By studying past returns of bonds with different maturities it is clear that although they generally move together, interest rates of different categories of bonds tend to differ from one another in any given year, and the difference between the interest rates varies over time.

Being able to understand why interest rates differ from bond to bond can be very useful especially to the actors that operate in financial markets, like businesses, banks, insurance companies, and private investors, in order to improve their decision making and in particular to better decide which bonds to purchase and which ones to sell.

This phenomenon is caused by 3 main factors, the Default Risk, Liquidity, and Income Tax.

The Default Risk

The default of a bond can occur when the issuer is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures. In fact, companies that are in a difficult situation because, for example, are suffering big losses due to a decrease in the demand level for their product, might be more likely to suspend interest payments on their bonds. In this case, the default risk is high, which means that investors will ask for higher returns in order to invest their money in it.

On the other hand, safer bonds like the U.S. Treasury bonds are commonly considered default-free bonds, because even if something bad happens, which slows the economic activity and therefore makes it harder to repay the interest rates, the federal government can always increase taxes or print more money to pay off its obligations. In this case default risk is extremely low, and therefore the returns that investors will ask to invest money into these instruments is very low.

The spread between the interest rates on bonds with the same maturity but with high default risk and those like default-free bonds is the risk premium. The risk premium indicates how much additional interest (returns) investors want to earn in order to be willing to hold a riskier bond. If he has to bear higher risk, he wants to have the chance to earn a higher return.

Overall we can say that a bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium.

Because of the importance of default risk, it is crucial that purchasers of bonds know whether the institution that issues a specific bond is likely to default or not, and this is where credit-rating agencies come into play.

They are firms that rate the quality of bonds in terms of their probability of default. The three largest agencies are Moody’s, Standard and Poor’s and Fitch, and they use similar ways to rate bonds, which generally goes from AAA (Aaa for Moody’s), which is the Prime Maximum Safety level, to C/CCC-/D.

Investment-grade bonds, with a relatively low risk of default, have a rating of BBB (Baa for Moody’s), while those with a rating below that are called junk bonds because they have higher default risk.

Liquidity

As we have seen with the factors that influence asset demand, liquidity is a major component in that mechanism, and with respect to bonds, it influences their interest rate.

In fact, the more liquid an asset is, the more desirable it becomes, and therefore interest rate tends to be lower. Generally, government bonds (like U.S. Treasuries) are more liquid than corporate bonds, and this is because they are more widely traded.

As said before, bonds that have a greater degree of liquidity are more desirable, mainly because they can be sold quicker and the cost of selling them is lower. As with all other assets, when the demand for an asset goes up, holding everything else equal, its price tends to go up as well. As we have seen in the article about the bond market, with bonds, a higher price usually means also a lower interest rate, and therefore lower returns because investors appreciate its qualities and therefore are willing to give up a higher profit in the face of a safer and better quality product.

Income Tax Treatment

Some bonds, like municipal bonds in the United States, even though are certainly not default-free and on the contrary, in some cases, they appear to be very risky, they still have very low returns as if they were safe assets, and this is because interest payments on municipal bonds are exempt from federal income taxes. This characteristic has a very positive effect on the demand for municipal bonds that becomes pretty similar to that of an increase in expected return.

Therefore, even though they are risky, they still have low-interest rates because investors that purchase them can enjoy not only the interest that they receive, but they also save money from taxes, making these instruments more interesting.

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