Financial Management
oguzhansaglik
Week_8.pptxInterest Rates and Bonds
Introduction to Interest Rates
First, let’s revisit the time value of money:
Recall that if we are offered $100 today or $100 a year from now we would almost always want the $100 today. Why?
If there are positive real interest rates throughout the year, we can take the $100, invest it, and earn interest on the $100 dollars
The only scenario where we would prefer the $100 in the future is when there are negative real interest rates (very rare)
Investors are compensated for locking up their money in an investment or savings in the form of interest.
Interest can be thought of as the fee paid to the investor for the current use of assets
Example:
A borrower needs cash (an asset) to finance a project
An investor may give them current use of their cash with the promise they will give it back later
Since there is the aspect of time involved with this transaction, the borrower needs to pay a fee to the investor
The fee is the interest rate on the loan and the magnitude of the interest rate is effected by several factors
Length of borrowing (bond maturity or loan term)
Credibility of the borrower (credit rating of an individual or company)
Market interest rates
The US Federal Reserve, Monetary Policy and Interest Rates
Monetary policy is the process by which the monetary authority (i.e., The Fed) controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability
In the United State, the Federal Reserve (aka, “The Fed”) implements monetary policies largely by targeting the federal funds rate
The federal funds rate is the rate that banks charge each other for overnight loans of funds
This is considered very short-term, safe lending that serves as a starting point to determine other interest rates
The Fed will take one of two approaches two monetary policy:
Expansionary: Used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding
Contractionary: Used to try to slow rising inflation in hopes of avoiding the resulting distortions and deterioration of asset values
The Fed will alter the fed funds rate based on key economic indicators such as:
Inflation (Rising inflation? Fed will raise interest rates to try and slow the growth in money supply)
Investment activity (Low investment activity? Fed will lower interest rates to encourage borrowing and expansion)
Unemployment rates (High unemployment rate? Fed will lower interest rates to lower corporate costs and encourage firms to hire employees)
Factors that Influence Market Interest Rates
Deferred Consumption: When money is loaned, the lender delays spending the money now.
According to time value of money principles, there will be a positive interest rate to compensate for this deferral in spending of money.
Inflationary Expectations: Assuming inflation (usually the case), a given amount of money is worth less in the future than it will now.
The borrower needs to compensate the lender for this expected inflation
If inflation expectations go up, so do nominal interest rates
Remember that nominal interest rates are a combination of inflation and real interest rates
Alternative Investments: The lender has a choice between using his money (a scarce resource) in different investments. Choosing one means forgoing all other options.
Availability of alternative investment options means different investments effectively compete for investor’s money, boosting the market interest rate up
Risks of Investments: Uncertainty in an investment because the borrower could go bankrupt or default on the loan.
This uncertainty is reflected in a risk premium to ensure that the lender (investor) is compensated for the varying possibility of a default or bankruptcy depending on creditworthiness of borrower
Liquidity Preference: Availability of resources is desirable in a form that can be immediately exchanged.
An increased willingness to hold money will cause the supply of money in circulation to contract. A decreased supply will cause market interest rates to rise.
Term Structure of Interest Rates
The term structure of interest rates describes how rates change over time (aka, the yield curve)
Yield curve shows interest rates across different contract lengths for a similar debt structure (i.e., US Treasuries)
The curve illustrates relationship between interest rates and the time to maturity (term) of the debt
Slope of the Yield Curve
The slope of the yield curve can tell us a lot about the financial health of the economy
A “normal” yield curve has a positive slope and short-term rates are lower than long-term rates
Reflects investor expectation for a growing economy
Usually seen at the beginning of economic expansion or at the end of a recession
Recent economic stagnation will cause central banks to depress short-term interest rates
A flat yield curve means all maturities of bonds have the same interest rates (yield)
Reflects that there is uncertainty on the state of economy as investors do not prefer short-term or long-term debt
An inverted yield curve occurs when long-term yields fall below short-term yields
Lenders are seeking long-term debt contracts more aggressively than short-term debt contracts
Lenders are uncertain about longer-term prospects of the economy and want to lock in borrowers and have to offer lower interest rates to do so
What is happening today?
Introduction to Bonds
A bond is an instrument of indebtedness of the bond issuer to the holders.
The issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed the maturity.
Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.
Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e. they are owners), whereas bondholders have a creditor stake in the company (i.e. they are lenders).
Broad Classifications of Bonds
Municipal bonds: A municipal bond is a bond issued by an American city or other local government, or their agencies.
Corporate bonds: A corporate bond is a bond issue by a corporation. It is a bond that a corporation issues to raise money effectively in order to expand its business.
Treasury bonds: A United States Treasury bond is a government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt.
Duration: A Measure of Interest Rate Risk
A good approximation for bond price changes due to yield is the duration, a measure for interest rate risk.
The yield-price relationship for bonds is inverse.
Investors ideally would like to have a measure of how sensitive their bonds are to yield changes
The Macaulay duration is the name given to the weighted average time until cash flows are received and is measured in years. It really makes sense only for an instrument with fixed cash flows.
The modified duration is the name given to the price sensitivity and is the percentage change in price for a unit change in yield. It really makes sense only for an instrument with fixed cash flows.
The modified duration is a derivative (rate of change) or price sensitivity and measures the percentage rate of change of price with respect to yield. The concept of modified duration can be applied to interest-rate sensitive instruments with non-fixed cash flows.
Example: If the duration of a bond is 4. We would say, “if interest rates rise 1%, the value of the bond falls 4%”
Credit Ratings: Another Critical Player in Bond Valuation
The credit rating is a financial indicator to potential investors of debt securities
Credit risk and interest rate risk make up the two major types of risks for most bonds (although there are others)
Ratings play a critical role in determining how much companies and other entities that issue debt, including sovereign governments, have to pay to access credit markets
Example: the amount of interest they pay on their issued debt.
The ratings are assigned by credit rating agencies such as Moody’s, Standard & Poor’s, and Fitch. Ratings to have letter designations (such as AAA, B, CC), which represent the quality of a bond.
A bond is considered investment -grade (IG) if its credit rating is:
BBB- or higher by Standard & Poor’s
Baa3 or higher by Moody’s,
BBB(low) or higher by DBRS.
Bond ratings below BBB/Baa are not considered to be investment grade; such bonds are called junk bonds (aka, high yield or speculative grade)
Credit Ratings Spectrum
