Investing 101: Interest Rates

In my Investing 101: Bonds post, I discussed how bonds worked with several references to interest rates. Most people are familiar with interest rates in the form of the interest rate on your mortgage loan or maybe the interest rate on your savings account or CD. These seem pretty fixed, but interest rates are a dynamic driver of both bond prices and the economy.

Interest rates in this context are defined as the market interest rate on US Treasury bonds. Treasury bonds come in a variety of term lengths (also called maturity dates) ranging from a month to thirty years, and each maturity date has an associated interest rate. The current one month US Treasury rate is 0.03% and the thirty year Treasury rate is 2.83%. The most often quoted Treasury rate is the ten year, which is currently at 2.18%. If you held a ten year US Treasury bond for ten years, you would expect your realized annual rate of return to be 2.18%. However if you do not hold the bond to maturity, the return will fluctuate with the current market interest rates.

Bond market investors drive Treasury interest rates up or down based on current news and expectations about the economy. When world news or economic expectations are negative investors tend to want to buy US Treasury bonds as a safety net. US Treasury bonds are the most easily traded bonds in the world, and the US Government is considered the most credit worthy. When more investors want to buy Treasury bonds interest rates go down. Think about it. If lots of people want to lend you money, you can negotiate a lower interest rate. The opposite is true if the news is rosy. Investors are willing to take more risk, and they sell US Treasury bonds. Interest rates rise. If no one wants to lend you money because they have better opportunities for their investments, you have to pay a higher interest rate to get people to lend to you.

At this point you may be thinking that you have heard the Federal Reserve sets interest rates. The Federal Reserve does set a very short term interest rate called the Federal Funds rate. This is the overnight rate used by banks to trade Federal Funds deposits with each other. This rate does influence all other short term interest rates in the US. However the Federal Reserve has no direct control over any other interest rates, so market forces drive those.

These market forces show up in the actual interest rates the US Treasury pays when it auctions new bonds. But for the bonds that are already outstanding, changes in interest rates impact the price of the bonds. When interest rates rise, the price of outstanding bonds decline, and when interest rates decline, the price of outstanding bonds rise. This brings the expected return to maturity for newly issued and outstanding bonds of the same maturity into alignment.

Changes in US Treasury rates drive changes in other rates, such as the rates on new mortgage loans, which are closely tied to the ten year Treasury rate. They also drive changes in interest rates for other issuers, such as corporate and municipal bond issuers. Interest is an expense for whoever borrows money. Higher interest rates means the expense of borrowing money goes up, while lower interest rates reduces the cost of borrowing. This is how interest rates impact the economy. When interest rates rise, it tends to have a dampening affect on the economy, because there is less borrowing, whether it is for business investment or buying homes, while lower interest rates tend to stimulate the economy, because the cost of borrowing is lower. Interest rates serve as a kind of economic regulator.

Interest rates are the driver behind changes in bond values as well as the rate of return you realize on your bond portfolio. Understanding how they are playing out in the economy can help you understand what is going on with your investments, and possibly make you a little more comfortable with them.

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