Answer to Question #101689 in Macroeconomics for Silvia

Question

1. Find the monthly yield data for 10 year Treasury, AAA, and BAA corporate bonds from January of 2007 and December of 2008 (3 points).

1) Plot them and explain the relation between interest rates and default risk.


2) Explain the impacts of default risk on interest rates when there was a financial crisis using the data.

Answer 1

1)The key characteristic of a bond, which determines its profitability and attractiveness for investments in general, is the degree of credit risk. The higher the probability of default, the higher this risk, and the higher should be the yield.

Default - the inability of the borrower to pay interest or the body of the debt on its obligations in a timely manner. As a result, the lender loses, in whole or in part, his funds lent to the borrower. The most reliable in the world are US government bonds, the so-called Treasuries. Conventionally, they are considered to be risk-free, that is, the probability of default on them is so small that it can be taken as zero.

The yield of risk-free securities is considered the base for calculating the yield of other bonds. An investor always has a choice: place funds in risk-free Treasuries or buy more risky securities. Accordingly, the higher the risk of investments, the higher profitability investors will demand from the issuer of the bond.

The difference between the yield of a corporate bond and the yield of a risk-free paper with the corresponding duration is called a credit spread. The higher the credit spread, the higher the risk of default on a particular bond. Conversely, the lower the spread, the more reliable it is considered.

In general, the structure of the bond yield can be described by the following formula:

Profitability = risk-free rate + premium for country risk + premium for default risk + premium for liquidity risk.

Since the United States is a major debtor, the problem of financing its deficits is extremely urgent. Resource flows from countries with excess savings have a downward effect on interest rates, which have been at a very low level for several years. This reduces the profitability of operations for financial market participants, who are forced, firstly, to pay attention to more profitable and, as a result, more risky instruments and, secondly, to use leverage that unnecessarily inflates their balances, which increases leverage making them less stable and increasing the risk of deleveraging in general (

see the above chart)

2)Note that the high leverage of the financial sector is accompanied by a large-scale increase in debt of the public and private sectors, especially in the 2000s. Despite problems in the American economy, investors' search for investment assets led to large-scale purchases of US Treasury bonds, which provoked an increase in their price and a decrease in yields to their minimum values ​​in 2007-2008 (

see the above chart)