THE RISK AND TERM STRUCTURE OF INTEREST RATE

In reality we have a large number of bonds and associated interest rates in the market where the
interest rates differ from each other. The relationship between interest rates on bonds with same
term to maturity is called the risk structure of interest rate though risk, liquidity and income tax
rules, all play important role in determining the risk structure. The relationship between interest
rates on bonds with different terms to maturity is called the term structure of interest rate.
Risk Structure of Interest Rates the risk structure of an interest rate is explained by three
factors: default risk, liquidity and the income tax treatment of a bonds interest payments. Each
one of these is explained below.
Default risk default risk or risk of default occurs when the issuer of a bond is unable to make
interest payments or pay off the face value when the bond matures. Bonds having no default risk,
like government bonds, are called default-free bonds. The spread between the interest rates on
bonds with default risk and default-free bonds of same maturity are called the risk premium.
Risk premium indicates how much additional interest people must earn to be willing to hold that
risky bond. The impact of default risk on interest rates can be examined using the following
diagram. To begin with suppose, a corporate bond has the same default risk as the govt. bond.
Therefore, for the same term to maturity, the two bonds will have same interest rates and prices
(Pc1 = PT1) and the risk premiums on corporate bonds will be zero.

Now, if the corporation begins to suffer large losses, the default risk on corporate bonds will
increase, the asset would become riskier. Following the Theory of Portfolio Choice, the demand
for riskier bond will decrease; the demand curve for the corporate bond would shift to the left
(from Dc1to Dc2). The bond price will fall to Pc2 and interest rate will rise. On the other hand, the
treasury bonds are now less risky relative to the corporate bond. Therefore, demand for this bond
will increase as reflected in a rightward shift in the demand curve. The price of this bond will

increase and the interest will fall. Therefore, now there will be a positive risk premium (ic2 iT2).
So, a bond with default risk will always have a positive risk premium and the risk premium
increases with increase in default risk.
The information on the possibility of default is provided by credit-rating agencies, investment
advisory firms that rate the quality of corporate and municipal bonds in terms of their probability
of default. Top three international credit rating agencies are Moodys Investor Service, Standard
and Poors Corporation, and Fitch Ratings. There are five credit rating agencies in India:
CRISIL, Fitch Ratings India, ICRA, Credit Analysis and Research (CARE), Brickwork Ratings
India, and SME Rating Agency of India (SMERA). CRISIL is a Standard and Poors Company
and its ratings for long-term instruments are given in the table below. There are separate ratings
for short-term instruments, fixed deposits, corporate credit, and long-term and short-term
structured finance instruments like derivatives, and can be viewed following
http://crisil.com/ratings/credit-rating-scale.html.
CRISIL Rating scale for Long-Term Instruments
AAA
(Highest Safety)

Instruments with this rating are considered to have the highest degree of
safety regarding timely servicing of financial obligations. Such
instruments carry lowest credit risk.

AA
(High Safety)

Instruments with this rating are considered to have high degree of safety
regarding timely servicing of financial obligations. Such instruments
carry very low credit risk.

A
(Adequate Safety)

Instruments with this rating are considered to have adequate degree of

safety regarding timely servicing of financial obligations. Such
instruments carry low credit risk.

BBB
(Moderate Safety)

Instruments with this rating are considered to have moderate degree of

safety regarding timely servicing of financial obligations. Such
instruments carry moderate credit risk.

BB
(Moderate Risk)

Instruments with this rating are considered to have moderate risk of

default regarding timely servicing of financial obligations.

B
(High Risk)

Instruments with this rating are considered to have high risk of default
regarding timely servicing of financial obligations.

C
(Very High Risk)

Instruments with this rating are considered to have very high risk of
default regarding timely servicing of financial obligations.

D
Default

Instruments with this rating are in default or are expected to be in

default soon.

