Topic 4 - Behaviour of interest rates

• Wealth


  The total resources owned by the individual, including all assets
• Expected Return


  The return expected over the next period on one asset relative to alternative assets
• Risk


  The degree of uncertainty associated with the return on one asset relative to alternative assets
• Liquidity


  The ease and speed with which an asset can be turned into cash relative to alternative assets
• Supply and demand determine bond prices (and bond yields)

  
• Bond supply curve

  The relationship between the price and the quantity of bonds people are willing to sell, all else equal

  
• Bond demand curve

  The relationship between the price and the quantity of bonds that investors demand, all else equal

  
• The bond supply curve slopes upward

  
• The bond demand curve slopes downward

  
• Factors that shift bond supply

  • Changes in government borrowing
  • Change in general business conditions
  • Changes in expected inflation
• Any increase in the government's borrowing needs

  Increases the quantity of bonds outstanding, shifting the bond supply curve to the right
• As business conditions improve

  The bond supply curve shifts to the right

  
• When expected inflation rises

  The cost of borrowing falls, shifting the bond supply curve to the right
• Factors that shift bond demand

  • Wealth
  • Expected inflation
  • Expected returns and expected interest rates
  • Risk relative to alternatives
  • Liquidity relative to alternatives

  
• Increases in wealth

  Shift the demand for bonds to the right
• Declining inflation

  Means promised payments have higher value - bond demand shifts right
• If the return on bonds rises relative to the return on alternative investments


  Bond demand shifts right
• When interest rates are expected to fall


  Prices are expected to rise shifting bond demand to the right
• If bonds become less risky relative to alternative investments


  Demand for bonds shifts right
• The more liquid the bond

  The higher the demand
• If bonds become more liquid relative to alternative investments


  Demand for bonds shifts right

  
• Increase in expected inflation


  Reduces the real cost of borrowing shifting bond supply to the right, but lowers real return on lending, shifting bond demand to the left
• Business-cycle downturn

  Shifts bond supply to the left and bond demand to the left
• Default risk


  The chance that the bond's issuer may fail to make the promised payment
• Inflation risk


  Investors cannot be sure of what the real value of payments will be
• Interest-rate risk


  Arises from a bond-holder's investment horizon, which may be shorter than the maturity date of the bond
• Risk Premium

  The spread between the interest rates on bonds with default risk and the interest rates on (same maturity) Treasury bonds
• Base interest rate

  The minimum interest rate or base interest rate that investors will demand for investing in a non-Treasury security. It also refereed to as the benchmark interest rate
• UK Treasury bonds have usually been considered default-free bonds
• When corporations or governments fail to meet their payments, the price of their bonds decreases
• Bondholders care about the real interest rate, not just the nominal interest rate
• Components of the interest rate

  • The real interest rate
  • Expected inflation
  • Compensation for inflation risk
• The longer the term of the bond, the larger the price change for a given change in the interest rate
• Factors that cause different interest rates on bonds with the same maturity

  • Default risk
  • Liquidity
  • Tax considerations
• Default is one of the most important risks a bondholder faces
• Bond rating services


  Moody's, Standard&Poor's, Fitch

  
• Investment-grade bonds

  Bonds with a very low risk of default, reserved for most government issuers and corporations that are among the most financially sound
• Speculative grade bonds

  Bonds issued by companies and countries that may have difficulty meeting their bond payments but are not at risk of immediate default
• Highly speculative bonds

  Debts that are in serious risk of default
• Bonds with grades below investment grade are often referred to as junk bonds or high-yield bonds