What determines the risk structure of interest rates?
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.
