Chapter 6 Interest Rates 173Since the yield curve is normally upward-sloping, short-term
debt is normally less expensive than long-term debt. However,
it’s dangerous to $ nance long-term assets with short-term debt.
To get around this problem, investment bankers created a new
instrument, auction rate securities (ARS), which are long-term
bonds with this wrinkle: Weekly (or monthly for some) auctions
are held. The borrower buys back at par the bonds of holders
who want to get out and simultaneously sells those reclaimed
bonds to new lenders. Potential new lenders indicate the lowest
interest rate they will accept, and the actual rate paid on the
entire issue is the lowest rate that causes the auction to clear.
Most of the bonds were insured by AAA insurance companies,
which gave them a AAA rating.
To illustrate, the total issue might be for $100 million
and the initial rate might be 3%. One week later holders of
$5 million of bonds might turn in their bonds, which would
then be o! ered in an auction to potential buyers. To get the
bonds resold, an annual rate of 3.1% might be required. Then
for the next week, all $100 million of the bonds would earn
3.1%. There was a cap on the interest rate tied to an index of
rates on regular long-term bonds.
Investors liked the ARS because they paid a somewhat
higher rate than money market funds and they were equally
safe and almost as liquid. They were underwritten by major
$ nancial institutions such as Goldman Sachs, Merrill Lynch,
and Citigroup, which would buy the excess if more bonds
were turned in than were bid for at rates below the cap. The
institutions would hold repurchased bonds in inventory and
then sell them to their customers.
Everything worked fine until the credit market melt-
down of 2008. The banks who back-stopped the auction
had lost billions in the subprime mortgage debacle, and
they didn’t have the capital to step in. After a couple of
failed auctions, many ARS holders became concerned
about liquidity and tried to turn in their bonds. That rush
to the exits caused the whole market to freeze up. Highly
liquid securities suddenly became totally illiquid. Penalty
rates for frozen securities kicked in, some as high as 20%.
That’s much higher than “normal” liquidity premiums, but
it does demonstrate that liquidity is valuable and that
high liquidity premiums are built into illiquid securities’
rates.Source: Stan Rosenberg and Romy Varghese, “Auction-Rate Bonds May Come to Rescue,” The Wall Street Journal, February 15, 2008, p. C2.
A 20% LIQUIDITY PREMIUM ON A HIGH-GRADE BOND
vary in their liquidity. Because liquidity is important, investors include a liquidity
premium (LP) in the rates charged on different debt securities. Although it is dif! -
cult to measure liquidity premiums accurately, a differential of at least two and
probably four or! ve percentage points exists between the least liquid and the
most liquid! nancial assets of similar default risk and maturity.
6-3f Interest Rate Risk and the Maturity Risk
Premium (MRP)
U.S. Treasury securities are free of default risk in the sense that one can be virtu-
ally certain that the federal government will pay interest on its bonds and pay
them off when they mature. Therefore, the default risk premium on Treasury
securities is essentially zero. Further, active markets exist for Treasury securities,
so their liquidity premiums are close to zero. Thus, as a! rst approximation, the
rate of interest on a Treasury security should be the risk-free rate, rRF , which is the
real risk-free rate plus an in" ation premium, rRF " r* # IP. However, the prices of
long-term bonds decline whenever interest rates rise; and because interest rates
can and do occasionally rise, all long-term bonds, even Treasury bonds, have an
element of risk called interest rate risk. As a general rule, the bonds of any orga-
nization, from the U.S. government to Delta Airlines, have more interest rate risk
the longer the maturity of the bond.^8 Therefore, a maturity risk premium (MRP),
Liquidity Premium (LP)
A premium added to the
equilibrium interest rate
on a security if that
security cannot be
converted to cash on short
notice and at close to its
“fair market value.”Liquidity Premium (LP)
A premium added to the
equilibrium interest rate
on a security if that
security cannot be
converted to cash on short
notice and at close to its
“fair market value.”Interest Rate Risk
The risk of capital losses to
which investors are
exposed because of
changing interest rates.
Maturity Risk Premium
(MRP)
A premium that reflects
interest rate risk.Interest Rate Risk
The risk of capital losses to
which investors are
exposed because of
changing interest rates.
Maturity Risk Premium
(MRP)
A premium that reflects
interest rate risk.(^8) For example, if someone had bought a 20-year Treasury bond for $1,000 in October 1998, when the long-term
interest rate was 5.3%, and sold it in May 2002, when long-term T-bond rates were about 5.8%, the value of the
bond would have declined to about $942. That would represent a loss of 5.8%; and it demonstrates that long-
term bonds, even U.S. Treasury bonds, are not riskless. However, had the investor purchased short-term T-bills in
1998 and subsequently reinvested the principal each time the bills matured, he or she would still have had the
original $1,000. This point is discussed in detail in Chapter 7.