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					                       Chapter 7
       The Risk and Term Structure of Interest Rates

I. Ratings and the Risk Structure of Interest Rates
   The risk of default (i.e., that a bond issuer will fail to make a bond’s promised
   payments) is one of the most important risks a bondholder faces, and it varies among
   issuers. Credit rating agencies have come into existence to assess the default risk of
   different issuers.
   A. Bond Ratings
       1. The best-known rating services are Moody’s and Standard & Poor’s.
       2. Companies with good credit earn high ratings, suggesting that they will have
           little difficulty meeting the bond’s payment obligations.
       3. “Investment Grade” comprises the top four ratings; the next group is the non-
           investment speculative grades, which are often referred to as “junk bonds”.
       4. There are two types of junk bonds: “fallen angels” which were once
           investment grade but the companies’ situations have changed, and “original
           issue” junk bonds which are bonds for which little is known about the risk of
           the issuer.
       5. The ratings companies continually monitor the situations of firms and
           announce rating changes; a lowering of the rating is a “downgrade” and an
           improvement is an “upgrade”.
   B. Commercial Paper Ratings
       1. Commercial paper is a short-term version of a bond, issued both by
           corporations and governments.
       2. This is unsecured debt because the borrower offers no collateral.
       3. Commercial paper is issued on a discount basis, and most of it has a maturity
           of between 5 to 45 days.
       4. Moody’s and Standard & Poor’s provide rations of commercial paper issuers
           in the same way they do bonds. The lowest default risk issues are now termed
           “prime” grade or investment grade.
   C. The Impact of Ratings on Yields
       1. The lower a bond’s rating the lower its price and the higher its yield.
       2. A bond yield can be thought of as the sum of two parts: the yield on the U.S.
           Treasury bond (called “benchmark bonds” because they are close to being
           risk-free) and a risk spread or default risk premium.
       3. The default risk premium should increase as the bond rating decreases.
       4. Considering yield this way also allows us to see that when U.S. Treasury bond
           yields change all other yields will change in the same direction.
       5. The difference of a couple of points in yield has a big affect on the cost of
           debt.


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II. Michael Milken and the History of Junk Bonds
    1. The lowest-grade bonds called junk bonds are also referred to as “high-yield”
       bonds.
    2. The modern history of junk bonds is the history of Michael Milken and Drexel
       Burnham Lambert.
    3. Milken believed that “fallen angels” were underpriced and that an investor could
       earn a better return by buying a well-diversified portfolio of such bonds (as
       compared to investment-grade bonds).
    4. Then in August 1977 he started to trade “original issue” junk bonds, providing
       financing to firms in poor financial condition.
    5. In 1984 he began to raise money for hostile corporate takeovers, a new
       phenomenon, called “leveraged buy-outs” (LBOs).
    6. Three important lessons can be learned from the history of junk bonds:
        The market in which junk bonds are bought and sold survived the person who
           created it.
        The ability of less-creditworthy firms to obtain funds by issuing high-yield
           bonds has surely improved the functioning of the financial system.
        New financial instruments, and the markets in which they are traded, can
           come into existence and prosper if they improve the allocation of economic
           resources.

III. Differences in Tax Status and Municipal Bonds
     1. The second important factor that affects the return on a bond is taxes.
     2. Bondholders must pay income tax on the interest income they receive from
        privately issued bonds, but government bonds are treated differently.
     3. Interest payments on bonds issued by state and local governments, called
        “municipal” or “tax-exempt” bonds are specifically exempt from taxation.
     4. A tax exemption affects a bond’s yield because it affects how much of the return
        the bondholder gets to keep.
     5. The yield on a tax-exempt bond equals the taxable bond yield times one minus the
        tax rate.

IV. The Term Structure of Interest Rates
    1. A third factor that affects a bond’s yield is its maturity.
    2. The relationship among bonds with the same risk characteristics but different
       maturities is called the term structure of interest rates.
    3. Three conclusions can be drawn from studying the data:
       a. Interest rates of different maturities tend to move together.
       b. Yields on short-term bonds are more volatile than those on long-term bonds.
       c. Long-term yields tend to be higher than short-term yields.

   A. The Expectations Hypothesis
      1. The hypothesis begins with the observation that the risk-free interest rate can
         be computed, assuming that there is no uncertainty about the future.


                                         7-2
      2. This means that an investor would be indifferent between holding a two-year
         bond or a series of two one-year bonds because certainty means that bonds of
         different maturities are perfect substitutes for each other.
      3. When interest rates are expected to rise long-term rates will be higher than
         short-term rates and the yield curve will slope up (and vice versa).
   B. The Liquidity Premium Theory
      1. Risk is the key to understanding the slope of the yield curve.
      2. The upward slope is due to long-term bonds being riskier than short-term
         bonds.
      3. The longer the term the greater the inflation and interest-rate risk.
         a. Inflation risk increases over time because investors, who care about the
             real return, must forecast inflation over longer periods.
         b. Interest-rate risk arises when an investor’s horizon and the bond’s maturity
             do not match. If holders of long-term bonds need to sell them before
             maturity and interest rates have increased, the bonds will lose value.
      4. Including risk in the model means that we can think of yield as having two
         parts: one that is risk-free and one that is a risk premium.

V. The Information Content of Interest Rates
   Information in the Risk Structure of Interest Rates
       1. An impending recession raises the risk premium on privately issued bonds
          because of the increasing risk that corporations cannot meet their obligations.
       2. An economic slowdown or recession does not affect the risk of holding
          government bonds.
       3. Recessions do not affect all companies equally, and the impact on those with
          high ratings is likely to be small. Therefore the spread between U.S.
          Treasuries and highly rated bonds is not likely to move by much.
       4. For firms with lower ratings, the situation is quite different; the lower the
          initial grade of the bond, the more the default risk premium rises as general
          economic conditions deteriorate.
   A. Information in the Term Structure of Interest Rates
       1. Information on the term structure also helps us to forecast general economic
          conditions.
       2. The yield curve usually slopes upward, but on rare occasions it can be
          inverted and slope downward (short-term rates exceed long-term yields).
       3. An inverted yield curve predicts an economic slowdown because it signals a
          fall in short-term interest rates.




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