Interest Rates II

We continue with interest rates.

All of us encounter interest rates, either as borrowers or as creditors (investors) or both. And for a lot of us, casualty is a big mystery. What forces move these things? Greenspan for example and other "experts" make them out to be nothing if not bewildering. But in fact the basics are not bewildering at all. We can fetch all the tools we need to make our lives more comfortable around and about interest rates.

Before we can translate economic activity into interest rates we need to know the fundamentals; we’re not launching a satellite here folks, just developing an anchor. After we have done that, we can take a look at a real life petri dish, the breakdown of Q4, 2008, and the follow through. We hope to acquire some tools in the process.

What is interest? It is in fact an aggregate composed of three elements. First, the pure or base rate, second, the inflationary premium (or lack of) and finally, the credit risk, that is, risk of default specific to the debtor. Assume you own the debt (bonds) of a corporation. The maturity is 10 years and the coupon is 6%. Of that 6%, perhaps 3% is the base, or fair rate at which, all else equal, you will lend money to a near riskless credit, and that borrower will pay for the privilege. That leaves 3%. One and one half percent assume is due to inflationary expectations, that is, the expected corrosion in value due to a weakening currency that you will demand over 10 years. Finally, the remaining 1 ½ % is credit risk, that risk the market has assigned to the probability that the borrower which owes you money, will fail. This all adds up to 6%. The calculation, the process is usually more complex; we don’t care. For our purpose, this is enough.

Next, we must understand how the movement in interest rates impacts debt prices. Very simple - interest up, price down / interest down, price up. Back to our example - bonds at 6%. Assume you are the owner of one bond (usually in denominations of $1000). The coupon of 6% pays $60 annually. You decide to sell, not waiting for maturity. But assume a recession has interceded so that interest rates are now 3% for similar credits. Only a fool would give the buyer $60 a year or 6% when the market rate is 3%. You adjust the bond price and demand $2000. The $60 coupon now yields 3%. That’s all there is to if folks. This is the core or heart of the process.

Institutional markets trade interest rate-bearing instruments regularly, in billions of dollars equivalent every day. These trades, no matter how complex, always adhere to the two rules above. It is instructive to look at a few of these. For example, speculators may sell short US treasuries if they believe interest rates are headed higher (interest up, price down) with the intent to buy back the bonds cheaper at a profit. Easy. Here they are targeting the inflation component noted earlier. Or, major world banks may trade interest bearing instruments relative to one another, so-called spread trades. For example, if Morgan believes that the recovery in the UK will significantly lag that in the US, Morgan will buy UK Gilts (gov’t bonds) and sell US Treasuries. The bank (speculator) does not know where UK or US interest rates are going outright and doesn’t need to. All it needs to make a profit is for US rates to move higher, quicker than those counterparts in the UK (in this case, presumably because the US recovery will pressure rates higher, faster - the bet). This trade then focuses on relative inflation. US debt prices will fall faster than UK debt prices so the bank will make more on the US side than it loses on the UK side. Easy. Finally, a speculator may expect Germany to be downgraded as a result of the recent financial turmoil. He will buy US debt and sell Euro debt, with no particular view to relative growth at all, but specifically to creditworthiness, expecting Euro debt prices to fall relative to US as soon as the downgrade becomes reality. Here the target is the credit risk, the other of our three components.

So it’s not so tough after all, understanding interest rates and price movement. We’re getting there, that is, closer to acquiring the tools we need to make our own decisions about interest rates and our investments.

In the next sketch we will look at the near meltdown in the world debt/interest rate markets, Q4, ‘08. That process will further assist our own ends, which reside much closer to home.

Robert Craven