The Risk and Term Structure of Interest Rates - The Risk structure of Interest Rates - Default Risk
3 important questions on The Risk and Term Structure of Interest Rates - The Risk structure of Interest Rates - Default Risk
What is a default risk?
When the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures
What are Credit rating agencies?
Investor advisory firms that rate the quality of corporate (and municipal) bonds in terms of their probability to default (based on Investment-grade versus speculative grade (junk) bonds)
Examples: Moody's, Standard and Poor's
Examples: Moody's, Standard and Poor's
What is the response in the increase in default risk on corporate bonds?
Step 1. An increase in default risk shifts the demand curve for corporate bonds to the left.
Step 2. And shifts the demand curve for Treasury bonds to the right
Step 3. Which raises the price of Treasury bonds and lowers the price of corporate bonds, and therefore lowers the interest rate on Treasury bonds and raises the rate on corporate bonds, thereby increasing the spread between the interest rates on corporate versus Treasury bonds.
Step 2. And shifts the demand curve for Treasury bonds to the right
Step 3. Which raises the price of Treasury bonds and lowers the price of corporate bonds, and therefore lowers the interest rate on Treasury bonds and raises the rate on corporate bonds, thereby increasing the spread between the interest rates on corporate versus Treasury bonds.
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