On Different Rates 20180831
(This article is mostly copy and pasted, just to serve as a reference piece for definitions of different types of interest rates.)
“I feel that interest rate is a hot topic now, but sometimes couldn’t keep up with all sorts of different rates. Can you write a piece about all these rates?” Bobo asked me.
Well, there are indeed a lot of different rates in the credit market, but most of them are connected in some way. Here are a few major ones:
Federal-funds rate:
The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight. When a depository institution has surplus balances in its reserve account, it lends to other banks in need of larger balances. In simpler terms, a bank with excess cash, which is often referred to as liquidity, will lend to another bank that needs to quickly raise liquidity.
(1) The rate that the borrowing institution pays to the lending institution is determined between the two banks; the weighted average rate for all of these types of negotiations is called the effective federal funds rate.
(2) The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target.
The Federal Open Market Committee (FOMC) meets eight times a year to determine the federal funds target rate. As previously stated, this rate influences the effective federal funds rate through open market operations or by buying and selling of government bonds (government debt). More specifically, the Federal Reserve decreases liquidity by selling government bonds, thereby raising the federal funds rate because banks have less liquidity to trade with other banks. Similarly, the Federal Reserve can increase liquidity by buying government bonds, decreasing the federal funds rate because banks have excess liquidity for trade. Whether the Federal Reserve wants to buy or sell bonds depends on the state of the economy. If the FOMC believes the economy is growing too fast and inflation pressures are inconsistent with the dual mandate of the Federal Reserve, the Committee may set a higher federal funds rate target to temper economic activity. In the opposing scenario, the FOMC may set a lower federal funds rate target to spur greater economic activity. Therefore, the FOMC must observe the current state of the economy to determine the best course of monetary policy that will maximize economic growth while adhering to the dual mandate set forth by Congress. In making its monetary policy decisions, the FOMC considers a wealth of economic data, such as: trends in prices and wages, employment, consumer spending and income, business investments, and foreign exchange markets.
The federal funds rate is the central interest rate in the U.S. financial market. It influences other interest rates such as the prime rate, which is the rate banks charge their customers with higher credit ratings. Additionally, the federal funds rate indirectly influences longer- term interest rates such as mortgages, loans, and savings, all of which are very important to consumer wealth and confidence.
Prime rate:
The U.S. Prime Rate is a commonly used, short-term interest rate in the banking system of the United States. All types of American lending institutions (traditional banks, credit unions, thrifts, etc.) use the U.S. Prime Rate as an index or foundation rate for pricing various short- and medium-term loan products. The Prime Rate is consistent because banks want to offer businesses and consumers loan products that are both profitable and competitive. A consistent U.S. Prime Rate also makes it easier and more efficient for individuals and businesses to compare similar loan products offered by competing banks.
Each U.S. state does not have its own individual Prime Rate, so the “New York Prime Rate” or the “California Prime Rate” are in fact the same as the United States Prime Rate.
Providers of consumer and commercial loan products often use the U.S. Prime Interest Rate as their base lending rate, then add a margin (profit) based primarily on the amount of risk associated with a loan. Moreover, some financial institutions use Prime as an index for pricing certain time-deposit products like variable-rate Certificates of Deposit.
It’s important to note that the Prime Rate is an index, not a law. Consumers and business owners can sometimes find a loan or credit card with an interest rate that is below the current Prime Lending Rate. Lenders will sometimes offer below-Prime-Rate loans to highly qualified customers as a way of generating business. Furthermore, below-Prime-Rate loans are relatively common when the loan product in question is secured, as is the case with mortgages, home equity loans, home equity lines of credit and car loans.
Every U.S. bank sets its own Prime Rate. However, the Prime Rate is invariably tied to America’s cardinal, benchmark interest rate: the Federal Funds Target Rate(or Fed Funds Target Rate [FFTR].) The FFTR is set by a committee within the Federal Reserve system called The Federal Open Market Committee (FOMC). The FOMC usually meets every six weeks, and it is at these meetings that the FOMC votes on whether or not to make changes to the FFTR. When the FFTR changes, the United States (Fed) Prime Rate will also change. If the FOMC votes to make no changes to the FFTR, then the U.S. Prime Rate will also remain unchanged.
Since the second quarter of 1994, a rule of thumb for the U.S. Prime Rate has been:
U.S. Prime Rate = (The Fed Funds Target Rate + 3)
The FOMC’s primary objectives are to keep inflation under control and maintain steady economic growth with maximum sustainable employment within the United States.
The U.S. Prime Interest Rate is used by many banks to set rates on many consumer loan products, such as student loans, home equity lines of credit, car loans and credit cards. If you read or hear about a change to the U.S. Prime Rate, then any loan product that is tied to the Prime Rate will also change, like variable-rate credit cards or certain adjustable-rate mortgages.
LIBOR:
LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It stands for Intercontinental Exchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world. LIBOR is administered by the ICE Benchmark Administration (IBA) and is based on five currencies: the U.S. dollar (USD), euro (EUR), pound sterling (GBP), Japanese yen (JPY), and Swiss franc (CHF). The LIBOR serves seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. There are a total of 35 different LIBOR rates each business day. The most commonly quoted rate is the three-month U.S. dollar rate (usually referred to as the “current LIBOR rate”).
LIBOR or ICE LIBOR’s primary function is to serve as the benchmark reference rate for debt instruments, including government and corporate bonds, mortgages, student loans, credit cards; as well as derivatives, such as currency and interest swaps, among many other financial products.
