Tài chính doanh nghiệp - Chapter 8: The risk structure of interest rates: defaults, prepayments, taxes, and other rate - Determining factors

Chapter 8The Risk Structure of Interest Rates: Defaults, Prepayments, Taxes, and Other Rate-Determining Factors Learning Objectives To see the effects of financial assets’ marketability, liquidity, default risk, call privileges, prepayment risk, convertibility and taxability upon their interest rates and prices.To understand why there are so many different interest rates within the global economy.To learn how the “structure of interest rates” is built and why it changes constantly. Learning Objectives To see why it is so difficult to forecast interest rates and financial asset prices accurately.IntroductionIn the preceding chapter, we examined how expected inflation and security maturity affect interest rates.In this chapter, we will look at how some other factors influence interest rates:  marketability,  default risk,  call privileges,  taxation of security income,  prepayment risk,  convertibility.MarketabilityMarketability – Can an asset be sold quickly?Marketability is positively related to the size and reputation of the institution issuing the securities and to the number of similar securities outstanding. However, marketability is negatively related to yield.LiquidityLiquidity – A liquid financial asset is readily marketable. Moreover, its price tends to be stable over time and it is reversible.Popular measures of liquidity include the bid-ask spread, trading volume, frequency of trades, and average trade size.Default Risk and Interest RatesDefault risk – The risk that a borrower will not make all the promised payments at the agreed-upon times. Promised yield on a risky asset= risk-free interest rate + default risk premiumThe promised yield on a risky debt security is the yield to maturity that will be earned by the investor if the borrower makes all promised payments when they are due.Default Risk and Interest RatesDefault Risk and Interest RatesAmong the leading U.S. bankruptcy filers in modern history are WorldCom, Enron, Conseco, Texaco, Global Crossing, UAL, Pacific Gas and Electric Company, Kmart, etc. Expected yield on a risky asset = S piyipi = probability that the ith possible yield, yi, occursAnticipated default loss on a risky asset= promised yield – expected yieldDefault Risk and Interest RatesFactors Influencing Default Risk PremiumsCredit ratings by rating companies such as Moody’s and Standard & Poor’sHighly-rated securities are perceived as having negligible default risk.Default Risk and Interest RatesBond-Rating CategoriesDefault Risk and Interest RatesThe Behavior of Interest RatesSource: Monetary Trends, Federal Reserve Bank of St. Louis, Dec 2003Default Risk and Interest RatesMarket Yield* Corporate bond ratings are from Moody’s Investors Service. ** 2004 interest rates are averages for January.Source: Board of Governors of the Federal Reserve SystemDefault Risk and Interest RatesFluctuations (cycles) in business activityThe yield spread between Aaa- and Baa-rated securities increases during economic recessions.For corporate securities, the period of time the firm has been in operation, variability in company earnings, and the amount of leverage employedFactors Influencing Default Risk PremiumsDefault Risk and Interest RatesInflation and Default Risk PremiumsDefault risk premiums tend to be higher and more volatile when inflation is high and volatile.Greater uncertainty about inflation tends to produce a “flight to quality” in the financial markets, and investors simply become more cautious about buying default-risk-exposed financial instruments.Default Risk and Interest RatesYield Curves for Risky SecuritiesThere is some evidence that the yield curves on high-default-risk instruments often have a downward (negative) slope or may have a significant bow or hump in them as maturity increases.Each required payment that is successfully made seems to lower the risk that subsequent payments will be missed.Default Risk and Interest RatesThe Volatile History of Junk BondsJunk bonds are long-term debt securities whose full repayment is judged to be significantly less certain than that for bonds rated investment quality.Default Risk and Interest RatesThe Junk-Bond Spread and the EconomyJunk bond spread =junk bond yields – Aaa corporate bond yieldsA rise in the junk bond spread indicates a growing fear among bond market investors that marginal-quality corporate borrowers are more likely to default on their debts (i.e. a weakening economy).New Ways of Dealing with Default Risk: Credit DerivativesCredit derivatives are financial contracts that seek to protect lenders against default risk by shifting that risk to someone else willing to accept it for a fee.In a credit swap, two or more lenders agree to exchange a portion of their expected payments.A credit option may enable the lender to be reimbursed if a credit asset begins to lose value.New Ways of Dealing with Default Risk: Credit DerivativesCall Privileges and Call RiskA call privilege on a bond contract grants the borrower the option to retire all or a portion of a bond issue by buying back the securities in advance of maturity at a specified call price.A bond may be callable immediately, or the privilege may be deferred for a specified period of time.Call Privileges and Call RiskThe yield on called financial assets can be calculated by equating the security’s price (P) with the present value of all its future cash flows (I):n = the number of periods until maturityk = the time period in which the security is called, k < nC = call pricei = the interest rate the call price is reinvested ath = holding period yieldCall Privileges and Call RiskAdvantages and DisadvantagesThe call option is an advantage to the security issuer because it grants greater financial flexibility and the potential for reducing future interest costs.However, it is a disadvantage to the security buyer. The holding-period