Interest Rates on Debt Securities

1
Interest Rates on Debt Securities

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

2
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

3

• 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

4
Feds 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

5
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)

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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 dont have
  that much extra to lend
• Rates on all lending will be higher when federal
  funds rate goes up, causing spending to decrease

7
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)

8

• 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

9
Federal Fiscal Policy

• Interest rates in general are also affected by
  federal government spending and borrowing
• When tax receipts arent sufficient to cover
  expenditures, govt must borrow, putting upward
  pressure on interest rates

10

• 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.

11
Interest Rates on Specific Debt Securities

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

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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
• Moodys SP rate debt for default risk

13
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)

14
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!

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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?

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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

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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

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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)

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Theories Explaining Term Structure of Interest
Rates

• Liquidity Preference
• Market Segmentation
• Expectations

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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

21
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

22
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

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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