■The first edition of The Handbook of Fixed Income Securities was published two decades ago. Over the years and seven editions of the book, I have benefited from the guidance of many participants in the various sectors of the bond market. I would like to extend my deep personal appreciation to the contributing authors in all editions of the book. Steven Mann, in particular, coauthored eight of the chapters in the current edition with me.
There are two individuals whom I would like to single out who contributed to the first six editions and are now retired from the industry: Jane Tripp Howe and Richard Wilson. Jane is widely recognized as one of the top corporate credit analysts. She contributed not only to the Handbook but also to several other books that I edited. She was my `go to` person when I needed a chapter on any aspect of corporate credit analysis. In the seventh edition, I have revised the chapter by Jane on corporate bond credit analysis and thank her for granting me permission to use the core of her chapter that appeared in the sixth edition. Let me add a historical footnote concerning another important contribution of Jane to the profession. In the first edition of the Handbook, Jane contributed a chapter entitled `A Corporate Bond Index Fund` based on her research that appeared in the November 1978 Proceedings published by the Center for Research Securities Prices, Graduate School of Business, University of Chicago. In that chapter, Jane made the argument for investing in a corporate bond index and discussed the operational process of running a corporate bond indexed portfolio. At the time, this was a novel idea. While the notion of indexing in common stock was being debated in the 1970s, little attention was given to this form of investing in the bond market.
Richard Wilson contributed several chapters to the various editions of the Handbook. When I began my study of the fixed income market in the late 1970s, he served as my mentor. There were so many nuances about the institutional aspects of the market that were not in print. His historical perspective and his insights helped me form my view of the market. In addition, from his many contacts in the industry, he identified for me potential contributors to the first edition.
THE STRUCTURE OF INTEREST RATES
Frank J. Fabozzi, Ph.D., CFA, CPA
Frederick Frank Adjunct Professor of Finance
School of Management
There is no single interest rate for any economy; rather, there is an interdependent structure of interest rates. The interest rate that a borrower has to pay depends on Щ a myriad of factors. In this chapter we describe these factors. We begin with a discussion of the base interest rate: the interest rate on U.S. government securities. Next, we explain the factors that affect the yield spread or risk premium for non-Treasury securities. Finally, we focus on one particular factor that affects the interest rate demanded in an economy for a particular security: maturity. The relationship between yield and maturity (or term) is called the term structure of interest rates, and this relationship is critical in the valuation of securities. Determinants of the general level of interest rates in the economy will not be discussed.
THE BASE INTEREST RATE
The securities issued by the U.S. Department of the Treasury are backed by the full faith and credit of the U.S. government. Consequently, market participants throughout the world view them as having no credit risk. Therefore, interest rates on Treasury securities are the benchmark interest rates throughout the U.S. economy. The large sizes of Treasury issues have contributed to making the Treasury market the most active and hence the most liquid market in the world.
The minimum interest rate or base interest rate that investors will demand for investing in a non-Treasury security is the yield offered on a comparable maturity for an on-the-run Treasury security. The base interest rate is also referred to as the benchmark interest rate.
Market participants describe interest rates on non-Treasury securities as trading at a spread to a particular on-the-run Treasury security. For example, if the yield
10-year nonjury security 7.68% and the yield on a 10-year Treasury security is 6.68%, the spread is 100 basis points. This spread reflects the additional risks the investor faces by acquiring a security that is not issued by the U.S. government and therefore can be called a risk premium. Thus we can express the interest rate offered on a non-Treasury security as
Base interest rate + spread
Base interest rate + risk premium
The factors that affect the spread include (1) the type of issuer, (2) the | issuer's perceived creditworthiness, (3) the term or maturity of the instrument, (4) provisions that grant either the issuer or the investor the option to do something, (5) the taxability of the interest received by investors, and (6) the expected liquidity of the issue.
Types of Issuers
A key feature of a debt obligation is the nature of the issuer. In addition to the U.S. government, there are agencies of the U.S. government, municipal governments, corporations (domestic and foreign), and foreign governments that issue bonds.
The bond market is classified by the type of issuer. These are referred to as market sectors. The spread between the interest rate offered in two sectors of the bond market with the same maturity is referred to as an intermarket-sector spread.
Excluding the Treasury market sector, other market sectors have a wide range of issuers, each with different abilities to satisfy bond obligations. For example, within the corporate market sector, issuers are classified as utilities, transportations, industrials, and banks and finance companies. The spread between two issues within a market sector is called an intramarket-sector spread.
Perceived Creditworthiness of Issuer
Default risk or credit risk refers to the risk that the issuer of a bond may be unable to make timely payment of principal or interest payments. Most market Participants rely primarily on commercial rating companies to assess the risks.
As we explained in Chapter 5, the price of a bond will fluctuate over its life as yields in the market change. As demonstrated in Chapter 9, the volatility of a bond's price is dependent on its maturity. With all other factors constant the longer the maturity of a bond, the greater is the price volatility resulting from a change in market yields.
The spread between any two maturity sectors of the market is called a yield-curve spread or maturity spread. The relationship between the yields on comparable securities with different maturities, as mentioned earlier, is called the term structure of interest rates.
The term-to-maturity topic is very important, and we have devoted more time to this topic later in this chapter.
Inclusion of Options
It is not uncommon for a bond issue to include a provision that gives the bondholder or the issuer an option to take some action against the other party. An option that is included in a bond issue is referred to as an embedded option. We discussed the various types of embedded options in Chapter 1. The most common type of option in a bond issue is the call provision, which grants the issuer the right to retire the debt, fully or partially, before the scheduled maturity date. The inclusion of a call feature benefits issuers by allowing them to replace an old bond issue with a lower-interest-cost issue when interest rates in the market decline. In effect, a call provision allows the issuer to alter the maturity of a bond. The exercise of a call provision is disadvantageous to the bondholder because the bondholder must reinvest the proceeds received at a lower interest rate.
The presence of an embedded option affects both the spread of an issue relative to a Treasury security and the spread relative to otherwise comparable issues that do not have an embedded option. In general, market participants will require a larger spread to a comparable Treasury security for an issue with an embedded option that is favorable to the issuer (such as a call option) than for an issue without such an option. In contrast, market participants will require a smaller spread to a comparable Treasury security for an issue with an embedded option that is favorable to the investor (such as a put option or a conversion option). In fact, the interest rate on a bond with an option that is favorable to an investor may be less than that on a comparable Treasury security.
Taxability of Interest
Unless exempted under the federal income tax code, interest income is taxable at the federal level. In addition to federal income taxes, there may be state and local taxes on interest income.