Chapter 7 The Risk and Term Structure of Interest Rates 1 Mr. McDonough s job was to monitor fi nancial market developments for the Federal Reserve System, to devise government reaction to such fi nancial crises, and to formulate policies that prevented crises. As we will see in our discussion of the structure of the Federal Reserve System in Chapter 16, the Federal Reserve Bank of New York is the largest of the 12 district banks in the Federal Reserve System. The president of that bank plays a special role as the eyes and ears of the government in world fi nancial markets. Learning ObjectivesUnderstand . . .LO1 Credit risk and bond ratingsLO2 The yield curve relating bond maturities to yieldsLO3 How yields anticipate and signal the futureOn October 5, 1998, William McDonough, president of the Federal Reserve Bank of New York, declared “I believe that we are in the most serious fi nancial crisis since World War II.” 1 Since August 17, when the Russian government had defaulted on some of its bonds, deteriorating investor confi dence had increased volatility in the fi nancial markets. Bond markets were the hardest hit; as lenders re-evaluated the relative risk of holding different bonds, some prices plummeted while others soared. This simulta- neous increase in some interest rates and decline in othersa rise in what are called interest-rate spreads was a clear sign to Mr. McDonough that the substantial stress the fi nancial markets were experiencing could easily spread to the wider economy, af- fecting everyone. Changes in bond prices, and the associated changes in interest rates, can have a pro- nounced effect on borrowing costs corporations face. The experience of Ford and Gen- eral Motors (GM), the American automobile manufacturers, provides an instructive example. Like virtually every large company, the two car makers borrow to maintain and expand their businesses. And the amounts are very large. By 2005, Ford s bor- rowing exceeded $150 billion while GM s was nearly twice that. The two companies produce about one-third of the cars and trucks Americans buy. And they buy quite a fewnearly 15 million in 2012. But for years before the fi nancial crisis that began in 2007, the fortunes of U.S. automakers were declining. Plummeting sales in the reces- sion of 20072009 triggered massive losses that eventually led to the bankruptcy of GM. Even before GM s failure, the perceived riskiness of Ford and GM s bonds led to a decline in the price investors were willing to pay for them. A fall in bond prices means an increase in interest rates and a corresponding rise in the cost the auto com- panies have to pay to borrow. cec2174X_ch07_162-188.indd 162cec2174X_ch07_162-188.indd 16225/11/13 5:38 PM25/11/13 5:38 PMRatings and the Risk Structure of Interest Rates Chapter 7 l 163These examples highlight the need to understand the differences among the many types of bonds that are sold and traded in fi nancial markets. What was it about the movement in the prices of different bonds that Mr. McDonough found so informative? How did information about profi tability affect investors willingness to lend to GM and Ford? To answer these questions, we will study the differences among the multitude of bonds issued by governments and private corporations. As we will see, these bonds differ in two crucial respects: the identity of the issuer and the time to maturity. The purpose of this chapter is to examine how each of these affects the price of a bond, and then to use our knowledge to interpret fl uctuations in a broad variety of bond prices. Ratings and the Risk Structure of Interest Rates Default is one of the most important risks a bondholder faces. Not surprisingly, the risk that an issuer will fail to make a bond s promised payments varies substantially from one borrower to another. The risk of default is so important to potential investors that independent companies have come into existence to evaluate the creditworthiness of potential borrowers. These fi rms, sometimes called rating agencies, estimate the likeli- hood that a corporate or government borrower will make a bond s promised payments. The fi rst such ratings began in the United States more than 100 years ago. Since 1975, the U.S. government has acknowledged a few fi rms as “nationally recognized statisti- cal rating organizations” (NRSROs), a designation that has encouraged investors and governments worldwide to rely on their ratings. In 2010, sweeping fi nancial reform legislation (called the Dodd-Frank Wall Street Reform and Consumer Protection Act) included provisions to reduce reliance on ratings agencies. Let s look at these compa- nies and the information that they produce. Bond Ratings The best-known bond rating services are Moody s and Standard or if the LTV is high; or if the borrower does not provide suffi- cient documentation of their ability to pay. All of these factors