For example, take a Swiss franc-denominated Floating-Rate Note (or floater) that pays coupons based on LIBOR plus a margin of 35 basis points (0.35%) annually. In this case, the LIBOR rate used is the one-year LIBOR plus a 35 basis point spread. Every year, the coupon rate is reset in order to match the current Swiss franc one-year LIBOR, plus the predetermined spread.
If, for instance, the one-year LIBOR is 4% at the beginning of the year, the bond will pay 4.35% of its par value at the end of the year. The spread usually increases or decreases depending on the credit worthiness of the institution issuing debt.
Another prominent trait of LIBOR or ICE LIBOR is that it helps to evaluate the current state of the world’s banking system, as well as to set expectations for future central bank interest rates.
Money Market Yield:
The money market yield is the interest rate earned by investing in securities with high liquidity and maturities of less than one year such as negotiable certificates of deposit, U.S. Treasury bills and municipal notes. Money market yield is calculated by taking the holding period yield and multiplying it by a 360-day bank year divided by days to maturity. It can also be calculated using bank discount yield. The money market yield is also known as the CD-equivalent yield or bond equivalent yield.
The money market is the part of the broader financial markets that deals with highly liquid and short term financial securities. The market links borrowers and lenders who are looking to transact in short-term instruments overnight or for some days, weeks, or months, but always less than a year. Active participants in this market include banks, money market funds, brokers, and dealers. Examples of money market securities include Certificates of Deposit (CD), Treasury bills (T-bills), commercial paper, municipal notes, short-term asset-backed securities, Eurodollar deposits, and repurchase agreements.
Money market investors receive compensation for lending funds to entities that need to fulfill their short-term debt obligations. This compensation is typically in the form of variable interest rates determined by the current interest rate in the economy. Since money market securities are considered to have low default risk, the money market yield will be lower than the yield on stocks and bonds but higher than the interest rates on standard savings accounts.
Treasury Yield:
Treasury yield is the return on investment, expressed as a percentage, on the U.S. government’s debt obligations. Looked at another way, the Treasury yield is the interest rate that the U.S. government pays to borrow money for different lengths of time.
Treasury yields don’t just influence how much the government pays to borrow and how much investors earn by investing in this debt, they also influence the interest rates that individuals and businesses pay to borrow money to buy real estate, vehicles, and equipment. Treasury yields also tell us how investors feel about the economy. The higher the yields on 10-, 20- and 30-year Treasuries, the better the economic outlook.
When the US government needs to raise capital to source projects, such as building new infrastructure, it issues debt instruments through the US Treasury. The types of debt instruments that the government issues include Treasury bills (T-bills), Treasury notes (T-notes), and Treasury bonds (T-bonds), which come in different maturities up to 30 years. The T-bills are short-term bonds that mature within a year, the T-notes have maturity dates of 10 years or less, and the T-bonds are long-term bonds that offer maturities of 20 and 30 years.
Treasuries are considered to be a low-risk investment because they are backed by the full faith and credit of the U.S. government. Investors that purchase these Treasuries loan the government money. The government, in turn, makes interest payments to these bondholders as compensation for the loan provided. The interest payment, known as coupons, represents the cost of borrowing to the government. The rate of return or yield required by investors for loaning their money to the government is determined by supply and demand.
Treasuries are issued with a face value and a fixed interest rate, and are sold at the initial auction or in the secondary market to the highest bidder. When there is a lot of demand for the securities, the price is bid up past its face value and trades at a premium. This lowers the yield that the investor will get since the government only repays the face value on the maturity date. For example, an investor that purchases a bond for $10,090 will be repaid only the face value of $10,000 when it matures. When the Treasury yield falls, lending rates for consumers and businesses also fall.
If the demand for treasuries is low, the Treasury yield increases to compensate for the lower demand. When demand is low, investors are only willing to pay an amount below par value. This increases the yield for the investor since he can purchase the bond at a discount, and be repaid the full face value on the maturity date. When Treasury yield increases, interest rates in the economy also increase since the government must pay higher interest rates to attract more buyers in future auctions.
Treasury yields can go up if the Federal Reserve increases its target for the federal funds rate (in other words, if it tightens monetary policy), or even if investors merely expect the fed funds rate to go up.
Each of the Treasury securities has a different yield. Under normal circumstances, longer-term Treasury securities have a higher yield than shorter-term Treasury securities. Since the maturities on T-bills are very short, they typically offer the lowest yield compared to the T-notes and T-bonds. As of November 29, 2017, the Treasury yield on a 3-month T-bill is 1.28%; 10-year note is 2.39%; and 30-year bond is 2.82%. The U.S. Treasury publishes the yields for all of these securities daily on its website.
DJ Corporate:
The Dow Jones Equal Weight U.S. Issued Corporate Bond Index is designed to track the total returns of 96 large and liquid investment-grade bonds issued by companies in the U.S. corporate bond market. It is an equal-weighted index comprised of 96 bonds from three different industries: Industrial (48 Bonds), Financial (36 Bonds) and Utility (12 Bonds). An issuer may have up to four bonds in the index, but no more than one in each maturity cell.
EMBI Global:
The J.P. Morgan Emerging Market Bond Index Global is designed to help individual and institutional investors benchmark bond performance in emerging markets around the world, with each index covering different types of emerging market economies.