9. RISK AND TERM STRUCTURE OF INTEREST RATES
Businesses and governments offer a variety of bonds that differ in default risk, liquidity,
information costs, and taxes. Thus, these differences cause interest rates and bond prices to
differ among these different securities. Furthermore, the U.S. government offers Treasury Bills,
Treasury Notes, and Treasury Bonds that range in maturity from 15 days to 30 years.
Consequently, economists study these interest rates from these securities that they call the term
structure of interest rates. Then economists can plot the term structure, called the yield curve.
Yield curve usually slopes upward and means the long-term U.S. government securities pay a
higher interest rate than the short-term ones. Economists use three theories to explain the
characteristics of the yield curve and utilize the yield curve to predict recessions.
Default Risk and Bond Prices...............................................................
Default risk is the possibility a borrower will not repay the principal and/or interest on a
loan. For instance, the U.S. government has little risk of default, and investors call U.S.
securities default-risk-free instruments. U.S. government can raise taxes, print money, or issue
new debt, when it experiences financial trouble. On the other hand, a business has some risk of
default. Business can bankrupt and cannot repay its debt. Economists call the difference between
the interest rate on the U.S. government bonds and corporate bonds the default risk premium.
Investors add default risk premium to a risk-free investment, so they can invest in “risky” bonds
because they earn a greater return. Risk premium is always positive. Rating companies such as
Standard & Poor’s Corporation and Moody’s Investor Service assess the default risk for
corporations. These companies calculate a single statistic, called the bond rating, based on a
corporation’s net worth, cash flow, and ability to meet its debt obligations.
Supply and demand functions that you already learned in the last chapter can help explain
the impact of risk of a market. We draw the supply and demand for two markets: government
bond market and corporate bond market. We set the same equilibrium price and quantity for
both markets in Figure 1, which means both markets have identical risks. Unfortunately, a
corporation could have financial trouble, so investors believe the corporation could default.
Some investors demand fewer corporate bonds and invest more in government bonds. Thus, the
demand for corporate bonds falls while the demand for government bonds rise because the
investors consider the government bonds default-free.
Did you notice the government bonds have a higher bond price while corporate bonds have
a lower bond price? Thus, the market interest rate always moves in the opposite direction of
bond prices because of the present value formula. Consequently, corporations pay greater
interest rates for their bonds while the U.S. government pays a lower interest rate. Taking the
difference between the government bond and corporate bond interest rates, we can calculate the
risk premium. As the default risk increases, then the risk premium increases too. During
recessions, when some businesses bankrupt, the default risk increases, increasing the risk
premium. Hence, the difference between government and corporate interest rates would widen.