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

1. 8 Marketability, Default Risk, Call Privileges, Prepayment Risk, Taxes, and Other Factors Affecting Interest Rates C h a p t e r Money and Capital Markets Financial Institutions and Instruments in a Global Marketplace Eighth Edition Peter S. Rose McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

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.

3.  Learning Objectives  • To appreciate the difficulties of forecasting interest rates and financial asset prices accurately.

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.

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.

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 = Spiyi pi = probability that the ith possible yield, yi, occurs • Anticipated default loss on a risky asset = promised yield – expected yield

7. Default Risk Source: Economic Trends, Federal Reserve Bank of Cleveland, July 2001

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.

9. Baa Corporate Bonds Aaa Corporate Bonds 30-year Treasury Bonds 10-year Treasury Bonds Default Risk Average Yields (% per annum) Data Source: Board of Governors of the Federal Reserve System

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

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).

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.

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.

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.

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.

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.

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.

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.

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

20. Taxation of Security Returns A Brief History of Marginal Income Tax Rates Source: Economic Trends, Federal Reserve Bank of Cleveland, January 2002

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.

22. Taxation of Security Returns • After-tax yield = (1– t) Before-tax yield where t is the investor’s marginal tax rate • An investor will be indifferent between taxable and tax-exempt securities when Tax-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.

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.

24. Convertible Securities • Note that the issuer may call in the securities early, forcing conversion.

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.

26. Premiums for:  marketability +0.35% Call risk +0.25% Default risk +1.25% Total = 1.85% Real risk-free rate +3.00% Expected inflation +2.00% Liquidity premium +0.75% Total = 5.75% The Structure of Interest Rates An Example During 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% =

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/

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

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