Money and Capital Markets

8C h a p t e r

Eighth Edition

Financial Institutions and Instruments in a Global Marketplace

Peter S. Rose

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

Marketability, Default Risk, Call Privileges, Prepayment Risk, Taxes, and Other Factors Affecting Interest Rates

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 2

Learning Objectives

To see the effects of the marketability, default risk, liquidity, call privileges, prepayment risk, convertibility and taxability of various loans and securities upon their interest rates.

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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 3

Learning Objectives

To appreciate the difficulties of forecasting interest rates and financial asset prices accurately.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 4

Introduction

In 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, and convertibility.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 5

Marketability and Liquidity

Marketability – 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.

Liquidity – A liquid financial asset is readily marketable. Moreover, its price tends to be stable and reversible.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 6

Default Risk

Default 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 premium

Expected yield on a risky asset = piyi

pi = probability that the ith possible yield, yi, occurs

Anticipated default loss on a risky asset= promised yield – expected yield

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 7

Default Risk

Source: Economic Trends, Federal Reserve Bank of Cleveland, July 2001

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 8

Default Risk

Factors Influencing Default Risk Premiums Credit ratings by rating companies such as

Moody’s and Standard & Poor’s Highly-rated securities are perceived as having

negligible default risk. Fluctuations (cycles) in business activity

The yield spread between Aaa- and Baa-rated securities increases during economic recessions.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 9

Default RiskA

vera

ge Y

ield

s (%

per

ann

um)

4

5

6

7

8

9

10

11

1990 1992 1994 1996 1998 2000 2002

Baa Corporate Bonds

Aaa Corporate

Bonds

10-year Treasury Bonds

30-yearTreasury

Bonds

Data Source: Board of Governors of the Federal Reserve System

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 10

Default Risk

For corporate securities, the period of time the firm has been in operation, variability in company earnings, and the amount of leverage employed

Inflation Default risk premiums tend to be higher and more

volatile when inflation is high and volatile.

Factors Influencing Default Risk Premiums

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 11

Default Risk

The Junk-Bond Spread and the Economy Junk bond spread =

junk bond yields – Aaa corporate bond yields A 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).

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 12

Default Risk

New Ways of Dealing with Default Risk Credit 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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 13

Call Privileges

A 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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 14

Call Privileges

Advantages and Disadvantages The 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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 15

Call Privileges

The Call Premium Issuers of callable securities must pay a call

premium in the form of a higher interest rate. The call premium is higher if

the market expects interest rates to fall (such that the call risk is higher),

the call deferment period is shorter, and the call price is lower.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 16

Prepayment Risk on Loan-Backed Securities

Prepayment 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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 17

Prepayment Risk on Loan-Backed Securities

Since prepayments may lower the investor’s return, loan-backed securities with greater prepayment risks are priced lower.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 18

Taxation of Security Returns

Taxes 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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 19

Taxation of Security Returns

In particular, governments may vary the income brackets and tax rates tie the applicable tax rates to the length of time that

securities were held grant certain amounts of tax exemptions for

various categories enable the deduction of capital losses (up to

specified limits) change the permissible annual contributions to

educational or retirement accounts

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 20

Taxation of Security Returns

A Brief History of Marginal Income Tax Rates

Source: Economic Trends, Federal Reserve Bank of Cleveland, January 2002

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 21

Taxation of Security Returns

Tax-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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 22

Taxation of Security Returns

After-tax yield = (1 – t ) Before-tax yieldwhere t is the investor’s marginal tax rate

An investor will be indifferent between taxable and tax-exempt securities whenTax-exempt yield = (1 – t ) Taxable yield

To make valid comparisons between taxable and tax-exempt issues, the taxed investor should convert all expected yields to an after-tax basis.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 23

Convertible Securities

Convertible (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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 24

Convertible Securities

Note that the issuer may call in the securities early, forcing conversion.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 25

The Structure of Interest Rates

The 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 securities to which those rates apply.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 26

The Structure of Interest Rates

An ExampleDuring the month of January 2002 …

The long-term U.S. Treasury bond rate averaged 5.75%

The corporate Baa bond rate averaged 7.60%

while

+ 1.85% =

Real risk-free rate +3.00%Expected inflation +2.00%Liquidity premium +0.75% Total = 5.75%

Premiums for: marketability +0.35%Call risk +0.25%Default risk +1.25% Total = 1.85%

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 27

Money and Capital Markets in Cyberspace

The world wide web addresses a number of the foregoing issues at a variety of websites: http://www.gac.edu/~elvis/EM42/Chapter7 http://www.taxpolicycenter.org/ http://www.federalreserve.gov/releases/ http://www.clev.frb.org/research/

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 28

Chapter Review

Introduction Marketability and Liquidity Default Risk

The Premium for Default Risk The Expected Rate of Return on a Risky Asset Anticipated Default Loss Factors Influencing Default Risk Premiums The Junk-Bond Spread and the Economy New Ways of Dealing with Default Risk

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

8 - 29

Chapter Review

Call Privileges Advantages and Disadvantages The Call Premium

Prepayment Risk on Loan-Backed Securities Taxation of Security Returns

Comparing Taxable and Tax-Exempt Securities Convertible Securities The Structure of Interest Rates