Interest Rates on Debt Securities

Interest Rates on Debt Securities • Rates in general are influenced by • 1) Actions of the Federal Reserve Board • 2) Federal fiscal policy

Federal Reserve Board • 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

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 • 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 • 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)

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 • 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)

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 • 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

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 • Determined by general level of interest rates plus three factors: • 1) Default Risk • 2) Liquidity • 3) Maturity

Default Risk • 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 • 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 • 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 • 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) • 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 • 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 • 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 • Liquidity Preference • Market Segmentation • Expectations

Liquidity Preference • 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 • Market for funds has different segments: short-term, intermediate-term, 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 • 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 • 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

Interest Rates on Debt Securities