The Interest Rate Cake
Think of interest rates like a slice of layered cake. Each layer represents a different type of risk that debt investors must be compensated for, also known as “risk premiums”.
The base layer of our cake is what is known as the “risk free” rate. This is basically the equivalent maturity sovereign bond yield (what the government pays to borrow). For example, a company issuing 10 year debt in the United States will have the base layer of its cake be the yield on the 10 year Treasury note.
Central Banks are thought to play a key role in setting “risk free” rates, especially at the short end of the yield curve. They do so as part of enacting monetary policy, where they set a target for overnight interest rates. They then get short term interest rate markets to trade at or near this target rate through a combination of telling markets what to expect and open market operations, where the Central Bank transacts directly in the marketplace.
It is important to note that the Central Bank really only has “control” over the short end of the curve. In the USA, conventional market practice is to take the 2 year Treasury note as the furthest point in the yield curve that the Fed’s interest rate policy affects. Of course, the advent of QE has changed this, since the Fed’s (and other Central Banks) direct buying of longer dated sovereign debt drives down those yields too.
Now to the next layer in our cake, which represents the premium the company will have to pay for how risky the market perceives it to be. This amounts to the market’s judgment of the probability of the company defaulting on its debt. The riskier the company, the higher the risk premium, i.e the thicker this layer of the interest rate cake.
In general, companies that have less predictable cash flows will have to pay higher risk premiums. Examples of such companies include those operating in cyclical industries, entertainment, or casinos. The reasoning behind this is that less predictable cash flows are less stable ones, and hence pose a higher chance of default.
The third layer in our cake is the premium paid for the lifespan of a bond. The longer its lifespan, or in professional parlance, the bond’s maturity, the higher the premium (thicker layer). This is to compensate for changes in interest rates from now until the bond matures, with the reasoning being that interest rates are less likely to change by much in the short term versus the long term.
Last but not least, the final layer represents every bond investor’s nightmare, inflation. Interest rates rise with inflation as investors demand compensation for the erosion of their interest income from the bond. This happens because in fixed rate bonds, coupon payments are fixed, which means that they are susceptible to rising inflation. Who wants a 2% coupon if inflation is moving from 1% to 1.5%?
Naturally, different bonds will have layers with differing thickness since their defining characteristics are not the same, but in general, the layers of “risk free” rate, default risk, maturity premium, and inflation will be there.
Whenever you need to think of what factors are affecting interest rates, remember – Cake!
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