Economics 122

FINANCIAL ECONOMI CS (DE BT S ECURITIES 4)

M. DE BUQUE - G ONZ ALES
AY2014 -201 5

SOURCE: BODIE ET AL. (2009), ROSS ET AL., LO (2008)

Overview of Term Structure
 Information on expected future short term rates can be implied
from the yield curve.
 The yield curve is a graph that displays the relationship between
yield and maturity.
 Note: Yields on different maturity bonds are not all equal.
 Need to consider each bond cash flow as a stand-alone zero-
coupon bond when valuing coupon bond.
Yield Curve Under Certainty
 An upward sloping yield curve is evidence that short-term rates are
going to be higher in the succeeding period.
1+𝑟 = 1+𝑅 1+𝑅
1+𝑟 = 1+𝑅 1+𝑅
 When  next  year’s  short  rate  is  greater  than  this  year’s  short  rate,  
the  average  of  the  two  rates  is  higher  than  today’s  rate.
Two 2-Year Investment Programs
Forward Rates from Observed Rates
 Recall your 1-year forward rates:
1+𝑟
1+𝑓 =
1+𝑟

where 𝑓 is the 1-year forward rate for period t

𝑟 is the yield for a security with a maturity of 𝑡
What  if  there’s  uncertainty?
 What can we say if future interest rates are not known today?
 Suppose  that  today’s  rate  is  5% and the expected short rate for the
following year is 𝐸 𝑅 = 6%
 Then 1 + 𝑟 = 1+𝑅 ×𝐸 1+𝑅 = 1.05 × 1.06
 The rate of return on the 2-year  bond  is  risky  for  if  next  year’s  
interest rate turns out to be above expectations, the price will lower
and vice versa.
 In the above example, if investors cared only about the expected
value of the interest rate, then 𝑦𝑡𝑚 would be 𝑟 and the price of a
2-year zero would be $898.47. (Why?)
What  if  there’s  uncertainty?
 Hence, if  there’s  uncertainty,  investors  would  require  a risk
premium to hold a longer-term bond.
 This liquidity premium compensates short-term investors for the
uncertainty about future prices.
Basic Theories of Term Structure
 Expectations hypothesis
 Liquidity preference
 Upward bias over expectations
Expectations Hypothesis
 The observed long-term  rate  is  a  function  of  today’s  short-
term rate and expected future short-term rates.
 Long-term and short-term securities are perfect
substitutes.
 Forward rates that are calculated from the yield on long-
term securities are market consensus expected future
short-term rates, i.e.,
𝑓 =𝐸 𝑅 .
Liquidity Premium Theory
 Investors prefer liquidity.
 Long-term bonds are more risky. Investors will demand a
premium for the risk associated with long-term bonds.
 The yield curve has an upward bias built into the long-term
rates because of the risk premium.
 Forward rates contain a liquidity premium and are not
equal to expected future short-term rates.
𝑓 = 𝐸 𝑅 + 𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
𝑓 >𝐸 𝑅
Liquidity Premium Theory
 Short-term investors would be willing to hold long-term bonds
only if the forward rate is greater than the expected short
interest rate, 𝑓 > 𝐸 𝑅 .
 Long-term investors would be willing to hold short-term bonds
only if the expected short interest rate is greater than the
forward rate, 𝐸 𝑅 >𝑓 .
 Advocates of the liquidity preference theory believe that short-
term investors dominate the market so that the forward rate
will generally exceed the expected short rate.
 That is, the excess of 𝑓 over 𝐸 𝑅 , the liquidity premium would be
positive.
Interpreting the Term Structure
 If the yield curve is to rise as one moves to longer
maturities:
 A longer maturity results in the inclusion of a new forward rate
that is higher than the average of the previously observed rate.
 Reason: higher expectations for forward rates or liquidity
premium.
 How do you interpret the opposite case (a downward-
sloping yield curve)?
Yield Curves
Corporate bonds and default risk
 Non-government bonds carry default risk
o A default is when a debt issuer fails to make a promised payment (interest or
principal)
o Credit ratings by rating agencies provide indications of the likelihood of default by
each issuer
 Rating companies:
o Moody’s  Investor  Service,  Standard  &  Poor’s,  Fitch
 Rating Categories
o Highest rating is AAA or Aaa
o Investment grade bonds are rated BBB or Baa and above
o Speculative grade/junk bonds have ratings below BBB or Baa.
Corporate bonds and default risk
 Factors Used by Rating Companies
 Coverage ratios
EBIT: o EBIT/interest obligations
Earnings o EBIT/fixed cash obligations (includes lease and sinking fund payments)
Before
Interest &  Leverage ratios
Tax o Debt-to-equity ratio
 Liquidity ratios
o ‘Current  ratio’  =  current  assets/current  liabilities
o ‘Quick  ratio’  =  current  assets  excluding  inventories/current  liabilities
 Profitability ratios
o ‘Return  on  assets’  =  EBIT/total  assets
o ‘Return  on  equity’  =  net  income/equity
 'Cash-flow-to-debt  ratio’  =  cash  flow/outstanding  debt

