Structure of Interest Rates: Why Yields Differ Between Securities

Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2

Chapter 2 explained why the general level of interest rates changes. Chapter 3 answers a different question: why do different securities pay different yields at the same point in time? A Treasury bond and a corporate bond with the same maturity do not offer the same return. This chapter explains why.

Four Reasons Yields Differ

1. Credit (Default) Risk

This is the biggest one. Treasury securities are considered risk-free because the U.S. government can always pay its debts. Corporate bonds carry the risk that the company might go bankrupt before repaying you.

To attract investors, riskier securities must offer higher yields. The book gives an example: if a Treasury bond pays 7%, a corporation like Zanstell Co. might need to offer 8% to get investors interested. That extra 1% is the credit risk premium.

That premium might sound small, but on a $30 million bond issue, 1% equals $300,000 in extra interest payments per year.

Rating agencies like Moody’s and Standard & Poor’s assess credit risk and assign ratings. Moody’s uses a scale from Aaa (highest quality) to C (lowest). S&P uses AAA to D. Investment-grade bonds are rated Baa/BBB or better. Anything below is speculative grade, sometimes called “junk bonds.”

The book points out that these agencies got it badly wrong before the 2008 crisis. Many securities that received high ratings ended up defaulting. The agencies defended themselves by saying they could not have predicted the crisis, but critics pointed out that the agencies are paid by the companies issuing debt, not by investors. That creates an obvious incentive to be generous with ratings.

The Financial Reform Act of 2010 created an Office of Credit Ratings within the SEC to oversee these agencies and hold them more accountable.

2. Liquidity

Liquidity means how easily you can sell a security without losing value. Treasury securities are very liquid because there are always buyers and sellers. Bonds from a small company might sit for days without a trade.

Less liquid securities need to offer higher yields to compensate. If you might get stuck holding something, you want to be paid more for taking that risk.

3. Tax Status

Municipal bonds are often exempt from federal income tax. This means they can offer lower before-tax yields and still be attractive, especially to investors in high tax brackets.

The conversion formula is simple: After-tax yield = Before-tax yield x (1 - Tax rate)

A taxable bond paying 8% gives an investor in the 25% bracket only 6% after taxes. A tax-exempt municipal bond paying 6.5% would actually be the better deal.

4. Term to Maturity

Securities with different maturities offer different yields even when everything else is equal. The relationship between maturity and yield at a specific moment in time is called the term structure of interest rates, and it is plotted as a yield curve.

The Yield Formula

The book provides a clean model for estimating what yield a security should offer:

Yn = Rf,n + DP + LP + TA

Where:

• Yn = yield on the security
• Rf,n = risk-free rate for the same maturity (Treasury yield)
• DP = default premium (credit risk)
• LP = liquidity premium
• TA = tax adjustment

So if the 3-month Treasury bill pays 8%, and a company needs to add 0.7% for credit risk, 0.2% for liquidity, and 0.3% for taxes, its commercial paper should yield about 9.2%.

Understanding the Yield Curve

The yield curve gets its own deep section because it is one of the trickiest concepts in finance. Three theories try to explain its shape.

Pure Expectations Theory

This theory says the yield curve shape depends entirely on what investors expect future interest rates to do.

If investors expect rates to rise, they will prefer short-term securities so they can reinvest at higher rates later. This floods the short-term market with money (pushing short-term yields down) and starves the long-term market (pushing long-term yields up). Result: an upward-sloping yield curve.

If investors expect rates to fall, the opposite happens. They rush into long-term securities to lock in current rates. Result: a downward-sloping or inverted yield curve.

The theory also introduces forward rates, which are implied future interest rates that you can calculate from the current yield curve. If the 1-year rate is 8% and the 2-year rate is 10%, you can figure out what the market expects the 1-year rate to be next year. In this case, it is about 12%.

Liquidity Premium Theory

This theory adds a layer on top of expectations. Even if investors expect rates to stay flat, long-term securities should offer slightly higher yields because they are less liquid. If you tie your money up for 10 years, you deserve extra compensation compared to lending for 3 months.

This means the yield curve has a natural upward bias. A flat yield curve actually implies the market expects rates to fall slightly. A slightly upward-sloping curve might mean no expected change at all, once you strip out the liquidity premium.

Segmented Markets Theory

This theory takes a totally different approach. It says different investors and borrowers have specific maturity preferences based on their needs, not their rate expectations.

Pension funds need long-term investments to match their long-term obligations. Banks take short-term deposits. These preferences create separate supply and demand conditions at each maturity, which is why yields can differ.

A limitation is that this theory cannot explain why rates across all maturities tend to move together. If markets were truly segmented, changes in one maturity market would not affect others. But they clearly do.

Putting It All Together

The reality is probably a combination of all three. Interest rate expectations drive the general shape. Liquidity preferences add an upward bias. And specific institutional needs at different maturities create some additional variation.

Using the Yield Curve

The yield curve is not just academic. People use it to:

Forecast interest rates. An upward slope generally signals expectations of higher rates. A flat or inverted curve has historically preceded recessions. The curve inverted slightly in March 2007, and the recession hit in 2008.

Make investment decisions. Some investors “ride the yield curve” by buying longer-term securities than they need, betting on capital gains if rates stay stable or decline.

Make borrowing decisions. Firms looking to issue bonds can compare yields at different maturities to decide how long to borrow.

My Take

This chapter is denser than the first two, especially the math around forward rates. But the core ideas are practical. The yield formula (risk-free rate plus premiums) is something you can actually use to evaluate any bond investment.

The yield curve as a recession predictor is fascinating. It is not perfect, but its track record is better than most economic indicators. When the curve inverts, it means the bond market is betting that the economy will weaken and the Fed will have to cut rates. That is a signal worth paying attention to.

The section on rating agencies is also a good reminder. Credit ratings are opinions, not guarantees. The 2008 crisis proved that in the most expensive way possible.

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