One attribute of a bond that influences its interest rate is its risk of default, which occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or to pay off the face value when the bond matures. A corporation suffering big losses, such as the major airline companies like United, Delta, US Airways, and Northwest in the mid-2000s, might be more likely to suspend interest payments on its bonds. The default risk on its bonds would therefore be quite high.
By contrast, U.S. Treasury bonds have usually been considered to have no default
16 14 12 10 8 6 4 2 0
1950 1960 1970 1980 1990 2000 2010 2020 State and Local Government
(Municipal)
U.S. Government Long-Term Bonds Corporate Baa Bonds
Annual Yield (%)
Corporate Aaa Bonds
1940 1930 1920
FIGURE 5.1 Long-Term Bond Yields, 1919–2016
Interest rates on different types of bonds differ from one another in any given year, and the spread (or difference) between the interest rates varies over time.
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal Reserve Bank of St. Louis FRED database, https://fred.stlouisfed.org/series/GS10, https://fred.stlouisfed.org/series/AAA, https://fred.stlouisfed.org/series/BAA.
M05_MISH5006_09_GE_C05.indd 130 13/10/17 1:06 PM
www.rasabourse.com
risk because the federal government can always increase taxes to pay off its obliga- tions. Bonds like these with no default risk are called default-free bonds. (However, during the budget negotiations in Congress in 1995–1996, and then again in 2011–
2013, the Republicans threatened to let Treasury bonds default, and this had an impact on the bond market.) The spread between the interest rates on bonds with default risk and default-free bonds, both of the same maturity, called the risk premium, indicates how much additional interest people must earn to be willing to hold that risky bond. Our supply-and-demand analysis of the bond market in Chapter 4 can be used to explain why a bond with default risk always has a positive risk pre- mium and why the higher the default risk is, the larger the risk premium will be.
To examine the effect of default risk on interest rates, let’s look at the supply- and-demand diagrams for the default-free (U.S. Treasury) and corporate long-term bond markets in Figure 5.2. To make the diagrams somewhat easier to read, let’s assume that initially corporate bonds have the same default risk as U.S. Treasury bonds. In this case, these two bonds have the same attributes (identical risk and maturity); their equilibrium prices and interest rates will initially be equal (Pc1 = PT1 and ic1 = iT1), and the risk premium on corporate bonds (ic1 - iT1) will be zero.
If the possibility of a default increases because a corporation begins to suffer large losses, the default risk on corporate bonds will increase, and the expected return on these bonds will decrease. In addition, the corporate bond’s return will be more uncertain. The theory of portfolio choice predicts that because the expected
Quantity of Corporate Bonds Quantity of Treasury Bonds
Price of Bonds, P Price of Bonds, P
(a) Corporate bond market (b) Default-free (U.S. Treasury) bond market
Risk Premium Pc2
Sc
Dc1 Dc2
PT2 P T1 ic2
ST
DT1 DT2 iT2
P c1
Step 1. An increase in default risk shifts the demand curve for corporate bonds left . . .
Step 2. and shifts the demand curve for Treasury bonds to the right . . .
Step 3. which raises the price of Treasury bonds and lowers the price of corporate bonds, and therefore lowers the interest rate on Treasury bonds and raises the rate on corporate bonds, thereby increasing the spread between the interest rates on corporate versus Treasury bonds.
FIGURE 5.2 Response to an Increase in Default Risk on Corporate Bonds
Initially Pc1 = PT1 and the risk premium is zero. An increase in default risk on corporate bonds shifts the demand curve from Dc1 to Dc2. Simultaneously, it shifts the demand curve for Treasury bonds from DT1 to DT2. The equilib- rium price for corporate bonds falls from Pc1 to Pc2, and the equilibrium interest rate on corporate bonds rises to ic2. In the Treasury market, the equilibrium bond price rises from PT1 to PT2 and the equilibrium interest rate falls to iT2. The brace indicates the difference between ic2 and iT2, the risk premium on corporate bonds. (Note that because Pc2 is lower than PT2, ic2 is greater than iT2.)
