Tài chính doanh nghiệp - Marketability, default risk, call privileges, prepayment risk, taxes, and other factors affecting interest rates

Money and Capital Markets8C h a p t e rEighth EditionFinancial Institutions and Instruments in a Global MarketplacePeter S. RoseMcGraw Hill / IrwinSlides by Yee-Tien (Ted) FuMarketability, Default Risk, Call Privileges, Prepayment Risk, Taxes, and Other Factors Affecting Interest Rates Learning Objectives To see the effects of the marketability, default risk, liquidity, call privileges, prepayment risk, convertibility and taxability of various loans and securities upon their interest rates.To understand why there are so many different interest rates within the global economy.To learn how the “structure of interest rates” is built and why it changes constantly. Learning Objectives To appreciate the difficulties of forecasting interest rates and financial asset prices accurately.IntroductionIn the preceding chapter, we examined how expected inflation and security maturity affect interest rates.In this chapter, we will look at how some other factors influence interest rates:  marketability,  default risk,  call privileges,  taxation of security income,  prepayment risk, and  convertibility.Marketability and LiquidityMarketability – Can an asset be sold quickly?Marketability is positively related to the size and reputation of the institution issuing the securities and to the number of similar securities outstanding. However, marketability is negatively related to yield.Liquidity – A liquid financial asset is readily marketable. Moreover, its price tends to be stable and reversible.Default RiskDefault risk – The risk that a borrower will not make all the promised payments at the agreed-upon times. Promised yield on a risky asset= risk-free interest rate + default risk premiumExpected yield on a risky asset = S piyipi = probability that the ith possible yield, yi, occursAnticipated default loss on a risky asset= promised yield – expected yieldDefault RiskSource: Economic Trends, Federal Reserve Bank of Cleveland, July 2001Default RiskFactors Influencing Default Risk PremiumsCredit ratings by rating companies such as Moody’s and Standard & Poor’sHighly-rated securities are perceived as having negligible default risk.Fluctuations (cycles) in business activityThe yield spread between Aaa- and Baa-rated securities increases during economic recessions.Default RiskAverage Yields (% per annum)Baa Corporate BondsAaa Corporate Bonds10-year Treasury Bonds30-yearTreasuryBondsData Source: Board of Governors of the Federal Reserve SystemDefault RiskFor corporate securities, the period of time the firm has been in operation, variability in company earnings, and the amount of leverage employedInflationDefault risk premiums tend to be higher and more volatile when inflation is high and volatile.Factors Influencing Default Risk PremiumsDefault RiskThe Junk-Bond Spread and the EconomyJunk bond spread =junk bond yields – Aaa corporate bond yieldsA rise in the junk bond spread indicates a growing fear among bond market investors that marginal-quality corporate borrowers are more likely to default on their debts (i.e. a weakening economy).Default RiskNew Ways of Dealing with Default RiskCredit derivatives are financial contracts that seek to protect lenders against default risk by shifting that risk to someone else willing to accept it for a fee.In a credit swap, two or more lenders agree to exchange a portion of their expected payments.A credit option may enable the lender to be reimbursed if a credit asset begins to lose value.Call PrivilegesA call privilege on a bond contract grants the borrower the option to retire all or a portion of a bond issue by buying back the securities in advance of maturity at a specified call price.A bond may be callable immediately, or the privilege may be deferred for a specified period of time.Call PrivilegesAdvantages and DisadvantagesThe call option is an advantage to the security issuer because it grants greater financial flexibility and the potential for reducing future interest costs.However, it is a disadvantage to the security buyer. The holding-period yield may decline if the security is called, and the potential for capital gains is limited.Call PrivilegesThe Call PremiumIssuers of callable securities must pay a call premium in the form of a higher interest rate.The call premium is higher ifthe market expects interest rates to fall (such that the call risk is higher),the call deferment period is shorter, andthe call price is lower.Prepayment Risk on Loan-Backed SecuritiesPrepayment risk is the risk that the purchaser may receive higher-than-expected repayments of principal early in the life of loan-backed securities.Prepayment risk is especially valid for the investors in securities that are backed by home mortgage loans, as many home loans will be retired early due to loan refinancing and home-owner turnover.Prepayment Risk on Loan-Backed SecuritiesSince prepayments may lower the investor’s return, loan-backed securities with greater prepayment risks are priced lower.Taxation of Security ReturnsTaxes imposed by the federal, state, and local governments can have a profound effect on the returns earned by investors on financial assets.Thus, governments can use their taxing power to encourage the investment in certain financial assets, thereby redirecting the flow of savings and investment toward areas of critical social need.Taxation of Security ReturnsIn particular, governments mayvary the income brackets and tax ratestie the applicable tax rates to the length of time that securities were heldgrant certain amounts of tax exemptions for various categoriesenable the deduction of capital losses (up to specified limits)change the permissible annual contributions to educational or retirement accountsTaxation of Security ReturnsA Brief History of Marginal Income Tax RatesSource: Economic Trends, Federal Reserve Bank of Cleveland, January 2002Taxation of Security ReturnsTax-exempt securities represent a subsidy to induce investors to support local governments.The exemption privilege shifts the burden of federal taxation from buyers of municipal bonds to other taxpayers.However, the privilege lowers the interest rates at which municipals can be sold in the open market relative to comparable taxable bonds.Taxation of Security ReturnsAfter-tax yield = (1 – t )  Before-tax yieldwhere t is the investor’s marginal tax rateAn investor will be indifferent between taxable and tax-exempt securities whenTax-exempt yield = (1 – t )  Taxable yieldTo make valid comparisons between taxable and tax-exempt issues, the taxed investor should convert all expected yields to an after-tax basis.Convertible SecuritiesConvertible (or hybrid) securities are special issues of corporate bonds or preferred stock that can be exchanged for a specific number of shares of the issuing firm’s common stock.Convertibles offer the investor the prospect of a stable interest or dividend income, as well as capital gains on common stock on conversion.Hence, investors are generally willing to pay a premium for convertibles.Convertible SecuritiesNote that the issuer may call in the securities early, forcing conversion.The Structure of Interest RatesThe risk-free interest rate underlies all interest rates and is a component of all rates.All other interest rates are scaled upward by varying degrees from the risk-free rate, depending on such factors as inflation, the term (maturity) of a loan, the risk of borrower default, the risk of prepayment, and the marketability, liquidity, convertibility, and tax status of the securities to which those rates apply.The Structure of Interest RatesAn ExampleDuring the month of January 2002 The long-term U.S. Treasury bond rate averaged 5.75%The corporate Baa bond rate averaged 7.60%while+ 1.85% =Real risk-free rate +3.00%Expected inflation +2.00%Liquidity premium +0.75% Total = 5.75%Premiums for: marketability +0.35%Call risk +0.25%Default risk +1.25% Total = 1.85%Money and Capital Markets in CyberspaceThe world wide web addresses a number of the foregoing issues at a variety of websites: ReviewIntroductionMarketability and LiquidityDefault RiskThe Premium for Default RiskThe Expected Rate of Return on a Risky AssetAnticipated Default LossFactors Influencing Default Risk PremiumsThe Junk-Bond Spread and the EconomyNew Ways of Dealing with Default RiskChapter ReviewCall PrivilegesAdvantages and DisadvantagesThe Call PremiumPrepayment Risk on Loan-Backed SecuritiesTaxation of Security ReturnsComparing Taxable and Tax-Exempt SecuritiesConvertible SecuritiesThe Structure of Interest Rates