Money and Banking Chapter 6 The Economics of Interest-Rate Spreads and Yield Curves

Chapter The Economics of Spreads and Yield Curves CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Define the risk structure of interest rates and explain its importance . Explain the term flight to quality . Define the term structure rates and explain its importance . Describe a yield curve and explain its economic meaning . URL books 113

A Short History of Interest Rates OBJECTIVE . How and why has the interest rate changed in the United States over time ?

In Chapter The Economics of Fluctuations you learned about the factors that the interest rate , or in other words the general level of interest rates . For the sake of clarity , we ignored the fact that different types of instruments have different interest rates . We were able to do so because interest rate movements are highly correlated . In other words , they track each other closely , as Figure The risk structure of interest rates in the United States , and Figure The term structure of interest rates in the United States , 2006 show . Figure The risk structure rates in the United States , Yield to Maturity ( 96 ) 88888 ' po , 31 ' Date Baa URL books 1319 114

Figure The term structure of in rates in the United States , I I Yield to Maturity ( sa Dale The graphs reveal that interest rates generally downward from 1920 to 1945 , then generally rose until the early , when they began trending downward again through 2005 . Given what you learned in Chapter The Economics of Fluctuations , you should be able to understand the basic causes underlying those general trends . During the , general business conditions were favorable ( President Calvin Coolidge summed this up when he said , The business of America is business ) so the demand for bonds increased ( the demand curve shifted right ) pushing prices higher and yields lower . The witnessed the Great Depression , an economic recession of unprecedented magnitude that dried up opportunities for businesses and hence shifted the supply curve of bonds hard 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 URL books ' 115

interest rates low ( as well see in Chapter 16 Monetary Policy Tools ) After the war , that policy came home to roost as began , for the time in American history , to become a perennial fact of life . Contemporaries called it creeping . A higher price level , of course , put upward pressure on the interest rate ( think Fisher Equation and Keynes real nominal balances ) The unprecedented increase in prices during the ( what some have called creepy and others the Great ) drove nominal interest rates higher still . Only in the early , after the Federal Reserve mended its ways ( a topic to which we will return ) and brought under control , did the interest rate begin to fall . Positive geopolitical events in the late and early , namely , the end of the cold war and the birth of what we today call 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 ) Pretty darn neat , eh ?

KEY TAKEAWAYS When general business conditions were favorable , demand for bonds increased ( the demand curve shifted right ) pushing prices higher and yields lower . When general business conditions were unfavorable , profit opportunities for businesses dried up , shifting the supply curve of bonds left , further increasing bond prices and depressing yields . During inflationary periods , interest rates rose per the Fisher Equation and Keynes real nominal balances . The end of the cold war and the birth of globalization 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 ) URL books 116

I The Risk Structure LEARNING OBJECTIVE . What is the risk structure of interest rates and flight to quality , and what do they explain ?

In this chapter , we re going out , as best we can , why yields on types . The analysis will help us to understand a couple of interesting features of Figure The risk structure of interest rates in the United States , and Figure The term structure of interest rates in the United States , Why the yields on Baa corporate bonds are always higher than the yields on corporate bonds , which in turn are higher than those on Treasury bonds ( issued by the federal government ) which for a long time have been higher still than those on ( bonds issued by municipalities , like state and local governments ) Why the yields on corporate Baa bonds bucked the trend of lower rates in the early and why , at one time , municipal bonds yielded more than Treasuries . Why bonds issued by the same economic entity ( the government ) with different generally , but not always , have different yields and why the rank ordering changes over time Figure The risk structure of interest rates in the United States , which holds maturity constant , is the easiest to understand because we ve already discussed the major concepts . We tackle it , and what economists call the risk structure of interest rates , first . Remember from Chapter The Economics of Fluctuations that investors care mostly about three things risk , return , and liquidity , Because the bonds in Figure The risk structure of interest rates in the United States , are all bonds , their expected relative returns might appear at first glance to be identical . Investors know , however , that bonds issued by economic entities have very probabilities of defaulting . they know the following . The government has never defaulted on its bonds and is extremely unlikely to do so because even if its political stability were to be shattered and its efficient tax administration ( that wonderful institution , the Internal Revenue Service IRS ) were to stumble , it could always meet its nominal obligations by creating money . That might create , as it has at times in the past . URL books 117

