Interest Rates And Your Bond Investments By David Harper

Most investors care about future interest rates, but none more than bondholders. If you are considering a bond or bond fund investment, you must ask yourself whether you think interest rates will rise in the future. If the answer is yes then you probably want to avoid long-term maturity bonds or at least shorten the average duration of your bond holdings; or plan to weather the ensuing price decline by holding your bonds and collecting the par value at maturity. (For a review of the relationships between prevailing interest rates and yield, duration, and other bond aspects, please see the tutorial Advanced Bonds Concepts.)

The Treasury Yield Curve
In the United States, the Treasury yield curve (or term structure) is the first mover of all domestic interest rates and an influential factor in setting global rates. Interest rates on all other domestic bond categories rise and fall with Treasuries, which are the debt securities issued by the U.S. government. To attract investors, any bond or debt security that contains greater risk than that of a similar Treasury bond must offer a higher yield. For example, the 30-year mortgage rate historically runs 1% to 2% above the yield on 30-year Treasury bonds.

Below is a graph of the actual Treasury yield curve as of December 5, 2003. It is considered normal because it slopes upward with a concave shape:

Consider three elements of this curve. First, it shows nominal interest rates. Inflation will erode the value of future coupon dollars and principal repayments; the real interest rate is the return after deducting inflation. The curve therefore combines anticipated inflation and real interest rates. Second, the Federal Reserve directly manipulates only the short-term interest rate at the very start of the curve. The Fed has three policy tools, but its biggest hammer is the federal funds rate, which is only a one-day, overnight rate. Third, the rest of the curve is determined by supply and demand in an auction process.

Sophisticated institutional buyers have their yield requirements which, along with their appetite for government bonds, determine how these institutional buyers bid for government bonds. Because these buyers have informed opinions on inflation and interest rates, many consider the yield curve to be a crystal ball that already offers the best available prediction of future interest rates. If you believe that, you also assume that only unanticipated events (for example, an unanticipated increase in inflation) will shift the yield curve up or down.

Long Rates Tend to Follow Short Rates
Technically, the Treasury yield curve can change in various ways: it can move up or down (a parallel shift), become flatter or steeper (a shift in slope), or become more or less humped in the middle (a change in curvature).

The following chart compares the 10-year Treasury yield (red line) to the one-year Treasury yield (green line) from June 1976 to December 2003. The spread between the two rates (blue line) is a simple measure of steepness:

An increase in feds funds (short-term) tends to flatten the curve because the yield curve reflects nominal interest rates: higher nominal = higher real interest rate + lower inflation.

Fundamental Economics
The factors that create demand for Treasuries include economic growth, competitive currencies and hedging opportunities. Just remember: anything that increases the demand for long-term Treasury bonds puts downward pressure on interest rates (higher demand = higher price = lower yield or interest rates) and less demand for bonds tends to put upward pressure on interest rates. A stronger U.S. economy tends to make corporate (private) debt more attractive than government debt, decreasing demand for U.S. debt and raising rates. A weaker economy, on the other hand, promotes a “flight to quality”, increasing the demand for Treasuries, which creates lower yields. It is sometimes assumed that a strong economy will automatically prompt the Fed to raise short-term rates, but not necessarily. Only when growth translates or overheats into higher prices is the Fed likely to raise rates.

In the global economy, Treasury bonds compete with other nations’s debt. On the global stage, Treasuries represent an investment in both the U.S. real interest rates and the dollar. The euro is a particularly important alternative: for most of 2003, the European Central Bank pegged its short-term rate at 2%, a more attractive rate than the fed funds rate of 1%.

Finally, Treasuries play a huge role in the hedging activities of market participants. In environments of falling interest rates, many holders of mortgage-backed securities, for instance, have been hedging their prepayment risk by purchasing long-term Treasuries. These hedging purchases can play a big role in demand, helping to keep rates low, but the concern is that they may contribute to instability.

We have covered some of the key traditional factors associated with interest rate movements. On the supply side, monetary policy determines how much government debt and money are supplied into the economy. On the demand side, inflation expectations are the key factor. However, we have also discussed other important influences on interest rates, including: fiscal policy (that is, how much does the government need to borrow?) and other demand-related factors such as economic growth and competitive currencies.

Here is a summary chart of the different factors influencing interest rates:

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