For many people, interest rates are a Churchillian riddle, wrapped in a mystery, inside an enigma.
Attempts to untie this economic knot lead inevitably to bonds. Yield curves. Yield spreads. Inflation. Duration. Accretion. Convexity. Hedging. Dot plots.
The stuff migraines are made of.
To avoid reaching for the Excedrin, we’re going to work through a mock dialogue between me and my imaginary client, Joe Bob. I’ve never tried writing a screenplay, but here goes nothing…
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INT. OFFICE – DAY
Brett is fully caffeinated. The office TV features Fox Business with Varney talking to David Bahnsen. Joe Bob calls Brett at his desk…
JOE BOB
Good morning, Brett! I’m calling because I feel lost whenever I hear news about bond yields. I know rates have gone up and that they impact the economy and markets, but I find them so confusing. What should I be taking away from all of this?
BRETT
Joe, there’s no shame in being confused. Repeat after me, “Interest rates reflect the price of money.”
JOE BOB
Ok – “Interest rates reflect the price of money.”
I kind of get it, but how is this supposed to help me?
BRETT
Bear with me a bit. Let me ask you a question. Have you ever loaned money to anyone?
JOE BOB
Yes, a few times. Why?
BRETT
If you loaned money for one month versus five years, would that change what you want as an interest payment?
JOE BOB
Absolutely. If I loaned money to William for one month, I would not charge as much as I would charge for five years to Vinny. I would definitely charge more for a longer period of time to Vinny because it feels riskier, and inflation might take some of the purchasing power away over five years. I could also put my money somewhere else and get a higher rate of return.
BRETT
Perfect. So, you intuitively understand that the risk and time of repayment would require a higher price for the money. We’re making good progress. By the way – don’t lend money to Vinny.
JOE BOB
Trust me, I won’t. How is this supposed to help me understand interest rates that I hear about on the news?
BRETT
This may seem counterintuitive because we don’t normally conceive of money having a price. We think of prices when we think of gas or groceries. We understand that gas prices go up when a war in the Middle East constrains the supply of oil. We intuit why eggs get expensive when an avian virus is killing thousands of chickens.
But we seem to have a mental disconnect when it comes to money. We forget that money – just like gas or eggs – is subject to supply and demand dynamics within different contexts. When money is borrowed (demand) with a promise to pay later (risk), the lender (supply) puts a price on that borrowed money.
JOE BOB
But if this is about borrowing money, why don’t we just use the word, “loan?” Why bother with all this bond jargon? You guys and your fancy-finance talk!
BRETT
I’m doing my best here, Joe. To keep it simple, loans generally involve one lender, like a bank. Bonds are designed to be spread among many lenders. And these lenders are usually investors using their own capital. When Google borrows billions of dollars to invest in AI, they don’t get a loan from Bank of America. Instead, they issue bonds that can be sold to many different investors who expect their money back plus interest over some period of time.
JOE BOB
Ok, that makes sense. It seems like there are a lot of kinds of bonds and I find that confusing.
BRETT
For sure. One way to think about it is that bonds are normally used by governments (like the United States), municipalities (states and cities), and major corporations (like Google). National and local governments use bonds as a way to raise money without raising taxes, and corporations use bonds instead of issuing stock or taking bank loans.
JOE BOB
Why would investors buy bonds instead of stocks? Bonds seem so boring.
BRETT
They can be boring – it’s true. Investors buy bonds for lots of reasons, but the major one is that stocks make no promise of repayment of capital plus interest. When you buy a bond, there is an underlying promise to return capital plus interest. And when you buy a U.S. government bond, the principal and interest are backed by the federal government. The perception of lower risk, capital preservation, and fixed interest income is very attractive to bond investors.
JOE BOB
So, when I hear your bud, Varney, talking about interest rates on the Fox Business channel, what is he talking about?
BRETT
You’ve got to love that Varney accent. Look, it certainly depends on the context, but usually they are talking about U.S. government backed securities that are broadly referred to as “treasuries.” The U.S. government borrows massive amounts of money to pay for its budget deficits and issues many types of bonds to cover its needs.
JOE BOB
I hear people talk about short-term treasuries, long-term bonds, and the “ten year.” What is all of this about?