Nevertheless , except for a special type of bond called TIPS , the government and other bond promise to pay a nominal value , not a real 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 . Although in the past , most recently during the Great Depression , some issued call them of credit , or chits . Nevertheless , the risk of default on municipal bonds ( aka ) is often quite low , especially for revenue bonds , upon which taxes and fees are pledged for interest payments . 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 . They have no power to tax and only a limited ability to create the money , a power that decreases in proportion to their need ! thinking of gift cards , declining balance debit cards , trade credit , and so forth . Some corporations are more likely to default on their bonds than others . Several agencies , including Moody and Standard and Poor , assess the probability of default and assign grades to each bond . There is quite a bit of grade built in ( the highest grade being not A or even but ) the agencies are rife with of interest , and the market usually senses problems before the agencies do . Nevertheless , bond ratings are a standard proxy for default risk because , as Figure Default rates on bonds rated by Moody from 1983 to 1999 shows , bonds are indeed more likely to default than ones . Like Treasuries , corporate bonds are fully taxable . 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 . So the bonds of the state of New Jersey might be more liquid than those of a small corporation , but less liquid than the bonds of , say , General Electric . Figure roles on ) IS ' I by Moo ( I 198 101999 URL books 118

Equipped with this knowledge , we can easily understand the reasons for the rank ordering in Figure The risk structure of interest rates in the United States , Corporate Baa bonds have the highest yields because they have the highest default risk ( of those ) and the markets for their bonds are generally not very liquid . bonds are next because they are relatively safer ( less default risk ) than Baa bonds and they may be relatively liquid , too . Treasuries are extremely safe and the markets for them are extremely liquid , so their yields are lower than those of corporate bonds . In other words , investors do not need as high a yield to own Treasuries as they need to own corporates . Another way to put this is that investors place a positive risk premium ( to be more precise , a credit or default risk , liquidity , and tax premium ) on corporate bonds . URL books 119

Stop and Think Box Corporate bond ratings go all the way down to ( Moody ) or ( Standard and Poor ) These used to be called or junk bonds but are now generally referred to as . or below investment grade bonds . If plotted on Figure The risk structure of interest rates in the United States , where would the yields of such bonds land ?

How do you know ?

They would have higher yields and hence would be above the Baa line because they would have a higher default risk , the same tax treatment , and perhaps less liquidity . The low yield on is best explained by their tax exemptions . Before income taxes became important , the yield on was higher than that of Treasuries , as we would expect given that Treasuries are more liquid and less likely to default . During World War II , investors , especially wealthy individuals , eager for income and convinced that the problems faced by many municipalities during the depression were over , purchased large quantities of municipal bonds , driving their prices up ( and their yields down ) all the time since , tax considerations , which are considerable given our highest income brackets exceed 30 percent , have overcome the relatively high default risk and illiquidity bonds , rendering them more valuable than Treasuries , Figure ( luring the ( URL books 120

Yield to Maturity ( 96 ) I 93 . on Date Baa Treasuries Risk , returns , and liquidity also help to explain changes in spreads , the between yields of bonds of types ( the distance between the lines in Figure The risk structure of interest rates in the United States , and Figure Risk premiums and bond spreads during the Great Depression , The big spike in Baa bond yields in the early , the darkest days of the Great Depression , was due to one simple cause companies with Baa bond ratings were going left and right , leaving hanging . As Figure Risk premiums and bond spreads during the Great Depression , shows , companies that issued bonds , municipalities , and possibly even the federal government were also more likely to default in that desperate period , but they were not nearly as likely to as weaker companies . Yields on their bonds therefore increased , but only a little , so the spread between Baa corporates and other bonds increased considerably in those troubled years . In better times , the spreads narrowed , only to widen again during the Roosevelt Recession of . Figure The flight to quality ( Treasuries ) and from risk ( corporate securities ) URL books 121

Price , Interest Rate , i Price of Bonds , Interest Rate , I ) i ) Quantity of Corporate Bonds Quantity of Treasury Bonds ( bond ' 91 ( Treasury ) bond market During crises , spreads can quickly soar because investors sell riskier assets , like Baa bonds , driving their prices down , and simultaneously buy safe ones , like Treasuries , driving their prices up . This called to quality is represented in Figure The to quality ( Treasuries ) and from risk ( corporate securities ) Stop and Think Box In the confusion following the terrorist attacks on New York City and Washington , in September 2001 , some claimed that people who had prior knowledge of the attacks made huge profits in the markets . How would that have been possible ?

