Session 5 - Determinants of Interest Rates

At the end of this session you should be able to:

1. identify the primary components of interest rates: the real rate, the inflation premium and the risk premium
2. understand the economic factors which may cause these components to change

Participants in the fixed income market

In order to get a better understanding of the financial market environment, it is useful to look briefly at the market’s participants.

Fundamentally the market can be divided into two core components, namely borrowers and lenders.

The main borrowers in the market are governments, banks, other financial institutions and corporations.     The main investors in the market are banks, fund managers, insurance companies, foreign investors, managed funds, self managed superannuation funds, high net worth individuals and retail investors.

Intermediaries such as the banks, brokers and dealers play an important role in the market by putting these investors and borrowers together.

Why investors invest in fixed income

There are many reasons why an investor would invest in fixed income products. Seven reasons are listed below:

1. Capital stability – one of the key characteristics of most fixed income investments is the repayment of initial investment at maturity, or in some cases, over the life of the bond. All securities are guaranteed by their issuers, so assuming the government or the corporation which issues the bond remains solvent (does not go into liquidation), investors receive repayment at maturity.
2. Income generation - many investors want the certainty of income that interest rate products provide.
3. Diversification - stock market investment can provide strong returns but often does so with significant volatility. Many investors are looking for assets that counter volatility and provide a low degree of correlation with the share market. The fixed income asset class offers lower volatility, lower risk and provides a very important element in diversifying overall portfolio return.
4. Ability to earn better returns than bank deposits – many investors use term deposits which provide minimal risk but earn relatively low returns. Investing in lower ranked (higher risk) fixed income assets issued by the same institution can offer higher returns yet still retain exposure to the same company (assured of its credit quality and ongoing viability).
5. Defined investment horizon - investors with projects in mind need to be certain funds will be available at a specific time. They may be saving for a deposit on a house or some other future planned project. Fixed income allows investors to align their investment with their horizon date. This strategy will also provide them with a degree of capital stability that cannot be replicated in equity markets.
6. Liquidity – low risk and highly liquid fixed income investments such as government bonds can be sold at short notice providing liquidity which is a fundamental factor in building a portfolio.
7. Protection against loss in a cyclical downturn – generally a fixed income allocation in your portfolio will act to protect it during a cyclical downturn.

Why borrow?

Entities borrow because their analysis indicates that the asset they want to purchase will generate a greater return compared to the cost of borrowing associated with funding the acquisition.

Traditionally the largest borrower in the Australian bond market has been the government sector. Governments borrow to fund their expenditures. Where they run a budget deficit they will borrow funds and they may also borrow for capital works. Generally governments borrow to build long term infrastructure projects such as roads, power stations and water treatment works.

Corporations, banks and structured issuers also borrow. They use debt as opposed to equity funding for a number of reasons. The first is that debt funding may be tax effective for them. Secondly, it may be a cheaper form of funding than equity, providing some leverage on their equity returns at lower than equity cost. There are a number of different elements in a corporation’s capital structure that may lead them to actually want to borrow funds rather than raise funds through an equity issue.

Monetary Policy

The Government has outsourced the setting of monetary policy to the Reserve Bank of Australia which acts independently of the government in the implementation of monetary policy. The very short term interest rate, the cash rate, is determined by the RBA. The RBA has a number of objectives in its charter that change in importance through time, but broadly their overall objectives are to provide sustainable economic growth, full employment and price and currency stability. Currently the RBA has an underlying inflation target of 2-3%, with economic growth and inflation the two primary drivers of monetary policy. When the RBA sees that the economy is growing too strongly to be able to sustain an inflation of 2-3% they may increase interest rates in order to slow the economy. Likewise if it felt that the 2-3% target was not being threatened, interest rates could be reduced to lift economic growth.

Money market yields

Money market yields are the yields available on short term instruments – (bank bills, promissory notes and treasury notes) and are all dependent, in terms of their overall return, on the official cash rate. Cash is a very viable investment alternative to short term discounted instruments so to a large extent the rate of return offered in money markets is set by the current RBA official cash rate.
It is also influenced by expectations of future changes in the official cash rate. If expectations are that interest rates will soon rise, short term money market yields may already reflect this expectation and therefore trade at a yield much higher than the current official cash rate, as seen in Figure 5.1 below. Also the characteristics of the specific asset being examined will affect the yield. Examples include whether it has a high or low credit quality and the term of the investment.

Long term rates

Imagine you have inherited some money and are thinking of purchasing a boat. You have the option of either purchasing the boat now, enjoying it immediately, or you can defer the purchase and the enjoyment of owning the boat until a later date.

Why would you defer your spending? Consumers will consider deferring consumption if adequate reward is available. The reward required for deferring consumption is normally over and above anticipated inflation and reflects the hope that the future purchase combined with the reward will provide the consumer with greater enjoyment in the future. The reward is your price for deferring consumption. In the meantime, the other party seeks use of your cash and the price on which you agree is the real rate of interest.

