The risk structure of interest rate indicates how bonds that have similar maturity dates relate to each other in terms of interest rates. It affects long term bonds, which can be viewed from the perspective of three important facts and these are:
I. The interest rates of government bonds tend to be lower than the corporate bonds because there is minimal possibility that the government can fail to pay.
II. The way the government bonds and those of corporations and other business organizations spread is dependent on the variation of time and is exacerbated by economic depressions and other financial crises.
III. The interest rate of government bonds has always exceeded those of corporations and this has been experienced for numerous years.
The three facts can be explained by three important economic factors and these are liquidity, default risk, and considerations of income tax.
Default risk, as part of risk structure, is experienced when the issuers of bonds fail to pay or have a big possibility of failing to pay the outstanding interest upon the maturity of the debtor to pay its face value when the bonds mature. In the USA, when the risk of a specific bond increases, the rate of interest tends to rise and this explains why the interest rate of corporate bonds is relatively high. The fear of default is one of the main reasons why corporate bonds attract a large interest rate compared to government bonds whose issuer, the government, cannot fail to pay.
The ease at which an asset can be transformed into a liquid form such as cash or its equivalents is referred to as liquidity and has a big influence on the interest rate placed on the face value of a bond. In the US, the treasury bonds are actively and extensively traded compared to the corporate bonds because they are more liquid and this explains why they have low-interest rates compared to the corporate bonds. The more liquid a bond is, the lower the interest rate while less liquid bonds attract high-interest rates.
In the case of income tax consideration, income tax exemption has a big role in determining the interest rate of a given bond, especially when comparing the government bond with a municipal bond. Generally, the demand for municipal bonds is higher than that for government bonds and this is the main factor that influences the low-interest rates enjoyed by municipal bonds. In the US, the interest rates of municipal bonds are lower than those on the federal bonds due to tax exemption and this has been experienced.