The FinanciaI Environment

Defautt Risk. When we speak of :lefauit risk, we mean the danger that the borrower may not meet payments due on principal or interest. Investors demand a risk premium (or extra expected return) to invest in securities that are not default free. The greater the possibility that the borrower will default, the greater the default risk and the premium demanded by the marketplace. Because Treasury securities are usually regarded as default free, risk and return are judged in relation to them. The greater the default risk of a security issuer, the greater the expected return or yield of the security, all other things the same.7 For the tlpical investor, default risk is not judged directly but rather in terms of quality ratings assigned by the principal rating agencies, Moody's Investors Service and Standard & Poor's. These investment agencies assign and publish letter grades for the use of investors.

In their ratings, the agencies attempt to rank issues in order of the perceived probability of default. The ratings used by the two agencies are shown in Table 2.2. The highest-grade securities, judged to have negligible default risk, are rated triple-A.

Credit ratings in the top four categories (for Moody's, Aaa to Baa; for Standard and Poor's, AAA to BBB) are considered "investment grade quaiity." This term is used by regulatory agencies to identify securities that are eligible for investment by financial institutions such as commercial banks and insurance companies. Securities rated below the top four categories are referred to as "speculative grade." Because of the limited institutional demand for these securities and their higher default risk, they must offer considerably higher expected returns than invesl ment-grade securities.

Marketabitity. The marketability (or liquidiry) of a security relates to the owner's ability to convert it into cash. There are two dimensions to marketability: the price realized and the amount of time required to sell the asset. The two are interrelated in that it is often possible to sell an asset in a short period if enough price concession is given. For financial instruments, marketabiiity is judged in relation to the ability to sell a significant volume of securities in a short period of time without significant price concession. The more marketable the security, the greater the ability to execute a large transaction near the quoted price. In general, the lower the marketability of a security, the greater the yield necessary to attract investors. Thus the yield differential between different securities of the same maturity is caused not by differences in default risk alone, but also by differences in marketability.

Maturity. Securities with about the same default risk, having similar marketability, and not faced with different tax implications can still trade at different yields. Why? "Time" is the answer. The maturity of a security can often have a powerful effect on expected return, or yield. The relationship between yield and maturity for securities differing only in the length of time (or term) to maturity is called the term structure of interest rates. The graphical representation of this relationship at a moment in time is called a yield curve. An example of the yield-maturity relationship for default-free Treasury securities on a particular date is shown in Figure 2.3.Maftriqr is plotted on the horizontal axis and yield on the vertical. What results is a line, or yield curve, fitted to the observations.

The most commonly observed yield pattern is the positive (i.e., upward-sloping) yield curve - where short-term yields are lower than long-term yields. Most economists attribute the tendency for positive yield curves to the presence of risk for those who invest in long-term securities as opposed to short-term securities. In general, the longer the maturity, the greater the risk of fluctuation in the market value of the security. Consequently, investors need to be offered risk premiums to induce them to invest in long-term securities. Only when interest rates are expected to fall significantly are they willing to invest in long-term securities yielding less than short- and intermediate-term securities.

TaxabiLity. Another factor affecting the observed differences in market yields is the differential impact of taxes. The most important tax, and the only one that we will consider here, is income tax. The interest income on all but one category of securities is taxable to taxable investors. Interest income from state and local government securities is tax exempt. Therefore state and local issues sell in the market at lower yields to maturity than Treasury and corporate securities of the same maturity. For corporations located in states with income taxes, interest income on Treasury securities is exempt from state income taxes. Therefore such instruments may hold an advantage over the debt instruments issued by corporations or banks because the interest they pay is fully taxable at the state level. Under present law, capital gains arising from the sale ofany security at a profit are taxed at the ordinary tax rates for corporations, or at a maximum of 35 percent.

0ption Features. Another consideration is whether a security contains any option features, such as a conversion privilege or warrants, which upon exercise allow the investor to obtain common stock. Other options include the call feature, which enables a company to prepay its debt, and a sinking-fund provision, which allows a company to retire bonds periodically with cash payments or by buying bonds in the secondary market. If the investors receive options, the issuing company should be able to borrow at a lower interest cost. Conversely, if the issuing company receives an option, such as a call feature, the investors must be compensated with a higher yield. The valuation principles behind options are complex. Chapter 22 covers these principles in detail.