Introduction to interest rates and fixed income investments
With interest rates expected to rise from their record lows, investors are flocking to equities and high yield securities in search of returns. However, investors are cautious in choosing fixed income investments given the potential for further rate increases as the economy continues to expand. This series examines the factors affecting interest rates and how fixed income investments can respond as rates rise.
What is an interest rate?
Interest rates reflect the cost of borrowing over time. They’re the return you get for loaning your money to the institution that is selling the particular fixed income instrument. They’re similar to getting a return on your bank deposits when you lend your money to the bank, which uses the deposits either to pay off its maturing liabilities or to earn money by extending credit.
Many factors impact interest rates, including the real cost of funds, inflation expectations, and preferences for shorter-term, more liquid securities.
Factors impacting interest rates
- Fed funds rate
The Fed determines and communicates the appropriate Fed funds rate[1. Fed funds rate is the interest rate at which a depository institution lends funds that are maintained at the Federal Reserve to another depository institution overnight.] through its monetary policy decisions. Short-term rates in the market are based on the Fed funds rate. An increase or decrease in the Fed funds rate will affect the short-term interest rates prevailing in the market, as it serves as a basis for determining the risk-free rate.
- Credit spread
The riskier the borrowing institution, the higher the rate of interest the investor will demand for taking on the additional credit risk, or the credit spread. So, high yield bonds that are issued by non-investment grade corporations pay higher yields than investment-grade bonds or Treasuries.
- Inflation expectations
The higher the current rate of inflation and the higher the expected future rates of inflation, the higher the yields will rise across the yield curve. The reason is investors will demand higher yields to compensate for inflation risk. This leads to a fall in bond value. In a way, inflation erodes the purchasing power of a bond’s future cash flows.
- Preference for shorter-term, more liquid securities
Long-term bonds have a greater duration than short-term bonds. So, a given interest rate change will have a greater effect on long-term bonds than on short-term bonds.
Also known as the liquidity preference theory, the idea is that investors demand a premium for securities with longer maturities, which involve greater risk, because they would prefer to hold cash, which involves less risk. The more liquid an investment, the easier it is for the investment to sell quickly for its full value. For example, a three-year Treasury note might pay 1% interest, a ten-year Treasury note might pay 3% interest, and a 30-year Treasury note might pay 4% interest. While this is the most common phenomenon, at times the yield curve can take different shapes. To learn more about yield curves, read Market Realist’s series Fixed income recommendation: Assess the shape of the yield curve.
While changes in interest rates may not prompt long-term investors of companies with lower credit risk such as Apple Inc. (AAPL) and Exxon Mobil Corporation (XOM) to react, investors holding stocks of highly leveraged companies may want to re-evaluate their holdings. The PowerShares Senior Loan Portfolio Fund (BKLN) is a popular exchange-traded fund (or ETF) that tracks the S&P/LSTA U.S. Leveraged Loan 100 Index. The Highland/iBoxx Senior Loan ETF (SNLN) and the First Trust Senior Loan Fund ETF (FTSL) are other popular ETFs in the leveraged loans category.
The next part of this series discusses the drivers for interest rate movements.