BRETT
Basically, the government issues bonds with different time horizons – or what we call maturities. Treasuries with time horizons less than a year are called “T-bills,” one to ten years are called “notes,” and twenty or thirty years are called “bonds” or “long bonds.”
Generally speaking, interest rates are lower for shorter maturities and higher for longer maturities because investors require more money for longer periods. This is where the phrase, “yield curve,” comes from. If you plot rates from the short maturities to the long maturities, you see a curve that usually goes up because lenders want more interest for more time.
JOE BOB
So, is this why they talk about the “short-end” and the “long-end?”
BRETT
Exactly right. When someone is talking about the short-end, they are talking about brief time frames and when they talk about the long-end, they’re typically talking about time frames that are decades out.
You probably hear the term, “yield spread,” as well. It refers to the difference in yields between the short-and-long ends – usually between the 2 yr and the 10 yr treasuries.
JOE BOB
Huh. Interesting. I feel like I hear a lot about the “ten year.” Why is that?
BRETT
The 10-yr note is considered a benchmark rate because of the way most loans are structured. Think about a 30-yr mortgage. Do you normally keep that for thirty years? Not at all. In fact, most people refinance or sell their home in less than ten years. So, the 10-yr is kind of a bellwether for how people understand the risk-free price of money over the intermediate term.
JOE BOB
Wait – so the federal government sets mortgage rates?
BRETT
No, not at all. In fact, mortgage rates are derived from mortgage bonds sold by entities like Fannie Mae and Freddie Mac. Investors buying those mortgage bonds keep their eye on what the 10-yr note is doing to understand what kind of rate they should be getting above and beyond the risk-free government rate.
JOE BOB
So, the federal government sets the 10-yr note rate?
BRETT
No. This is where it gets very interesting. When the government sells 10-yr notes, it announces the amount available and the maturity date. And then it holds an auction! The bond buyers say they would be willing to buy $500 million at a yield no lower than 4.25%. Then the Treasury takes this auction data and sets the interest rate / coupon accordingly! So, the government does NOT set the rates. The market participants set the rates based on their required return!
JOE BOB
But wait. I feel like we hear about the Federal Reserve meeting to set rates up or down all the time! I thought they did set interest rates?!
BRETT
The one rate they DO target is the federal funds rate, the overnight rate banks charge each other. It’s a signal about whether they want money cheaper or more expensive. But it only anchors the very short end. The market prices everything else.
JOE BOB
Then how do market participants know what rates to bid at during auction? Who sets interest rates?
BRETT
Now we’re back to the beginning. Interest rates reflect the price of money. And the price of money depends on what people think about the future. If they expect higher inflation, they will want a higher interest rate. If they think stocks are going to go up as the economy expands, then they will also want a higher interest rate. And vice versa!
JOE BOB
I’m starting to get it, but what does this mean to me as an investor?
BRETT
Think about which side of the transaction you’re on. When you borrow money, interest is a cost. When you lend money, interest is income, unless you lend it to Vinny and he defaults. And most investors live on both sides.
Higher rates can make financing a home or expanding a business more expensive. But they can also offer better income opportunities for someone buying bonds. There is a complication, though: bonds you already own may fall in market value because buyers can get more attractive interest payments elsewhere.
JOE BOB
So higher interest rates can be good news or bad news depending on where I’m sitting?
BRETT
Exactly. And the same applies to the companies you own. A business that needs to borrow heavily faces a different situation from one that can fund its growth from the cash it generates. That’s one reason we favor companies that pay for their growth, and their growing dividends, with their own cash rather than borrowed money. When the price of money goes up, they’re far less exposed to it.
Ultimately, we pay attention to the price of money because it affects decisions throughout the economy—from buying a house to building a factory to investing for retirement. Understanding it helps us ask better questions about what we own and why we own it.
JOE BOB
This has been helpful. I think I can listen to the financial news now without immediately reaching for the Excedrin.
BRETT
Keep it handy. We haven’t talked about convexity yet.
FADE OUT.
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What do you think, folks? Did I miss my true calling for writing screenplays?
As you can imagine, there is much more to talk about when it comes to interest rates, bonds, bond markets, etc. However, I think if you can hold onto the idea that “the price of money” is what is at stake, it will start to form a better intuitive sense of how to make sense of economic news and financial commentary.
Brett Bonecutter
Private Wealth Advisor
