Risk & Term Structure of Interest Rates

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Bonds are issued by businesses and governments to finance operations. Bond prices depend on interest rates, which in turn depend on monetary policy, economic conditions and the perceived creditworthiness of the bond issuer. Bond prices rise when interest rates fall and fall when rates rise. Term structure is the relationship between interest rates on bonds of different maturities, and risk structure is the relationship between interest rates on bonds with the same maturity.

Yield Curve

  • The yield curve is a plot of the yield -- interest payments divided by price -- versus the maturity terms for the same type of bonds. Yield curves, which usually refer to U.S. Treasury securities, generally slope upward because long-term interest rates are higher than short-term rates. A flat yield curve occurs when short- and long-term rates have converged. In an inverted yield curve, the long-term rates are below short-term rates.

Term Structure

  • The term structure of interest rates is reflected in yield curve patterns. Interest rates generally move together. For example, if the U.S. Federal Reserve raises rates, the yield on U.S. Treasury securities for all maturities will move higher, meaning the yield curve will also move higher. The converse is true when the Fed lowers rates. The term structure is important for bond investors because the bond term determines the interest payments. It is also important for businesses because capital investment decisions are based on long-term interest rates.

Risk Structure

  • Bonds with the same term to maturity but different risk characteristics have different interest rates. This is the risk structure of bonds. For example, riskier corporate bonds have higher rates than risk-free Treasury bonds that are backed by the U.S. government. The difference between corporate and Treasury rates is the risk premium or the risk spread. The riskier the bond, the higher the risk premium. Bonds issued by state and local governments, known as municipal bonds, also must pay a risk premium because their bonds are subject to default risk. Liquidity and income tax considerations can also impact the risk structure. For example, corporate bonds are not quite as liquid as U.S. Treasuries, meaning they are harder to trade. Municipal bond interest payments are generally tax-exempt, and so might be appealing to investors, even at lower interest rates.

Considerations

  • According to Harvard Business School professor Luis M. Viceira, bond risks change over time, and the changes are correlated to the term structure of interest rates. The yield spread, which is the difference in yields between different types of bonds, is a proxy for business conditions. The spread widens when business conditions are poor, and narrows when conditions are good.

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