Risk structure of interest rates

Default risk

Liquidity risk

Taxes: coupon payments on municipal bonds are exempt from federal income tax.

Term structure of interest rates

Basic properties:

1. Yields are typically higher on longer-maturity bonds.

2. Interest rates on bonds of different maturities tend to move together.

3. Yield curves usually slope upward [downward] when short-term interest rates are low [high].

Why? Four theories:

Expectations hypothesis

Segmented markets theory

Preferred habitat theory

Liquidity premium theory

Expectations hypothesis:

Predicts long-term interest rates = average expected future short-term interest rates.

Assumes all maturities are perfect substitutes for each other.

Can't explain property #1.

Segmented markets theory:

Assumes each maturity has its own supply and demand; investors prefer short maturities.

Can't explain properties 2 and 3.

Preferred habitat theory and liquidity premium theory:

Both combine features of the previous two theories: investors have to be paid a higher return to hold long-maturity bonds (due to higher risk), but there is some linkage across the markets for various maturities.

Both explain all three basic properties.

Both allow us to draw certain conclusions from the shape of the yield curve.