Interest rates are the monetary compensation or the cost of borrowing given to the lender(s) or supplier(s) of funds by the borrower(s) or demander(s) of funds or loans (CMU, 2010). The terms required returns and interest rates are similar in that the lender gets compensated for the funds they provide to the borrower. However, required returns are used when referring to equity instruments (investments) like common stock, and the interest rate is used when referring to debt instruments like bonds or bank loans. There are several factors that influence interest rates. They include inflation, risk and liquidity preference.
In a real rate of interest world, these factors do not exist. Therefore, the real rate of interest is a rate that creates equilibrium between the suppliers of the fund (supply of savings) and the demanders of the funds (for investment) (Mazzucato et al., 2010).The real rate of interest is subject to change in the real world due to changing economic conditions. As the name suggests, the actual or nominal rate of return (interest) is the actual rate of interest paid by the borrower or demander of funds for investment. The actual rate of interest differs from the real rate of interest in regards to risk and inflation. Therefore, investors or lenders demand a higher rate of return if there is foreseen inflation or the investments are risky. These higher rates of return are referred to as the expected inflation premium (IP) and risk premium (RP) respectively. The various factors that influence the expected inflation premium include international political events, changes in fiscal and monetary policies and currency movements (CMU, 2010).
The United States of America (USA) treasury offers short term, three months, treasury bills (T-bills) that are regarded as the most secure investment in the world (Mazzucato et al., 2010).
These T-bills are the closest to risk free investments as you can get. However, due to the increasing rates of interest and inflation, the T-bills rates have declined slightly since the recession. Bonds have a fixed interest rate that cannot be changed as the expected inflation changes with the exception of I-bonds (Inflation adjusted savings bonds). Normally, if inflation rises and the nominal rate is fixed, it means that the real rate of return of bonds falls. However, the composite rate is used to calculate the interest earned by I- bonds. The composite rate is made up of a fixed rate (for the life of the bond) and an adjustable rate (equal to the inflation rate). However, I-Bonds have several disadvantages. Firstly, there is a three month interest penalty if you redeem the I-bond within the first five years. Secondly, to maximize on the interest earned, investors must redeem the I-bond after the first day of the month. Thirdly, the adjustable rate feature can lower investors’ returns if deflation (falling prices) occurs (CMU, 2010).
Term structure of interest describes the association between the rate of return and the maturity of bonds with similar risk levels (CMU, 2010). A graph showing this relationship is known as the yield curve. Through the yield, curve analysts are able to tell the varying rates of long, short and medium term bonds. The yield curve may also aid analysts to see general future trends of interest rates and the economy. Term structure of interest rates is explored by analysts through a focus on treasury securities which are known for their lack of default risk.
When an investor allows a bond to mature and makes all the promised bond payments, the bond can earn them a compound annual rate of return which is a bond’s yield to maturity (YTM) (CMU, 2010). This YTM is plotted on the y-axis while the time to maturity is plotted on the x-axis in the yield curve. The yield curves’ shape and position are subject to change over time. An inverted yield curve (downward-sloping yield curve) is one that shows the short term interest rates being higher than the long term interest rates. An inverted yield curve occurs rarely, but most of the times precedes most recessions (weakened economy). The norm is a normal yield curve (upward-sloping yield curve) which shows the short term interest rates being lower than the long term interest rates.
Occasionally, there may be a flat yield curve which shows that the short term interest rates do not vary much from the long term interest rates at different maturities. The yield curve shape may affect corporate financing decisions. For instance, an inverted yield curve may prompt overreliance on cheaper long term financing which in future may be quite expensive due to falling interest rates. Likewise, a normal yield curve may prompt corporates to mostly rely on cheaper short term financing which in future the costs may rise due to rising interest rates. This may also mean that firms may fall short when it comes to refinancing short term loans. There are other factors that affect the loan maturity choice. Nevertheless, the yield curve shape is crucial in making a choice about borrowing long term versus short term (CMU, 2010).
There are three theories (theories of term structure) that explain the general yield curve shape: the market segmentation and liquidity preference theory the expectations theory (CMU, 2010). According to the liquidity preference theory, long term interest rates are generally higher than short term interest rates due to the fact that short term investments are more liquid and less risky than long term investments. The long term interest rates for bonds must be higher to entice investors into buying them vis-a-vis the short term bonds. According to the segmentation theory, the loans market is segmented on the basis of maturity. The prevailing interest rates are determined by the demand and supply of loans in each segment. The relationship between prevailing rates within each market segment defines the yield curve slope. According to the expectations theory, the yield curve represents the expectations of investors about future interest rates. Therefore, the expectation of rising short term interest rates results in a normal yield curve while the expectations of declining short term interest rates result in an inverted yield curve.