The most obvious way , given the analyses provided in this chapter , would have been to sell riskier corporate bonds and buy Treasuries on the eve of the attack in expectation of a to quality , the mass exchange of risky assets ( and subsequent price decline ) for safe ones ( and subsequent price increase ) Time for a check of your knowledge . EXERCISES . What would happen to the spreads between different types of bonds if the federal government made Treasuries and at the same time raised income taxes considerably ?

If the Supreme Court unexpectedly declared a major source of municipal government tax revenue illegal , what would happen to municipal bond yields ?

URL books ' 122 . If several important bond brokers reduced the brokerage fee they charge for trading Baa corporate bonds ( while keeping their fees for other bonds the same ) what would happen to bond spreads ?

What happened to bond spreads when , a major corporation , collapsed in December 2001 ?

KEY TAKEAWAYS The risk structure of interest rates explains why bonds of the same maturity but issued by different economic entities have different yields ( interest rates ) The three major risks are default , liquidity , and return . By concentrating on the three major risks , you can ascertain why some bonds are more ( less ) valuable than others , holding their term ( repayment date ) constant . You can also , if not outright predict , the changes in rank order as well as the spread ( or difference in yield ) between different types of bonds . A flight to quality occurs during a crisis when investors sell risky assets ( like bonds ) and buy safe ones ( like Treasury bonds or gold ) URL books 123

The of Interest Rates II The Term Structure LEARNING OBJECTIVE . What is the term structure of interest rates and the yield curve , and what do they explain ?

Now we are going to hold the risk structure of interest risk , liquidity , and and concentrate on what economists call the term structure rates , the variability due to . As Figure Risk premiums and bond spreads during the Great Depression , reveals , even bonds from the same issuer , in this case , the government , can have yields that vary according to the length of time they have to run before their principals are repaid . Note that the general postwar trend is the same as that in Figure The risk structure of interest rates in the United States , a trend upward followed by an equally dramatic slide . Unlike Figure The risk structure of interest rates in the United States , however , the ranking of the series here is much less stable . Sometimes Treasuries have lower yields than ones , sometimes they have about the same yield , and sometimes they have higher yields . To study this phenomenon more closely , economists and market watchers use a tool called a yield curve , which is basically a snapshot of yields of bonds of different at a given moment . Figure The risk structure of interest rates in the United States , is what the Treasury yield curve looks like as reported in the Wall Street Journal , which publishes it daily . The current yield curve can also be viewed many places online , including and the Treasury itself . What observers have discovered is that the yields of bonds of ( but identical risk structures ) tend to move in tandem . They also note that yield curves usually slope upward . In other words , rates are usually lower than rates . Sometimes , however , the yield curve is bonds are identical , or nearly so . Sometimes , particularly when rates are higher than normal , the curve or slopes downward , indicating that the yield on bonds is higher than that on bonds . And sometimes the curve goes up and down , resembling a sideways ( sometimes tilted on and sometimes its back ) URL books 124

or . What explains this ?

Remember , it can be tax , default , or liquidity risk because those variables are all the same for Treasuries . Figure ) yield ' TREASURY YIELD CURVE Yield to maturity of current bills , notes and bonds . month ( years maturity Source Reuters Theory and empirical evidence both point to the same conclusion bonds of are partial substitutes for each other , not perfect substitutes , but not completely segmented either . URL books , 125

Generally , investors prefer bonds to ones , but they reverse their preference if the interest rate goes unusually high . Investors are willing to pay more for bonds , other factors ( like the interest rate and the risk structure ) held constant , because bonds are more subject to interest rate risk , as we learned in Chapter Money . Or , to put it another way , investors need a premium ( in the form of a lower price or higher yield ) to hold bonds Ergo , the yield curve usually slopes upward , as it does in Figure Treasury yield ( A But what about those times when the curve is or inverted ?