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Financial Ratios and Default Risk by Rating
Class, Long-Term Debt

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Can financial ratios predict default risk?
○ – Firms that
remained
solvent

x – Firms that
eventually
went bankrupt

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Protection Against Default
Sinking funds – a way to call bonds early
Subordination of future debt – restrict additional
borrowing
Dividend restrictions – force firm to retain assets rather
than pay them out to shareholders
Collateral – a particular asset bondholders receive if the
firm defaults

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Default Risk and Yield
 The risk structure of interest rates refers to the pattern of
default premiums.
 There is a difference between the yield based on expected
cash flows (expected YTM) and yield based on promised cash
flows (promised YTM).
 The difference between the expected YTM and the promised
YTM is the default risk premium.

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Corporate bonds and default risk
 Decomposition of corporate bond yields:
o Promised YTM – the yield if default does not occur.
o Expected YTM – the probability-weighted average of all possible yields.
o Default premium – the difference between promised yield and expected
yield.
o Risk premium of a bond – the difference between the expected yield on a
risky bond and the yield on a risk-free bond of similar maturity and coupon
rate .
Corporate bonds and default risk
 Example: Suppose all bonds have par value of $1,000 and:
o 10-year Treasury STRIPS is selling at $463.19, yielding 8%
o 10-year zero issued by XYZ Inc. is selling at $321.97
o Expected payoff from XYZ's 10-year zero is $762.22
 For the 10-year zero issued by XYZ:
$ , /
o Promised 𝑦𝑡𝑚 = − 1 = 12%
$ .
$ . /
o Expected 𝑦𝑡𝑚 = − 1 = 9%
$ .
o Default premium = Promised 𝑦𝑡𝑚 − Expected 𝑦𝑡𝑚 = 12% − 9% = 3%
o Risk premium = Expected 𝑦𝑡𝑚 – Default-free 𝑦𝑡𝑚 = 9% − 8% = 1%
Corporate bonds and default risk
 Decomposition of corporate bond yields
14%

12%
Promised YTM
3%
10%
Expected YTM
1% Default-free YTM
8%

6%

4% 8%

2%

0%
Corporate bond yield
Default-free rate Risk premium Default premium
Credit Default Swaps
 In credit default swaps (CDS) the buyer of the swap seller of the swap makes
payments until maturity of the contract, while the seller agrees to pay off the
third-party debt in the event of a default.
 CDS are considered as insurance against nonpayment of debt. By purchasing a
swap, the buyer is transferring the risk that a debt security will default.
 Institutional bondholders, e.g. banks, used CDS to enhance creditworthiness of
their loan portfolios, to manufacture AAA debt.
 However, buyers of CDS may be simply speculating that a default would occur.
That is, CDS can be used to speculate that bond prices will fall.
 Therefore, there can be more CDS outstanding than there are bonds to insure!

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Prices of Credit Default Swaps

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Credit Risk and Collateralized Debt
Obligations (CDOs)
 Major mechanism to reallocate credit risk in the fixed-income
markets
◦ Structured Investment Vehicle (SIV) often used to create the
CDO.
◦ Loans are pooled together and split into tranches with different
levels of default risk.
◦ Mortgage-backed CDOs were an investment disaster in 2007

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Collateralized Debt Obligations

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