In essence, ratings are functions of both qualitative functions like financial ratios, balance sheet
strength and qualitative factor such as competitive pressure and management competence. There
are two main types of models: rating models which assign a credit rating from which is inferred a
default probability and default models which model the default probability and map this into a
rating scale. Details apart, both represent the same methodology. Bonds with relatively low risk
of default having a rating of BBB and above are called investment-grade securities. Bonds with
ratings below BBB are called speculative-grade or junk bonds.
Liquidity treasury bonds are the most liquid of all long term bonds because it is easiest to sell
them at a low cost. The lower liquidity of corporate bonds relative to treasury bonds increases
the spread between the interest rates on these two bonds. Because with increased relative
liquidity the demand for Treasury bond will increase pushing its price up and interest rate down.
On the other hand, when the relative liquidity of the corporate bond is less or lowered, its
demand decreases (demand curve shifts to the left) resulting in a decrease in price and hence,
increase in interest rate. Therefore, the risk premium on the corporate bond becomes positive.
Income Tax Consideration if payments on certain bonds are exempted from income taxes then
the expected returns from those bonds increase. This leads to an increase in the demand for those
bonds which pushes up bonds prices. Consequently, the interest rate lowers. Therefore, these
bonds tend to have a negative risk premium compared to other corporate bonds. In India there
are not many tax-free bonds or securities. Most often pub sector companies, like Airport
Authority of India (AAI), NHAI, Hudco, Rural Electrification Corporation (REC), Power
Finance Corporation (PFC) issue tax-free bonds in India.
Term Structure of Interest Ratesbonds with identical risk, liquidity and tax characteristics may
have different interest rates because of different terms to maturity. A plot of the yields on bonds
with different maturities but same risk, liquidity and tax considerations is called a yield curve. It
describes the term structure of interest rates. There are three theories that attempt to explain the
shapes and movements of yield curves: i) The Expectation Theory, ii) The Segmented Market
Theory and iii) The Liquidity Premium Theory. It has been observed that
Interest rates on bonds of different maturities move together over time.
Yield curves are usually upward sloping, but they can be flat or downward sloping (often
referred to as inverted yield curve) as well. For an upward sloping yield curve long term
interest are above short-term interest rates and vice versa. For a flat yield curve, the two
interest rates are same. However, they can take U or an inverted-U shape as well.
Yield curves almost always slope upward.
The first two statements are explained by the Expectation Theory. The Segmented Market
Theory explains the third one while all three are explained by The Liquidity Premium Theory.
Expectations TheoryThe theory assumes that the expected returns or interest rates from
different bonds are the determining factor regarding which one should be held and maturity does

not play any role. If bonds with different maturities have same expected return then they will be
perfect substitutes. The theory essentially says that the interest rates on long term bonds equal
average interest rates on short term bonds. Otherwise, people will not hold any amount of the
bond which has lower expected interest rate. For instance, if the interest rate on a one-year bond
is 9 percent and it is expected to be 10 percent in the next year, then the interest rate on a twoperiod bond should be 9.5 percent. Generalizing this to n periods, one can say that the interest
rate on an n-period bond, in must be equal to
+ + + + + + +
=

where i0 is todays interest on a one-period bond, i0+1 is the expected interest on a one-period
bond after 1 year and so on. Thus, the n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond.
12.0000
10.0000
8.0000
6.0000
4.0000
2.0000
0.0000
2002- 2003- 2004- 2005- 2006- 2007- 2008- 2009- 2010- 201103Apr 04
05
06
07
08
09
10
11
12
Apr Apr Apr Apr Apr Apr Apr Apr Apr
15-91 Days

5 Year

20 Year

Movements of Interest Rates on Government Securities with Different Maturities

The expectations theory is an elegant theory that explains why the term structure of interest rates
(as represented by yield curves) changes at differenttimes. When the yield curve is upwardsloping, the expectations theory suggests that short-term interest rates are expected to rise in the
future, as we have seen in our numerical example. In this situation, in which the long-term rate is
currently higher than the short-term rate, the average of future short-term rates is expected to be
higher than the current short term rate, which can occur only if short-term interest rates are
expected to rise. When the yield curve is inverted (slopes downward) , the average of future
short-term interest rates is expected to be lower than the current short -term rate , implying that
short -term interest rates are expected to fall, on average , in the future. Only when the yield
curve is flat does the expectations theory suggest that short-term interest rates are not expected to
change, on average, in the future.

The expectations theory also explains the first statement, which states that interest rates on bonds
with different maturities move together over time. Historically, short-term interest rates have had
the characteristic that if they increase today, they will tend to be higher in the future. Hence a rise
in short-term rates will raise people's expectations of future short-term rates. Because long-term
rates are the average of expected future short-term rates, a rise in short-term rates will also raise
long-term rates, causing short and long-term rates to move together.
The expectations theory also explains the second statement that yield curves tend to have an
upward slope when short-term interest rates are low and are inverted when short-term rates are
high. When short-term rates are low, people generally expect them to rise to some normal level
in the future, and the average of future expected short-term rates is high relative to the current
short-term rate. Therefore, long-term interest rates will be substantially higher than current short
-term rates, and the yield curve would then have an upward slope. Conversely, if short-term rates
are high, people usually expect them to come back down. Long-term rates would then drop
below short-term rates because the average of expected future short-term rates would be lower
than current short-term rates and the yield curve would slope downward and become inverted.
However, the drawback of this theory is that it fails to explain the third observation or statement.
Segmented Market Theory - As the name suggests, the segmented markets theory of the term
structure sees markets for different-maturity bonds as completely separate and segmented. The
interest rate for each bond with a different maturity is then determined by the supply of and
demand for that bond, with no effects from expected returns on other bonds with other
maturities. The key assumption in the segmented markets theory is that bonds of different
maturities are not substitutes at all, so the expected return from holding a bond of one maturity
has no effect on the demand for a bond of another maturity. The argument for why bonds of
different maturities are not substitutes is that investors have very strong preferences for bonds of
one maturity but not for another, so they will be concerned with the expected returns only for
bonds of the maturity they prefer.
In the segmented markets theory, differing yield curve patterns are accounted for by supply and
demand differences associated with bonds of different maturities. If, as seems sensible, investors
have short desired holding periods and generally prefer bonds with shorter maturities that have
less interest-rate risk, the segmented markets theory can explain the third statement that yield
curves typically slope upward. Because in the typical situation the demand for long-term bonds
is relatively lower than that for short term bonds, long-term bonds will have lower prices and
higher interest rates, and hence the yield curve will typically slope upward. However, the
drawback with segmented market theory is that it fails to explain the first two statements.
Therefore, the third theory is brought in by combining these two theories.
Liquidity Premium and Preferred Habitat Theories - The liquidity premium theory of the term
structure states that the interest rate on a long-term bond will equal an average of short-term
interest rates expected to occur over the life of the long-term bond plus a liquidity premium (also

