Chapter 6

• occurs when the issuer of the bond is unable or unwilling to make interest payment when promised or pay off the true value when the bond matures

  Default Risk
• bonds with no default risk

  Default-Free Bonds
• the spread between interest rates on bonds with difficult risk and interest rate on default-free bonds, both of the same maturity

  Risk Premium
• indicates how much additional interest people must earn to be willing to hold the risky bond

  Risk Premium
• A bond with default risk always has a positive risk premium.
• A higher default risk means a larger risk premium.
• investment advisory firms that rate the quality of corporate and municipal bonds in terms of their profability of default

  Credit-Rating Agency
• bonds with rating below Baa (or BBB) have higher default risk and have been aptly dubbed speculated-grade


  Junk Bond
• one that can be quickly and cheaply converted into cash if the need arises

  Liquidity
• Corporate bonds are not as liquid because fewer bond for any one corporation are traded; thus it can be costly to sell bonds in an emergency it might be hard to find buyers quickly.
• certainly not default free; state and local goverments have defaulted on municipal bonds in the past, particularly during the Great Depression

  Municipal Bond
• not liquid as the U.S Treasury Bonds

  Municapal Bonds
• are exempt from Federal Income Interest

  Municipal Bond
• Interest Rates on bonds with the same maturity are influenced by three key factor:

  • Default Risk
  • Liquidity
  • Task Treatment
• a plot of yields on the bonds with altering terms to maturity but the same risk, liquidity, and tax consideration

  Yield Curve
• describes the term structure of interest rates for particular types of bonds, such as government bonds

  Yield Curve
• can be classified as upward sloping, flat, and downward sloping


  Yield Curve
• most common case, long-term interest rate are above short-term interest rates

  Upward Sloping Yield Curve
• short and long-term interest rate are the same

  Flat Yield Curve
• long-term interest rate are below short-term interest rate

  Downward Sloping or Inverted Yield Curve
• Theories of Term Structure of Interest Rate

  • Expectations Theory
  • The Segmented Markets Theory
  • Liquidity Premium Theory
• the interest rate on a lond-term bond will equal the average of the short-term interest rate that people expect to occur over the life of the long-term bond

  Expectation Theory
• The Expectation Theory predicts that interest rates are expecte to have different values at future dates.
• The key assumption behind this theory is that buyers of bond do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if it is expected return is less than of another bond with a different maturity.
• Interest rate on long-term bond is equal to the average of the short-term interest rates that people expect occur over the life of that long-term bond.
• Short-term interest rate are just as likely to fall as they are to rise, and so the expectations theory suggest that the typical yield curve should be flat rather than upward sloping.
• sees markets for dofferent-maturity bons as completely separate and segemented

  Segmented Markets Theory
• The key assumption of the segmented market theory is that bonds of different maturity are not substitues at all, and so the expected return from holding a bond of one maturity has no effect on the demand of another maturity.
• Segmneted Theory is the opposit extreme of Expected Theory, which assures that bonds of different maturities are perfect substitutes.
• Risk averse investors have short desired holding periods and generally preferred bonds with shorter maturities that have less interest rate risk.
• the interest rate on a long-tem bond will equal an average of short-term interest rate expected to occurs over the life of the long-term bonds

  Liquidity Premium
• Key assumption is that bonds of differnet maturities are substitutes , which means that the expected return on one bond does influence the expected return on a bond of a different maturity.
• bonds with different maturities are substitutes but not perfect substitutes


  Liquidity Premium
• assumes that investors have a preference for bonds of one maturity over bond of anoter-a particular bond maturity in which they prefer to invest

  Preferred Habitat
• they prefer long-term bond

  Preferred Habitat