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Money and Capital Markets: Financial Institutions and Instruments in a Global Marketplace, 8/e

Peter Rose, Texas A & M University

Marketability, Default Risk, Call Privileges, Prepayment Risk, Taxes, and Other Factors Affecting Interest Rates and Asset Prices

Chapter Summary

This chapter has focused our attention upon multiple factors that cause interest rates or yields to differ between one type of financial asset and another. Its special target has been such rate-determining elements as marketability, liquidity, default risk, call privileges, and taxation.
Among the principal conclusions of the chapter are the following:

Marketability, or the capacity to be sold readily, is positively related to an asset’s price and negatively related to its rate of return or yield. More marketable financial instruments generally carry lower rates of return or lower yields.
Liquid financial instruments also tend to carry lower yields, but possess the advantages of ready marketability, stable price, and reversibility (i.e., the capacity to fully recover the funds originally invested in an asset).
Default risk—the danger that a borrower will not make all promised payments at agreed-upon times—typically results in the promised yields of risky securities rising above the yields on riskless financial instruments. Potential buyers of these instruments compare their estimated (subjective) probability of loss from a risky security to the market’s assigned default-risk premium. If a potential buyer anticipates less risk of loss than suggested by the market’s assigned risk premium he or she will tend to purchase the financial instrument in question because its risky yield appears to be too high and its price too low (i.e., the security in question looks like a bargain). Conversely, a potential purchaser expecting greater probability of loss due to default than the market’s assigned risk premium will tend to avoid or sell such an instrument because its price seems too high and its yield too low for the amount of risk involved.
Default-risk premiums attached by the financial marketplace to the promised yields on risky securities tend to be heavily influenced by the credit ratings assigned by various credit rating agencies (such as Moody’s Investors Service or Standard & Poor’s Corporation) and by the condition of the economy. An expanding economy tends to result in lower default-risk premiums, while an economy trapped in a recession with rising business bankruptcies tends to generate higher default-risk premiums on risky securities.
Many lower-rated companies with questionable credit ratings began to issue speculative or junk bonds in large quantities during the 1980s and 1990s. The rapid rise of junk bonds broadened the market for corporate bonds greatly, offering participating investors substantially higher yields than were previously available.
Debt securities with call privileges attached tend to carry higher promised rates of return than financial instruments not bearing a call privilege. The right of a security issuer to call away the security he or she has previously issued and retire it in return for paying a prespecified price gives borrowers greater flexibility in adapting their capital structure to changing economic and financial conditions. Most recently, call privileges have been declining in use as corporate borrowers have discovered other ways of protecting their financial structure and sources of funds.
The rapid growth of loan-backed securities (such as mortgage-backed instruments) has given rise to prepayment risk. This is the danger that loans used to back loan-backed securities may be paid back early, lowering an investor’s expected yield from these loan-backed instruments. The rapid expansion of loan-backed security issues has made prepayment risk more important with time. Issuers of these instruments have sought to make them more attractive to buyers by such devices as creating different maturity classes so that potential buyers can select how much prepayment risk they are willing to take on.
Event risk has long been a potentially significant factor in the pricing of corporate stock and debt securities. Among the events that appear to have an especially significant impact upon corporate security values include announcements of new security issues, stock dividends, stock splits, and management changes within a particular business firm.
Financial assets generate interest or dividend payments and capital gains or losses—any or all of which may be subject to taxation at federal and state levels. Investors, therefore, must be cognizant of changes in tax laws and regulations. It is also important to be able to calculate tax-exempt yields versus taxable returns from financial assets because some financial instruments (such as municipal bonds) generate tax-exempt income and some investing institutions (such as credit unions and pension funds) are tax-exempt investors.
Some corporate debt and stock instruments carry a convertibility feature which allows them to be exchanged for a certain number of shares of common stock. These are often called “hybrid securities” because they offer not only relatively stable or guaranteed income (interest payments or fixed dividends) but also the prospect of substantial capital gains when once converted into common stock. Thus, financial instruments with convertibility features attached tend to sell at a higher price and a lower promised yield due to their potential for exceptional capital gains upon conversion.
Finally, the chapter closes with an overview of the interest rate structure model which aids us in understanding why there are so many different interest rates in the real world. Each different interest rate or yield is viewed in this model as the sum of the risk-free interest rate plus a series of risk premia dependent on the different degrees of risk exposure of each financial instrument. Among the possible risk premiums included in this model are liquidity and term (or maturity) risk, inflation risk, default risk, call risk, and exposure to tax risk. Because any of these risk premia can change at any time, interest rates themselves may change at any time and the causes of any interest-rate movement can be very complex.

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