Well , there is one thing that can induce investors to give up their liquidity preference , habitat of bonds the expectation of a high interest rate for a short term Investors think of a bond yield as the average of the yields on obligations , so when the interest rate is high by historical norms but expected after a year or so to revert to some mean , they will actually begin to prefer term bonds and will buy them at much higher prices ( lower yields ) than bonds . More formally , investors believe that iu ( iu ( where in interest rate today on a bond that matures in years in expected interest rate at time ( through 11 ) the liquidity or term premium for an bond ( it is always positive and increases with ) So the yield today of a bond with years to maturity , if the liquidity premium is percent and the expected interest rate each year is , is is ( implying an upward sloping yield curve because If the interest rate is expected to rise over the next years , the yield curve slopes upward yet more steeply URL books ' 126

is ( 65 , again implying an upward sloping curve because . If , on the other hand , interest rates are expected to fall over the next years , the yield curve will slope downward , as in this example is ( 12 10 ) implying an inverted yield curve because 12 . Investors may also realize that bonds will increase in price when interest rates fall ( as they are expected to do in this example and as we learned in Chapter Money ) so they are willing to pay more for them now . Stop and Think Box In the nineteenth century , the yield curve was usually under normal conditions . It inverted during panics . In other words , and bonds issued by the same economic entity did not often differ much in price . Why might that have been ?

One possibility is that there was no liquidity premium then . Then , as now , bonds suffered less interest rate risk than bonds , but investors often complained of extremely high levels of reinvestment risk , of their inability to easily and cheaply reinvest the principal of bonds and mortgages when they were repaid . Often , lenders urged good borrowers not to repay ( but to continue to service their obligations , of course ) Another not mutually exclusive possibility is that the price level stability engendered by the specie standard made the interest rate less volatile . The expectation was that the interest rate would not long stray from its tendency . The neat thing about this theory is that it reveals the yield curve as the markets prediction interest rates , making it , by extension , an economic forecasting tool . Where the curve slopes sharply upward , the market expects future interest rates to rise . Where it slopes slightly upward , the market expects future rates to remain the same . Where the curve is , rates , it is thought , will fall moderately in the future . Inversion of the curve means interest rates should fall sharply , as in the numerical example above . The simplest way to remember this is to realize that the prediction equals the yield curve minus , the term premium . URL books 127

Empirical research suggests that the yield curve is a good predictor of future interest rates in the very short term , the months , and the long term , but not in between . Part of the is that is not well understood nor is it easily observable . It may change over time and or not increase much from one maturity to the next on the short end of the curve . Nevertheless , economic forecasters use the yield curve to make predictions about and the business cycle . A or inverted curve , for instance , portends lower interest rates in the future , which is consistent with a recession but also with lower rates , as we learned in Chapter The Economics of Rate Fluctuations . A curve sloped steeply upward , by contrast , portends higher future interest rates , which might be brought about by an increase in rates or an economic boom . Time once again to ensure that we re on the same page , er , Web site . EXERCISES . What does the following yield curve tell us ?

Treasury yield curve for January 20 , 2006 . Hip month months months year years years years years 10 years 20 years . What does the following yield curve predict ?

Treasury yield curve for July 31 , 2000 . Hip month URL books 079 ?

128 iI Yield months months year years years years years 10 years 30 years KEY TAKEAWAYS The term structure rates explains why bonds issued by the same economic entity but of different sometimes have different yields . Plotting yield against maturity produces an important analytical tool called the yield curve . The yield curve is a snapshot of the term structure of interest rates created by plotting yield against maturity for a single class of bonds , like Treasuries or , which reveals the market prediction of future interest rates , and thus , by extension , can be used to make inferences about inflation and business cycle expectations . mana URL books 129

Suggested Reading , Analysing and Interpreting the Yield Curve . John Wiley and Sons , 2004 . Frank . Interest Rate , Term Structure , and Valuation Modeling . John Wiley and Sons , 2002 . Frank , Steven Mann , and . Measuring and Controlling Interest Rate and Credit Risk . John Wiley and Sons , 2003 . Homer , Sidney , and Richard . A History of Interest Rates , ed . John Wiley and Sons , 2005 . URL books 130