yield may decline if the security is called, and the potential for capital gains is limited.Call Privileges and Call RiskThe Call Premium & Interest Rate ExpectationsIssuers of callable securities must pay a call premium in the form of a higher interest rate.The call premium is higher ifthe market expects interest rates to fall (such that the call risk is higher),the call deferment period is shorter, andthe call price is lower.Call Privileges and Call RiskResearch EvidenceResearch studies generally support the expected inverse relationship between interest rate expectations and the value of the call privilege.Research also suggests that calling in bonds to save on interest costs may be a “zero sum game” between the bondholders and stockholders of a company.Prepayment Risk and the Yields on Loan-Backed SecuritiesPrepayment risk is the risk that the purchaser may receive higher-than-expected repayments of principal early in the life of loan-backed securities.Prepayment risk is especially valid for the investors in securities that are backed by home mortgage loans, as many home loans will be retired early due to loan refinancing and home-owner turnover.Prepayment Risk and the Yields on Loan-Backed SecuritiesSince prepayments may lower the investor’s return, loan-backed securities with greater prepayment risks are priced lower.Prepayment Risk and the Yields on Loan-Backed SecuritiesOne of the most popular devices today to reduce prepayment risk is to divide the loan-backed security issue into classes or tranches.Each tranche promises a different rate of return based on a different maturity and risk profile.Taxation of Returns on Financial AssetsTaxes imposed by the federal, state, and local governments can have a profound effect on the returns earned by investors on financial assets.Thus, governments can use their taxing power to encourage the investment in certain financial assets, thereby redirecting the flow of savings and investment toward areas of critical social need.Taxation of Returns on Financial AssetsIn particular, governments mayvary the income brackets and tax ratestie the applicable tax rates to the length of time that securities were heldgrant certain amounts of tax exemptions for various categoriesenable the deduction of capital losses (up to specified limits)change the permissible annual contributions to educational or retirement accountsTaxation of Returns on Financial AssetsTax-exempt securities represent a subsidy to induce investors to support local governments.The exemption privilege shifts the burden of federal taxation from buyers of municipal bonds to other taxpayers.However, the privilege lowers the interest rates at which municipals can be sold in the open market relative to comparable taxable bonds.Taxation of Returns on Financial AssetsAfter-tax yield = (1 – t )  Before-tax yieldwhere t is the investor’s marginal tax rateAn investor will be indifferent between taxable and tax-exempt securities whenTax-exempt yield = (1 – t )  Taxable yieldTo make valid comparisons between taxable and tax-exempt issues, the taxed investor should convert all expected yields to an after-tax basis.Taxation of Returns on Financial AssetsRecent Marginal Federal Income Tax RatesConvertible SecuritiesConvertible (or hybrid) securities are special issues of corporate bonds or preferred stock that can be exchanged for a specific number of shares of the issuing firm’s common stock.Convertibles offer the investor the prospect of a stable interest or dividend income, as well as capital gains on common stock on conversion.Hence, investors are generally willing to pay a premium for convertibles.Convertible SecuritiesFor the corporate bond issuer, the advantages of convertible bonds is a significantly lower interest cost and being able to avoid issuing more common stock.Interest on convertible bonds is often a tax-deductible expense in many countries too.Note that the issuer may call in the securities early, forcing conversion.The Structure of Interest RatesThe risk-free interest rate underlies all interest rates and is a component of all rates.All other interest rates are scaled upward by varying degrees from the risk-free rate, depending on such factors as inflation, the term (maturity) of a loan, the risk of borrower default, the risk of prepayment, and the marketability, liquidity, convertibility, and tax status of the financial assets to which those rates apply.The Structure of Interest RatesMarkets on the NetDuff & Phelps Credit Rating Company at www.duffllc.com/Federal Reserve Bank of Cleveland at www.clevelandfed.org/Federal Reserve System at www.federalreserve.gov/releases/Fitch Ratings at www.fitchratings.comHigh Yield or “Junk” Bonds at www.finpipe.com/bndjunk.htmMarkets on the NetMoody’s Investor Service at www.moodys.comStandard & Poor’s Corporation at www.standardpoor.comThe Bond Market Association at www.investinginbonds.comThomson Bank Watch at www.bankwatch.comChapter ReviewIntroductionMarketabilityLiquidityChapter ReviewDefault Risk and Interest RatesThe Premium for Default RiskThe Expected Rate of Return or Yield on a Risky AssetAnticipated Loss and Default-Risk PremiumsFactors Influencing Default Risk PremiumsInflation and Default-Risk PremiumsYield Curves for Risky SecuritiesThe Volatile History of Junk BondsThe Junk-Bond Spread and the EconomyChapter ReviewNew Ways of Dealing with Default Risk: Credit DerivativesCall Privileges and Call RiskCalculating the Yields on Called Financial AssetsAdvantages and Disadvantages of the Call PrivilegeThe Call Premium and Interest Rate ExpectationsResearch Evidence on Call Privileges and Call RiskChapter ReviewPrepayment Risk and the Yields on Loan-Backed SecuritiesTaxation of Returns on Financial AssetsRecent Changes in Tax LawsTreatment of Capital LossesTax-Exempt SecuritiesChapter ReviewConvertible SecuritiesAdvantages for the Corporate Bond IssuerAdvantages for the Investor in Convertible BondsThe Structure of Interest Rates in the Financial System