Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond

Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond

may change as the supply and demand for funds changes. The interest paid on your bond does not change (you get $50 per year), but the bond’s price does. Suppose instead you buy the $1,000 face value bond for $900. The bond still pays $50 interest per year, but you only paid $900 for it. There- fore, you are earning more than the 5% interest rate ($50/$900 = 5.56%). The 5.56% is the yield on the bond, and 5% is the interest rate on the bond.

Most bonds are issued at their face or par value, so when they are issued the yield is often equal to the coupon rate. And if you buy a bond when it is issued and hold it until it matures, you will earn the bond’s interest rate (i.e., pay $1,000 and get $50 per year). As time marches on,

a bond’s value change and its yield (that is, what investors can earn if they buy the bond at the time) will often deviate from its interest rate. If you hold the bond to maturity, you don’t care about its changing value. But if you buy the bond sometime after it is issued or sell the bond before it matures, you do care about its changing value.

FOUNDATIONS

We often use the terms “interest rate” and “yield” interchangeably because they tell us how much we get for the amount we invest. When we are talking about what investors are getting in terms of a return, we gen- erally talk about the “yield”—the return investors get if they buy a secu- rity at its current price. And, to make returns comparable across securities with different maturities, we quote these yields in terms of a common time frame—a year. This allows us to compare the yield on, say, a 3- month Treasury Bill with a 1-year Treasury Bill.

Determinants of Interest Rates Interest rates are determined by the supply and demand for money. The

supply of money depends in large part on the actions of the Fed, as we discussed previously. Therefore, let’s focus on the demand for money.

The demand for money arises from two sources: transactions demand and asset demand. The transactions demand arises from individuals’ and businesses’ need to use money as a medium of exchange in transactions. The more goods and services exchanges take place in the economy, the greater the transactions demand. The asset demand is individuals’ and businesses’ need to use money as a store of value—they keep some of their wealth in the form of money (instead of in, say, stocks or bonds), which is risk-free and liquid.

Firms raise funds to invest in capital projects, which are investments that have long-term future cash flow consequences. If a firm has many possible ways to invest—to build a new plant, to start an advertising campaign—it will rank these projects based on profitability and invest in those whose profit exceeds the cost of the funds. Meanwhile, other firms are doing the same thing. As a result, firms compete for funds for their investment projects. Firms with the most profitable investment opportunities get the necessary funds, and firms with the least profitable investment opportunities do not. In other words, money is distributed to the capital projects that are most profitable.

Since money earns little or nothing, how much wealth individuals or firms are willing to keep in the form of money depends not only on how they feel about liquidity and risk, but also on what they could earn on the funds if they invested them elsewhere (say, in bonds). Therefore, the demand for money is affected by interest rates: the higher the interest rate, the lower the demand for money.

The Structure of Interest Rates There is not one interest rate in any economy. Rather, there is a struc-

ture of interest rates. The interest rate that a borrower will have to pay depends on a myriad of factors. We discuss these factors next.

Financial Institutions and the Cost of Money

The Base Interest Rate The securities issued by the U.S. Department of the Treasury, popularly

referred to as Treasury securities or simply Treasuries, are backed by the full faith and credit of the U.S. government. Consequently, market par- ticipants throughout the world view them as having no credit risk. As a result, historically the interest rates on Treasury securities have served as the benchmark interest rates throughout the U.S. economy as well as in international capital markets.

The U.S. Treasury is the largest single issuer of debt in the world and the large size of any single issue has contributed to making the Treasury market the most active and, hence, the most liquid market in the world. However, in recent years, the U.S. Department of the Treasury has reduced its issuance of Treasury securities, particularly long-term securi- ties, as well as buying back long-term Treasury securities in the market. This has decreased the supply of these securities and, as a result, there are market participants who feel that the yields on Treasury securities are no longer a suitable benchmark for interest rates throughout the world. As a result, as of this writing, there is a search for other possible benchmarks.