There are several issue and issuer related components of risk premiums (CMU, 2010). These include interest rate risk, business risk, tax risk, financial risk, liquidity risk and debt specific risks (default risk, contractual provision risk and maturity risk). The default risk refers to the possibility that the debt issuer (borrower) will not pay the principal or the contractual interest as scheduled. Contractual provision risk refers to the conditions included in a stock issue or debt agreement. Some of these conditions may serve to reduce risk, but others increase risk. Great default risks are associated with risk premium. Low default risks reflect high bond ratings and vice versa. In maturity risk, the longer the maturity, the more the value of a security changes in reaction to a given interest rate change. Generally, securities issued by corporate firms with high default risks and securities from maturities that are long term and have unfavorable contractual provisions give rise to the highest risk premiums and returns (CMU, 2010).
Corporate bonds are long term debt instruments acquired by firms or corporations. These corporations borrow certain amounts of money and promise to repay in the future according to clearly defined terms. The coupon interest rate describes the proportion of the par value of a bond that is payable as interest every year, usually in two installments (Choudhry, 2004). These installments are made semiannually.
Bond yields (rate of returns) are used to evaluate the performance of bonds during a given time period (usually one year) (CMU, 2010). There are several ways to measure bond yields. Therefore, it is crucial to comprehend popular yield measures. There are three common bond yields: the current yield, the yield to maturity (YTM) and the yield to call (YTC). These bond yields give a distinct measure of bond returns. The current yield is the simplest yield measure (annual interest payments divided by current price). The current yield shows the cash return from the bond for the year. The current yield does not measure the total return due to the fact that it ignores any changes in bond value. The YTM and YTC measure the total return (CMU, 2010).
Bond prices and trading are not readily available to individuals due to corporate bonds being held and purchased by institutional investors (Choudhry, 2004). Most corporate bonds are dispensed with a face or par value of one thousand dollars. However, all bonds are cited as a percentage of par. Corporate bond prices are in dollars and cents. The YTM of a bond (compound annual rate of return) is earned when the bond is purchased and held to maturity.
Bond ratings are generated by independent agencies like Standard & Poor, Fitch. By using cash flow analysis and financial ratio to evaluate the default risks, these agencies develop their ratings (Mazzucato et al., 2010). The rate of return to bondholders and the quality of a bond have an inverse relationship. Therefore, lower rate of return is a product of high quality bonds (high rated) and vice versa. This reveals the risk return trade-off for the lender. Finance managers must always take into consideration the bond issue expected ratings when thinking about bond financing since these ratings affect the cost and salability.
There are a variety of ways that can be used to classify bonds. There are the traditional bonds and the contemporary bonds (CMU, 2010). Traditional bonds are those that have been there for years while contemporary bonds are the more innovative newer types of bonds. Traditional bonds are characterized according to the priority of the claim of the lender and key characteristics. Popular traditional bonds include income bonds, debentures, subordinated debentures (these first three are unsecured), equipment trust certificates, mortgage bonds and collateral trust bonds (these last three are secured). Contemporary bonds may be unsecured or secured. Contemporary bonds include junk bonds, zero or low-coupon bonds, putable bonds, extendible notes and floating rate bonds. Innovation continues in bond financing as inspired by investor preferences and changing capital market conditions (CMU, 2010).
Governments and companies can be able to borrow internationally by issuing bonds. These bonds are issued in two major financial markets: the foreign bond market and Eurobond market. These markets offer an opportunity to quickly acquire large long term debt financing with flexible repayment terms in the currency of your choosing. A Eurobond is a bond sold to investors in countries which do not use the Euro as their currency and an international borrower issues it. A foreign bond is a bond sold in the investor’s home market and denominated in his home currency and a government or foreign corporation issues it. Recently, the Eurobond market has become more balanced in terms of currency of denomination, total issue volume and the mix of borrowers (CMU, 2010).
In conclusion, this proposal on interest rates and bonds and their role enlightens one on some crucial aspects of personal and corporate financing. I have gained an understanding of the Treasury bills, theories of term structure, interest rates, required return, inflation, deflation, liquidity preferences, bonds, risk premiums, yields and market segmentation. Personally, I have gained perspective on how interest rates may affect my returns from savings and investments. I am keen in checking out the interest rates charged on loans I acquire and the credit cards we have or want to get. This proposal has been crucial at equipping me to maximize my profits to achieve success in my finances.
References
Central Michigan University, CMU. (2010). MSA 602: Financial Analysis, Planning and Control Package. Pearson. 978-1-269-33642-0
Choudhry, M. (2004). Corporate bonds and structured financial products. Amsterdam: Elsevier Butterworth Heinemann.
Mazzucato, M., Lowe, J., Shipman, A. and Trigg, A. (2010). Personal Investment: Financial Planning in an Uncertain World. London. Palgrave Macmillan.