referred to as a term premium) that responds to supply and demand conditions for that bond. The
liquidity premium theory's key assumption is that bonds of different maturities are substitutes,
but not perfect substitutes. This means that the expected return on one bond does influence the
expected return on a bond of a different maturity, but it allows investors to prefer one bond
maturity over another. Investors tend to prefer shorter-term bonds because these bonds bear less
interest-rate risk. For these reasons, investors must be offered a positive liquidity premium to
induce them to hold longer-term bonds. Such an outcome would modify the expectations theory
by adding a positive liquidity premium to the equation that describes the relationship between
long and short-term interest rates. The liquidity premium theory is thus written as
+ + + + + + +
=
+

where ln is the liquidity premium for the n-period bond at time n, which is always positive and
rises with the term to maturity or n.
Closely related to the liquidity premium theory is the preferred habitat theory. It assumes that
investors have a preference for bonds of one maturity over another, a particular bond maturity
(preferred habitat) in which they prefer to invest. Because they prefer bonds of one maturity over
another, they will be willing to buy bonds that do not have the preferred maturity (habitat) only if
they earn a somewhat higher expected return. Because investors are likely to prefer the habitat of
short-term bonds over that of longer-term bonds, they are willing to hold longterm bonds only if
they have higher expected returns. This reasoning leads to the same equation implied by the
liquidity premium theory with a term premium that typically rises with maturity.
Lets see if the liquidity premium and preferred habitat theories are consistent with all three
empirical facts mentioned above. They explain fact l, which states that interest rates on differentmaturity bonds move together over time: A rise in short-term interest rates indicates that shortterm interest rates will, on average, be higher in the future, and the first term in the equation then
implies that long-term interest rates will rise along with them. They also explain why yield
curves tend to have an especially steep upward slope when short-term interest rates are low and
to be inverted when short-term rates are high. Because investors generally expect short-term
interest rates to rise to some normal level when they are low, the average of future expected
short-term rates will be high relative to the current short -term rate. With the additional boost of a
positive liquidity premium, long-term interest rates will be substantially higher than current
short-term rates, and the yield curve will then have a steep upward slope. Conversely, if shortterm rates are high, people usually expect them to come back down. Long-term rates will then
drop below short-term rates because the average of expected future short-term rates will be so far
below current short-term rates that despite positive liquidity premiums, the yield curve will slope
downward.The liquidity premium and preferred habitat theories explain the third statement,
which states that yield curves typically slope upward, by recognizing that the liquidity premium
rises with a bonds maturity because of investors' preferences for short-term bonds. Even if short-

term interest rates are expected to stay the same on average in the future, long-term interest rates
will be above short-term interest rates, and yield curves will typically slope upward.
How can the liquidity premium and preferred habitat theories explain the occasional appearance
of inverted yield curves if the liquidity premium is positive. It must be that at times short-term
interest rates are expected to fall so much in the future that the average of the expected shortterm rates is well below the current short-term rate. Even when the positive liquidity premium is
added to this average, the resulting longterm rate will still be lower than the current short -term
interest rate.
As our discussion indicates, a particularly attractive feature of the liquidity premium and
preferred habitat theories is that they tell you what the market is predicting about future shortterm interest rates just from the slope of the yield curve. A steeply rising yield curve indicates
that short-term interest rates are expected to rise in the future. A moderately steep yield curve
indicates that short-term interest rates are not expected to rise or fall much in the future. A flat
yield curve indicates that short-term rates are expected to fall moderately in the future. Finally,
an inverted yield curve indicates that short term interest rates are expected to fall sharply in the
future.