Chapter 3 Structure of Interest Rates: describe how characteristics of debt securities cause their yields to vary, demonstrate how to estimate the appropriate yield for any particular debt security, explain the theories behind the term structure of interest rates. | 1 1 ■ describe how characteristics of debt securities cause their yields to vary ■ demonstrate how to estimate the appropriate yield for any particular debt security ■ explain the theories behind the term structure of interest rates (relationship between the term to maturity and the yield of securities) 2 Chapter Objectives 3 Structure of Interest Rates 2 Why Debt Security Yields Vary The yields on debt securities are affected: Credit (default) risk Liquidity Tax status Term to maturity 3 3 Why Debt Security Yields Vary Credit (Default) Risk – securities with a higher degree of default risk offer higher yields. Rating Agencies - Rating agencies charge the issuers of debt securities a fee for assessing default risk. (Exhibit ). Accuracy of Credit Ratings - The ratings issued by the agencies are useful indicators of default risk but they are opinions, not guarantees. Oversight of Credit Rating Agencies - The Financial Reform Act of 2010 established an Office of Credit Ratings within the Securities and Exchange Commission in order to regulate credit rating agencies. Rating agencies must establish internal controls. 4 4 Exhibit Rating Classification by Rating Agencies 5 5 Why Debt Securities Yields Vary Liquidity - The lower a security’s liquidity, the higher the yield preferred by an investor. Tax Status (Exhibit ) Investors are more concerned with after-tax income. Taxable securities must offer a higher before-tax yield. Term to Maturity (Exhibit ) Maturity dates will differ between debt securities. The term structure of interest rates defines the relationship between term to maturity and the annualized yield. 6 6 Why Debt Securities Yields Vary Computing the Equivalent Before-Tax Yield: = after-tax yield = before-tax yield = Investor’s marginal tax rate Computing the Equivalent Before-Tax Yield: 7 7 Exhibit After-Tax Yields Based on Various Tax Rates and Before-Tax Yields 8 8 Exhibit Example of Relationship between Maturity and Yield of Treasury | 1 1 ■ describe how characteristics of debt securities cause their yields to vary ■ demonstrate how to estimate the appropriate yield for any particular debt security ■ explain the theories behind the term structure of interest rates (relationship between the term to maturity and the yield of securities) 2 Chapter Objectives 3 Structure of Interest Rates 2 Why Debt Security Yields Vary The yields on debt securities are affected: Credit (default) risk Liquidity Tax status Term to maturity 3 3 Why Debt Security Yields Vary Credit (Default) Risk – securities with a higher degree of default risk offer higher yields. Rating Agencies - Rating agencies charge the issuers of debt securities a fee for assessing default risk. (Exhibit ). Accuracy of Credit Ratings - The ratings issued by the agencies are useful indicators of default risk but they are opinions, not guarantees. Oversight of Credit Rating Agencies - The Financial Reform Act of 2010 established an Office of Credit Ratings within