M05_MISH5006_09_GE_C05.indd 131 13/10/17 1:06 PM
www.rasabourse.com
return on the corporate bond falls relative to the expected return on the default-free Treasury bond while its relative riskiness rises, the corporate bond is less desirable (holding everything else equal), and demand for it will fall. Another way of thinking about this is that if you were an investor, you would want to hold (demand) a smaller amount of corporate bonds. The demand curve for corporate bonds in panel (a) of Figure 5.2 then shifts to the left, from Dc1 to Dc2.
At the same time, the expected return on default-free Treasury bonds increases relative to the expected return on corporate bonds, while their relative riskiness declines. The Treasury bonds thus become more desirable, and demand rises, as shown in panel ( b) by the rightward shift in the demand curve for these bonds from DT1 to DT2.
As we can see in Figure 5.2, the equilibrium price for corporate bonds falls from Pc1 to Pc2, and since the bond price is negatively related to the interest rate, the equilibrium interest rate on corporate bonds rises to ic2. At the same time, however, the equilibrium price for the Treasury bonds rises from PT1 to PT2, and the equilib- rium interest rate falls to iT2. The spread between the interest rates on corporate and default-free bonds—that is, the risk premium on corporate bonds—has risen from zero to ic2- iT2. We can now conclude that a bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium.
Because default risk is so important to the size of the risk premium, purchasers of bonds need to know whether a corporation is likely to default on its bonds. This information is provided by credit-rating agencies, investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default. Table 5.1 provides the ratings and their description for the two largest credit-rating agencies, Moody’s Investor Service and Standard and Poor’s Corporation. Bonds with relatively low risk of default are called investment-grade
TABLE 5.1 Bond Ratings by Moody’s and Standard and Poor’s Rating
Moody’s Standard
and Poor’s Descriptions Examples of Corporations with Bonds Outstanding in 2016
Aaa AAA Highest quality (lowest
default risk)
Microsoft, Johnson & Johnson
Aa AA High quality Apple, General Electric
A A Upper-medium grade MetLife, Intel Corp., Harley- Davidson
Baa BBB Medium grade McDonald’s, Bank of America,
Hewlett-Packard, FedEx, Southwest Airlines
Ba BB Lower-medium grade Best Buy, American Airlines, Delta Airlines, United Airlines
B B Speculative Netflix, Rite Aid, J.C. Penney
Caa CCC, CC Poor (high default risk) Sears, Elizabeth Arden
C D Highly speculative Halcon Resources, Seventy-Seven
Energy GO
ONLINE www.federalreserve.gov/
Releases/h15/update/
Study how the Federal Reserve reports the yields on different quality bonds. Look at the bottom of the listing of interest rates for AAA- and BBB-rated bonds.
M05_MISH5006_09_GE_C05.indd 132 13/10/17 1:06 PM
www.rasabourse.com
securities and have a rating of Baa (or BBB) and above. Bonds with ratings below Baa (or BBB) have higher default risk and have been aptly dubbed speculative- grade or junk bonds. Because these bonds always have higher interest rates than investment-grade securities, they are also referred to as high-yield bonds.
Next let’s look at Figure 5.1 at the beginning of the chapter and see if we can explain the relationship between interest rates on corporate and U.S. Treasury bonds. Corporate bonds always have higher interest rates than U.S. Treasury bonds because they always have some risk of default, whereas U.S. Treasury bonds do not.
Because Baa-rated corporate bonds have a greater default risk than the higher-rated Aaa bonds, their risk premium is greater, and the Baa rate therefore always exceeds the Aaa rate. We can use the same analysis to explain the huge jump in the risk premium on Baa corporate bond rates during the Great Depression years 1930–1933 and the rise in the risk premium after 1970 (see Figure 5.1). The depression period saw a very high rate of business failures and defaults. As we would expect, these factors led to a substantial increase in the default risk for bonds issued by vulnerable corporations, and the risk premium for Baa bonds reached unprecedentedly high levels. Since 1970, we have again seen higher levels of business failures and defaults, although they were still well below Great Depression levels. Again, as expected, both default risks and risk premiums for corporate bonds rose, widening the spread between interest rates on corporate bonds and those on Treasury bonds.
Liquidity
Another attribute of a bond that influences its interest rate is its liquidity. As we learned in Chapter 4, a liquid asset is one that can be quickly and cheaply converted