You may reply that if you wait a couple of years until you buy this boat the price may increase. Investors need to be rewarded for this expected increase in price and still be able to buy the boat. This premium is compensation for inflation and this is added to the real rate of interest to get the nominal rate of interest. This is broadly the rate of interest that will be seen on government securities.

But then we also run the risk that maybe the person you invested money with won’t be there to give the money back. So you need also to be compensated for the risk that the borrower is going to default and be unable to repay your money. The amount of compensation you require for this risk is going to vary significantly with the borrower and the term of the borrowing.

A Commonwealth Government investment is significantly more creditworthy than a gold mining company or airline. While there is to some extent, always a risk of default, the risk of default on an Australian Government or state government asset is so small that it is regarded as negligible. If an investor decides to invest into a higher risk or speculative type investment they should consider the level of reward necessary to compensate them for the risk that they may not get any or all of their money back.

The real yield plus the inflation premium gives a nominal yield or a nominal interest rate. By adding a risk premium for a particular security we end up with the security yield.

What causes real yields to change?

What might cause the real yield to change? Whether you want to buy a boat now or later is going to determine how much compensation you are going to get for deferring your consumption. If you are really keen to buy the boat now, you are going to have to be well rewarded to compensate for deferring the purchase of the boat. Similarly, if you are not in a hurry to make the purchase and happier to wait, then that is going to affect the price you are prepared to pay.

In a broader economic environment how much money you put into the ‘savings system’ is going to depend on your individual preferences. For the economy as a whole, it is the sum of all these ‘consumer preferences’ that will determine the amount of savings put into the system. Thus saving patterns and saving rates are going to affect how much money is supplied into the system. The risk appetite of investors is also going to affect real rates. The more conservative investors are, the more likely they are to put money into interest rate products. The more they are willing to take on risk, the more likely they are going to invest in higher risk securities such as shares.

Looking now at the demand for this capital, we must remember it is the interaction of supply and demand that gives us real yield. The demand for money is a function of the demand by entities that want to borrow money. They are going to consider growth projections, investment expectations and government policies. All these factors are going to influence business investment in plant, equipment, machinery and other productive capacity.

Any factor that might increase future growth, investment expectations or government policies can cause real yields to rise. Likewise anything that is going to improve saving patterns will bring rates down.

What causes inflation premiums to change?

An investor who wants to be rewarded for inflation has to make a forecast of what inflation is going to be over the investment’s time horizon. So the investor would have to have some idea of the growth expectations for the economy.

Generally the faster the economy is growing the more likely inflation is to increase. Investors may also look at wages growth and currency effects to estimate future inflation. It is known that if the Australian dollar is falling the cost of imported goods is going to rise so that is going to affect the inflation expectation. The effect of monetary policy, whether the Government is being pre-emptive or reactive in their monetary policy, may affect the longer term inflation expectation. Global commodity prices will clearly cause inflation premiums to change; for example rising oil prices will exert upward pressure on inflation.

The impact of these economic variables is to alter inflation expectations which will, in turn, affect the yields we see in money markets and other securities.

What causes risk premiums to change?

There are also a large number of factors that could affect the actual risk premium an investor is prepared to accept or that they are expecting to demand from the borrower. Clearly the industry that the borrower (issuer) is in is going to affect their long term viability and the volatility of that industry will affect their ability to pay an investor back over the term of the borrowing. The structural features of the individual bond are also going to affect the risk premium demanded. The longer the term of the bond the higher the premium an investor is going to demand to offset the risk that something could go wrong over a longer term.

Clearly the financial stability and gearing of the actual company issuing the security will affect what sort of risk premium the investor is prepared to accept. It was pointed out earlier that companies borrow rather than raise share funds because it is a cheaper form of capital and this is true up to a point. When borrowings in a company become so great that investors start to require too high a risk premium, it becomes uneconomical for the firm to expand its borrowing further.

The liquidity of the instruments will also impact the risk premium. Anything that may improve or hamper the liquidity of the instrument going forward can cause the risk premium to change.

Conclusion

You should now be able to identify the primary components of interest rates: the real rate, the inflation premium and the risk premium. You should have an understanding of the economic factors that may cause each of these components to change and the direction in which they will move.

Review questions

1. In Australia, which institution is in charge of setting monetary policy?

1. The Australian federal Government
2. RBA
3. AOFM
4. ASIC

2. Money Market Yields are a function of:

1. Current cash rate
2. Expected change in interest rates
3. US domestic interest rates
4. The nature of the specific security
5. Term to maturity

Possible answers

1. a, c & d
2. a, b & e
3. a, b & d
4. All of the above

3. Which of the following best describes a nominal interest rate?

1. The interest, coupon or discount rate
2. The real return investors would expect to receive once inflation is deducted from the coupon rate
3. BBSW
4. The real yield plus an inflation premium