply curve of bonds left, further increasing bond prices and depressing yields. (If the federal government had not run budget deficits some years during the depression, the interest rate would have dropped even further.)
During World War II, the government used monetary policy to keep interest rates low. After the war, that policy came home to roost as inflation began. A higher price level puts upward pressure on the interest rate.
Positive geopolitical events in the late 1980s and early 1990s, the end of the cold war, and the globalization, also helped to reduce interest rates by rendering the general business climate more favorable (thus pushing the demand curve for bonds to the right, bond prices upward, and yields downward).
6.2 Interest-Rate Determinants I: The Risk Structure
Why the yields on Baa corporate bonds are always higher than the yields on Aaa corporate bonds?
Why bonds issued by the same economic entity with different maturities, have different yields, why the rank order changes over time?
Investors care mostly about three things: risk, return, and liquidity.
Bonds issued by different economic entities have very different probabilities of default.
The U.S. government has never defaulted on its bonds and is extremely unlikely to do so, and its efficient tax administration (the Internal Revenue Service [IRS]) could always meet its nominal obligations by creating money. (That might create inflation) Except for a special type of bond called TIPS, the government promise to pay a nominal value, not a real [inflation-adjusted] sum, so the government does not technically default when it pays its obligations by printing money.)
Municipalities have defaulted on their bonds in the past and could do so again in the future because, although they have the power to tax, they do not have the power to create money at will. Nevertheless, the risk of default on municipal bonds (aka munis) is often quite low.
Munis are exempt from most forms of income taxation.
Corporations are more likely to default on their bonds than governments are because they must rely on business conditions and management acumen.
Credit-rating agencies, including Moody’s and Standard and Poor’s, assess the probability of default and assign grades to each bond, the agencies are rife with conflicts of interest, and the market usually senses problems before the agencies do.
The most liquid bond markets are usually those for Treasuries. The liquidity of corporate and municipal bonds is usually a function of the size of the issuer and the amount of bonds outstanding.
Corporate Baa bonds have the highest yields because they have the highest default risk, and not very liquid.
Investors do not need as high a yield to own Treasuries as they need to own corporates.
Corporate bond ratings go all the way down to C (Moody’s) or D (Standard and Poor’s), used to be called high-yield or junk bonds but are now generally referred to as B.I.G. or below investment-grade bonds.)
Eager for tax-exempt income lead people to purchased large quantities of municipal bonds, driving their prices up (and their yields down) since, tax considerations, the highest income brackets exceed 30 percent.
The terrorist attacks on New York City and Washington, DC, in September 2001, some claimed that people who had prior knowledge of the attacks made huge profits in the financial markets. How would that have been possible?
The most obvious way would have been to sell riskier corporate bonds and buy U.S. Treasuries on the eve of the attack in expectation of a flight to quality, the mass exchange of risky assets (and subsequent price decline) for safe ones (and subsequent price increase).
6.3 The Determinants of Interest Rates II: The Term Structure
Holding the risk structure of interest rates, default risk, liquidity, and taxes, all constant. The term structure of interest rates, the variability of returns due to differing maturities.
Even bonds from the same issuer, the U.S. government, can have yields that vary according to the length of time they have to run before their principals are repaid.
Sometimes short-term Treasuries have lower yields than long-term ones, sometimes they have about the same yield, and sometimes they have higher yields.
The yields of bonds of different maturities (but identical risk structures) tend to move in tandem, and the yield curves usually slope upward.
Sometimes, the yield “curve” is actually flat—yields for bonds of different maturities are identical, or nearly so.
Sometimes, particularly when short-term rates are higher than normal, the curve inverts or slopes downward, indicating that the yield on short-term bonds is higher than that on long-term bonds.
Theory and empirical evidence both point to the same conclusion: bonds of different maturities are partial substitutes for each other, not perfect substitutes.
Generally, investors prefer short-term bonds to long-term ones, but they reverse their preference if the interest rate goes unusually high.
There is one thing that can induce investors to give up their liquidity preference, their preferred habitat of short-term bonds: the expectation of a high interest rate for a short term.
Investors think of a long-term bond yield as the average of the yields on shorter-term obligations, so when the interest rate is high by historical norms but expected after a year or so to revert to some long-term mean, they will actually begin to prefer long-term bonds and will buy them at much higher prices (lower yields) than short-term bonds.
in = [ (ie0 + ie1 + ie2 + ie3 + .... ie (n − 1 ) ) / n ] + ρn
in = interest rate today on a bond that matures in n years
iex = expected interest rate at time x (0, 1, 2, 3, . . . through n)
ρ = the liquidity or term premium for an n-period bond.
The yield today of a bond with 5 years to maturity, if the liquidity premium is 0.5% and the expected interest rate each year is 4, is 4.5: i5 = (4 + 4 + 4 + 4 + 4)/5 + .5 = 20/5 + .5 = 4.5, implying an upward sloping yield curve because 4 < 4.5.
Short-term and long-term bonds issued by the same economic entity did not often differ much in price.
One possibility is that there was no liquidity premium then. Short-term bonds suffered less interest rate risk than long-term bonds, but investors often complained of extremely high levels of reinvestment risk, of their inability to cheaply reinvest the principal of bonds and mortgages when they were repaid. Lenders often urged good borrowers not to repay, to continue to service their obligations.
Another not mutually exclusive possibility is that the long-term price level stability, the interest rate less volatile. The expectation was that the interest rate would not long stray from its long-term tendency.
The yield curve as the market’s prediction of future short-term interest rates, by extension, an economic forecasting tool. Where the curve slopes sharply upward, the market expects future short-term interest rates to rise. Where it slopes slightly upward, the market expects future short-term rates to remain the same. Where the curve is flat, rates, it is thought, will fall moderately in the future.
Empirical research suggests that the yield curve is a good predictor of future interest rates in the very short term, the next few months, and the long term, but not in between.
Economic forecasters use the yield curve to make predictions about inflation and the business cycle.
A flat or inverted curve, for instance, portends lower short-term interest rates in the future, which is consistent with a recession but also with lower inflation rates.
A curve sloped steeply upward, by contrast, portends higher future interest rates, which might be brought about by an increase in inflation rates or an economic boom.
Reference
Wright, R. E. (2009). Money and Banking. Saylor Foundation. https://open.umn.edu/opentextbooks/formats/641.
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