CHAPTER 6 Interest Rates and Bond Valuation 271term interest rates, and the equilibrium between suppliers and demanders of
long-term funds, such as real estate loans, would determine prevailing long-term
interest rates. The slope of the yield curve would be determined by the general
relationship between the prevailing rates in each market segment. Simply stated,
low rates in the short-term segment and high rates in the long-term segment cause
the yield curve to be upward-sloping. The opposite occurs for high short-term
rates and low long-term rates.All three theories of term structure have merit. From them we can conclude
that at any time, the slope of the yield curve is affected by (1) inflationary expec-
tations, (2) liquidity preferences, and (3) the comparative equilibrium of supply
and demand in the short- and long-term market segments. Upward-sloping yield
curves result from higher future inflation expectations, lender preferences for
shorter-maturity loans, and greater supply of short-term loans than of long-term
loans relative to demand. The opposite behaviors would result in a downward-
sloping yield curve. At any time, the interaction of these three forces determines
the prevailing slope of the yield curve.Risk Premiums: Issuer and Issue Characteristics
So far we have considered only risk-free U.S. Treasury securities. We now re-
introduce the risk premium and assess it in view of risky non-Treasury issues.
Recall Equation 6.1:
k 1 k*IPRP 1
risk-free risk
rate, RF premium
In words, the nominal rate of interest for security 1 (k 1 ) is equal to the risk-free
rate, consisting of the real rate of interest (k*) plus the inflation expectation pre-
mium (IP) plus the risk premium (RP 1 ). The risk premiumvaries with specific
issuer and issue characteristics; it causes similar-maturity securities^88 to have dif-
fering nominal rates of interest.
EXAMPLE The nominal interest rates on a number of classes of long-term securities on
March 15, 2002, were as follows:^910Security Nominal interestU.S. Treasury bonds (average) 5.68%
Corporate bonds (by ratings):
High quality (Aaa–Aa) 6.13
Medium quality (A–Baa) 7.14
Speculative (Ba–C) 8.11
Utility bonds (average rating) 6.99- To provide for the same risk-free rate of interest, k*IP,it is necessary to assume equal maturities. When we do
so, the inflationary expectations premium, IP,and therefore RF, will be held constant, and the issuer and issue char-
acteristics premium, RP,becomes the key factor differentiating the nominal rates of interest on various securities. - These yields were obtained from Mr. Mike Steelman at UBS PaineWebber, La Jolla, CA (March 25, 2002). Note
that bond ratings are explained later in this chapter, on page 278.
Hint An upward-sloping
yield curve will result if the
supply outstrips the demand for
short-term loans, thereby re-
sulting in relatively low short-
term rates at a time when long-
term rates are high because the
demand for long-term loans is
far above their supply.