Transcript Interest Rates on Debt Securities

Interest Rates on Debt Securities
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Rates in general are influenced by
1) Actions of the Federal Reserve Board
2) Federal fiscal policy
Federal Reserve Board
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The Fed controls two key rates:
1) Discount rate - rate at which banks
borrow directly from Fed when they
have insufficient reserves to meet
reserve requirement
Thus, rate is set directly by Fed
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2) Federal Funds rate - Rate one bank
charges another for overnight borrowing
(in order to meet reserve requirement)
Fed controls this rate indirectly
Sets target for Federal Funds rate
Rate moves toward target in response
to changes in money supply
Fed’s Open Market Operations
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Fed can control money supply by
buying or selling T bills on the open
market
Change in money supply leads to
change in interest rates
Increase in supply - lower interest rates
Decrease in supply - higher interest
rates
Raising Federal Funds Rate
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When Fed thinks CPI is growing too
fast, it tries to cut spending by raising
interest rates
Achieves this by decreasing supply of
money
Decreases money supply by SELLING
additional T bills (takes money out of
circulation)
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Decrease in money supply causes
banks’ reserves to be lower
When banks loan to each other, they
will charge higher interest rates
because they don’t have that much
extra to lend
Rates on all lending will be higher when
federal funds rate goes up, causing
spending to decrease
Lowering Federal Funds Rate
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When Fed thinks economy needs a
boost, it lowers interest rates to
increase spending
Achieves this by increasing the supply
of money
Increases money supply by BUYING
additional T bills (puts more money out
in circulation)
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Increase in money supply causes banks
to have more in reserves
Having ample reserves leads banks to
charge each other lower rates on
federal funds borrowing
Lower federal funds rates lead to lower
rates on all bank lending, causing
spending to increase
Federal Fiscal Policy
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Interest rates in general are also
affected by federal government
spending and borrowing
When tax receipts aren’t sufficient to
cover expenditures, govt must borrow,
putting upward pressure on interest
rates
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When govt takes in more than it spends,
there is a decrease in demand for borrowed
funds, which causes interest rates to drop
Govt used to be running a surplus - interest
rates have been relatively low for the past
decade.
Surplus ran out after 9/11/01 – govt. now
running at a deficit.
Interest Rates on Specific Debt
Securities
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Determined by general level of interest
rates plus three factors:
1) Default Risk
2) Liquidity
3) Maturity
Default Risk
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The higher the default risk, the higher
the interest rate must be to attract
investors
The lower the default risk, the lower the
interest rate the security must carry
Moody’s & S&P rate debt for default risk
Liquidity
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The greater the liquidity (more easily
traded, good secondary market), the
lower the interest rate the debt security
has to carry
The lower the liquidity, the higher the
interest rate (in order to attract
investors)
Maturity
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How does the maturity of a security whether it is short-term or long-term affect the interest rate it carries?
Does short-term debt carry a higher or
lower interest rate than long-term debt
(that has the same default risk and
same liquidity)?
Answer = It varies!
Determining Impact of Maturity
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Look at securities whose maturities vary
but that have same default risk and
same liquidity
Look at Treasury Securities - T bills,
notes, & bonds
Only difference is maturity
Which yields the higher interest rate?
Yields on Treasury Securities
(as of 1/19/11)
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3 month T bill 0.16%
6 month T bill 0.19%
2 year T note 0.59%
3 year T note 0.99%
5 year T note 1.94%
10 year T note 3.35%
30 year T bond 4.54%
Yield Curve
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Construct a curve showing these
Treasury yields, with maturities on X
axis and yields on Y axis
Current yield curve is upward sloping
Observed Shapes of Yield Curves
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Upward sloping: long-term rates higher
than short-term rates
Downward sloping: long-term rates
lower than short-term rates
Flat: no difference between long-term
and short-term rates
Intermediate rates higher or lower than
long- or short-term rates (bump or dip in
middle of curve)
Theories Explaining Term
Structure of Interest Rates
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Liquidity Preference
Market Segmentation
Expectations
Liquidity Preference
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Lenders prefer liquidity (access to
funds)
Must reward lenders with higher rates
for going without access to their funds
for longer periods of time
According to this theory, long-term rates
should be higher than short-term rates
Market Segmentation
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Market for funds has different
segments: short-term, intermediateterm, long-term
Interest rate within a given segment is
determined by supply of funds and
demand for funds within that segment
This theory could conceivably explain
any shape of the yield curve
Expectations
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Investors should be able to average the
same return whether investing in a
series of successive short-term
investments or one long-term
investment
Therefore, long-term rates give clues to
what investors expect will happen to
short-term rates in the future
Conclusion on effect of maturity
on interest rates
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Most of the time in our economic
history, short-term rates have been
lower than long-term rates
However, that is not always the case, so
investors and borrowers need to check
yield curve before making decisions as
to whether to invest (borrow) short-term
or long-term