Structure of Interest Rates
The annual interest rate offered by debt securities at any given time varies among debt securities. Individual and institutional investors must understand why quoted yields vary so that they can determine whether the extra yield on a given security outweighs any unfavorable characteristics.
Structure of Interest Rates
WHY DEBT SECURITY YIELDS VARY . Credit (default) risk
. Liquidity . Tax status
. Term to maturity
Credit (default) risk
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Liquidity
Investors prefer securities that are liquid. meaning that they could be easily converted to cash without a loss in value. Thus if all other characteristics are equal) securities with less liquidity will have to offer a higher yield to be preferred.
Securities ,with a short-term maturity or an active secondary market have greater liquidity.
Tax status
Investors are more concerned with after-tax income than before-tax
income earned on securities. If all other characteristics are similar, taxable securities will have to offer a higher before-tax yield to
investors than tax-exempted securities to be preferred.
Term to maturity
The term structure of interest rates defines the relationship between the term to maturity and the annualized yield of debt securities at a specific point in time, holding other factors such as risk constant.
Term structure of interest rates
The relationship between the yields on comparable securities but different maturities is called the term structure of interest rates.
When the yield increases with maturity, is referred to as an upward- sloping yield curve or a positively sloped yield curve.
A downward-sloping or inverted yield curve is the one, where yields in general decline as maturity increases.
Theories of term structure of interest rates
Expectations theory
Liquidity premium theory
Market segmentation theory
Preferred habitat theory
Expectations theory
The pure expectations theory assumes that investors are indifferent between investing for a long period on the one hand and investing for a shorter period with a view to reinvesting the principal plus interest on the other hand.
Consider the relationship between
interest rates on a two-year security and a one-year security as follows:
Compounded yield to investors who purchase a two-year
security
Anticipated
compounded yield from purchasing a one-year security and reinvesting the proceeds in a new one-year security at the end of one year.
Forward rate
Assume that, as of today (time t), the annualized two-year interest rate is 10 percent and the one-year interest rate is 8 percent. The forward rate is then estimated as follows:
This result implies that, one year from now, a one-year interest rate must equal about 12.037 percent in order for consecutive investments in two one-year securities to
generate a return similar to that of a two-year investment
Liquidity Premium Theory
Liquidity premium is a premium demanded by investors when any given security cannot be easily converted into cash for its fair market value. When the liquidity premium is high, the asset is said to be illiquid, and investors demand additional compensation for the added risk of investing their assets over a more extended period since valuations can fluctuate with market effects.
In a nutshell, a liquidity premium means that illiquid investments need to offer higher yields than liquid ones, all other things being equal.
Usually this is used to help explain the difference between bond prices, particularly those of different maturities.
Segmented Markets Theory
According to the segmented markets theory, investors and borrowers choose securities with maturities that satisfy their forecasted cash needs.
Pension funds and life insurance companies may generally prefer long-term investments that coincide with their long-term liabilities.
Commercial banks may prefer more short-term investments to coincide with their short-term liabilities.
If investors and borrowers participate only in the maturity market that satisfies their particular needs,
Use of the Term Structure
Forecasting Interest Rates
Forecasting Recessions
Making Investment Decisions
