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LeoGlossary: Interest Rate

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An interest rate is the rate charged for using money. This is typically done by financial institutions buy can extend to anyone who is willing to act as a lender. Essentially it is the price one pays to borrow money.

In return for the use of the funds, a borrower will agree to a specific amount of interest charged over the life of the loan. This is stated on a percentage basis and is usually framed in 12 month terms.

When the interest rate is 6%, that means 6% of the total is charged annually.

Monetary Policy

Movement of interest rates is one of the tools central banks such as the Federal Reserve use to implement its monetary policy. Since the institution lacks the ability to directly inject money into the economy, it has to utilize different approaches.

One of the keys to growing an economy is to have commercial banks lend. It is through the loan making process that the money supply expands. A standing belief is that when interest rates are lowered, borrowing will increase. The research on this is mixed.

The Fed has the ability to adjust the Fed Funds Rate. This is the interest rate that banks charge each other. Many consider this the base rate upon which all else are derived.

From here, in theory, all other rates will mirror the decisions of the central bank. An increase in the Fed Funds Rate should result in a parallel move in all other rates.

This is not always the case.

Yield Curve

The yield curve is a graphical representation of the different interest rates of a series of like assets. An example of this is the Treasury Yield Curve which reflects the interest rates on all US Treasuries being issued. There is also on for LIBOR (now SOFR).

On the left hand side is the short date assets with the long end of the yield curve being further out in terms of expiration. A well functioning yield curve is one that starts on the left and heads up towards the right in roughly a 45 degree angle.

The reason for this is the rate of interest should increase the longer money is tied up. A higher rate is the incentive to investors to commit to a longer term.

Yield curves can invert. Under this scenario, the interest rates on the longer dated securities will either drop or not move up as much as the shorter term ones. When the yield curve flattens, i.e. the longer dates interest rates moving closer to the shorter ones, it is a warning something is amiss.

Inversion happens when the rate at the long end actually drops below the short side. This kills demand for the bonds since people are not going to commit money over an extended period for less return than can be acquired by going into a shorter term instrument.

The yield curve is a barometer for many as to the effectiveness of the central banks actions. Bonds are the largest market with roughly $125 trillion outstanding. An inverted yield curve means the bond market is in disagreement with the central bank.

Irving Fisher wrote extensively about this a century ago. He stated that an inverted yield curve meant inflation and growth (economic) expectations were low.

Fixed Income Instruments

Investors often buy fixed income instruments. These are assets that pay a standard rate of return. People are often seeking yield as opposed to speculating.

Bonds are problem the most common of these products. A bond has a coupon rate which is the amount paid each year until maturity.

For example, someone might invest $10,000 in a 10-Y Treasury paying $300. This means the bond pays 3% yearly. Holding until the end means the investor will get $3000 plus the $10,000 back. This is known before buying.

There are other fixed income instruments such as certificates of deposit (CDs). This is offer through commercial banks as opposed to buying bonds through a brokerage firm. A CD operates on the same principle. Investing in a 3 year will pay a higher return than a 3 month.

With these types of investments, the price of the instrument is secondary since it can be viewed as a loan. Even bonds, which are part of the debt market, will return the money after the contracted time.

The price of the asset can rise or fall based upon market condition. This leads some to speculate on these assets. There are many who purchase bonds or mortgage backed securities with the intention of them being worth more in the future.

Credit Worthiness

Before credit is issued, lenders want to determine the worthiness of the borrower. This is true whether an individual or a company. The process is also similar when dealing with a traditional loan such as a mortgage or entering the debt markets.

Most borrow money from banks. These institutions are usually responsible for mortgages, auto loans, and credit cards. Even if the loan is received from a non-banking institution, like a car dealership, there is usually a bank providing the money.

Credit worthiness is used to determine the likelihood that someone will pay back the loan. Banks and other financial institutions have worked to establish a system which they can access to aid in this determination. Here is where one's credit score comes in.

For corporations looking to sell their debt into the bond market, investment banks work to establish a rating on these assets. Companies that are in a weak financial position will have to pay a higher interest rate to attract buyers. When the threat of default is increased, investors want a higher return.

The same is true for individuals. If one has a bad enough credit score, he or she might end up in subprime, which is going to carry a very high interest rate on that loan.

Monetary policy also affects the interest rate that some pays. In an environment of loosening where the central bank has rates low, the corresponding rate for something like a mortgage will be lower than in a period of tightening (higher Fed Funds Rate). This move will not always be consistent as shown by the yield curve.

Interest Rate And Investments

When investing, interest rates will reflect the return someone receives.

One of the keys is that it can be a reflection of the risk one is assuming when purchasing an asset. Those which carry more risk will likely push investors to want a higher return.

Wall Street banks often structure their products to cater to different risk appetites. When they bundle products, the underlying assets are considered. Those who are of less quality will carry a lower rating, presenting a higher rate.

Mortgage backed securities (MBS) are a prime example of this. Mortgages are purchased and broken up into different products. A MBS might have pieces of 1,000 different mortgages contained in them.

These are rated based upon the quality of the mortgages going in. Those which use subprime mortgages will provide a greater return to the investor. This is reflected in the fact that the risk is likely greater since subprime borrowers tend to default on their loans at a higher rate than prime borrowers.

Real Versus Nominal Interest Rate

A nominal interest rate is one that has no adjustment for inflation. The examples provided here are nominal.

If an fixed income asset pays a rate of 6%, that is the nominal interest rate.

Real interest rate is the return adjusted for inflation.

Taking the same asset, the return would be 1% if the inflation rate is 5% (6%-5%).

It is possible for the real interest rate to be negative.

Negative Interest Rate Policy (NIRP)

Many central banks bought into the idea of Negative Interest Rate Policy (NIRP). This was adopted across Europe and Japan as a way to stimulate the economy.

The idea is to remove the incentive to hold money. According to the theory, if people had to "pay" to save, they would spend instead. This would push money out of the banks and into the economy, causing an increase.

Like most monetary theories, the results are mixed at best. The result of this action was the bond markets for these countries were destroyed. Pension funds often require a particular rate of return to make their yearly payouts. Negative interest rates obliterated the revenues these funds were bringing in.

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