I.  Level of Interest Rates--Market for Loanable Funds

• Demand for Loanable Funds
• behavior of issuers and borrowers--r represents the cost of borrowing, so demand curve is downward sloping
• what shifts the demand for loanable funds?
• tax rules: deductible bond interest paid, mortgage interest
• more favorable tax treatment for interest paid by borrower will increase the demand for loanable funds (shift it to the right)
• expected profitability of investments
• recessions decrease the demand for loanable funds, expansions increase it
• government borrowing
• deficits that increase the national debt increase demand, surpluses and paying down the debt will decrease demand
• nominal vs. real interest rates
• nominal interest rate = real interest rate + expected inflation
• i = r + p
• Supply of Loanable Funds
• behavior of savers and lenders--r is the reward for postponing present consumption, so the supply curve is upward sloping
• what shifts the supply of loanable funds?
• tax rules: IRAs, consumption based tax
• any tax rules that exempt interest income will increase the supply
• income and wealth: rising income/wealth increases the amount and percentage of savings
• rate of time preference: if people become more/less patient about postponing future consumption, this shifts the supply curve right/left.
• FOMC policy: if the Fed buys Treasuries, the supply will shift to the right
• Example: FOMC sells Treasuries while the federal government runs a deficit
• The demand for loanable funds shifts right (deficit)
• The supply of loanable funds shifts left (FOMC)
• interest rates rise
• What is i?
• i is the benchmark or base interest rate
• rate to which all others are compared, reflecting the minimum rate acceptable to lenders for a given maturity
• in U.S. benchmark r is the Treasury yield for that maturity
• default free and highly liquid--minimum investors will accept

• money demand and supply determine the interest rate
• money demand
• interest rate is opportunity cost of holding money, so MD downward sloping
• changes in income, payment technology, prices will shift the MD curve
• money supply
• assume that the Fed fully controls MS, then MS is vertical
• Changes in the MS shift the MS curve an cause interest rates to change
• increase in MS causes interest rates to fall:
• liquidity effect


• but falling interest rates will lead to
• economic expansion and an increase in income
• potentially an increase in price expectations
• MD increases
• interest rates rise
• total long-term effect of increase on MS depends on which effects are larger

Assets with same maturity, but different properties--what accounts for different yields?

 For example, consider the following interest rates from 3/5/2004:

Debt security	maturity	yield to maturity
Treasury bill	3 months	.95%
Commercial Paper	3 months	1.02%
Treasury note	10 years	3.85%
Aaa Corporate bond	10 years	4.31%
Baa Corporate bond	10 years	5.02%
conventional mortgage	30 years	5.36%
Aaa municipal bond	10 years	3.47%

These differences are due to the different characteristics of these debt instruments such as the payment structure, the maturity, and the issuer.

• measuring the differences between yields
• spread = difference in yield between two bonds measured in percentage points or basis points
• 100 basis points = 1 percentage point
• examples:
• 10 year Tnote and Baa Corporate Bond
• spread = 5.02% - 3.85% = 1.07 percentage points or 107 basis points
• 3 month Tbill and commercial paper
• spread = .95% - 1.02% = .07 percentage points or 107 basis points
• Risk Premium
• base interest rate + risk premium = interest rate on non-Treasury debt
• size of risk premium will depend on
• issuer
• default risk
• maturity (chapter 12)
• options
• tax treatment
• liquidity
•  benchmark or base interest rate
• rate to which all others are compared, reflecting the minimum rate acceptable to lenders for a given maturity
• in U.S. benchmark r is the Treasury yield for that maturity
• default free and highly liquid--minimum investors will accept

• Type of Issuer
• spreads exists among issuers of different market sectors
• Treasury, municipals, corporate, foriegn
• spreads are intermarket and intramarket
• corporate: utilities, industrials, finance, banks
• Default risk/credit risk
• risk of not receiving promised cash flows on time
• Treasuries, and other U.S. Gov't-backed debt have zero default risk because they are backed by the "full faith and credit" of the U.S. Gov't
• higher default risk implies a higher spread relative to Treasuries, and a higher yield overall
• the spread due to default risk is always greater than zero but the size will vary with economic conditions
• in the example above, the Russian debt default in the summer of 1998 created a panic among bondholders and results in a spread double of what we see today
• the default spread will rise if investors anticipate a recession, and fall if investors anticipate an expansion
• because of this the default spread is often used as a leading economic indicator to predict business cycles
• default risk is measured by credit ratings done by rating agencies (such as Moody's, S&P, Fitch's) and paid for by the borrower (bond issuer)
• higher credit rating mean lower default risk and a smaller spread relative to the Treasury security

• Liquidity
• ease/expense of buying & selling an assets
• Treasury securities are the most liquid debt market in the world today
• greater liquidity implies a smaller spread relative to Treasuries
• liquidity is not rated like default risk,
• but is somewhat related to default risk in that bonds with higher default risk (lower ratings) tend to be less liquid
• liquidity is also affected by the size of the issue
• Embedded Options
• special rights granted to either the issuer or the holder of the bond
• affect of an option on the spread depends on whether the option is beneficial to the issuer or the holder
• options that benefit the issuer increase the spread over an option free bond
• example: call provision = issuer has the right to pay off bonds early at specified time and terms
• advantage to issuer who may call the bonds after interest rates fall to reborrow at a lower rate; however holder will have to reinvest at the lower rate, which is a disadvantage
• bond with a call provision will have a higher yield than a bond with no options (and same liquidity & default risk)
• options that benefit the holder result in a lower yield relative to an option free bond
• example: put provision = holder has the right to sell back bonds early
• holder will more likely exercise this right when interest rates have risen, which is a disadvantage to the issuer
• Tax Treatment
• for the bond holder
• municipal debt interest is exempt from federal and maybe state income taxes
• Treasury debt interest is exempt from state income taxes
• corporate debt interest is fully taxable
• in general, bonds with more favorable tax treatment will have a lower before tax yield
• investors accept a lower before tax yield because they lose less of their interest $ to taxes
• investment grade municipals typically have before-tax yields below that of Treasuries
• example:
• 10 yr. municipal Baa bond, 6%
• 10 yr. corporate Baa bond, 8%
• tax rate = 28%
• which bond has a higher after tax yield?
• muni after tax yield = 6%
• corporate after tax yield = 8% (1 - .28) = 5.76%
• what corporate yield would make investor indifferent?
• equivalent taxable yield = 6%/(1-.28) = 8.33%
• what tax rate would make investor indifferent between the 6% muni and 8% corp?
• 8% = 6%/(1 - t)
• t = 25%
• the spread between corporate and municipal bonds will change if tax laws change
• increase in tax rates will increase the spread; decrease in tax rates will decrease the spread
• municipal debt is subject to regulatory risk
• IRS may rule debt is NOT tax exempt

changes in tax law may make tax exemption less valuable