Interest Rates & Yield Curves
Interest rates are among the most important factors affecting securities prices. Investment advisers must understand how rates work, how they're set, and what the yield curve reveals about economic expectations.
What Are Interest Rates?
An interest rate is the cost of borrowing money, expressed as a percentage of the principal. It's also the return earned by lenders for providing funds.
Key Interest Rates
| Rate | What It Is | Set By | Current Typical Level |
|---|---|---|---|
| Federal Funds Rate | Rate banks charge each other overnight | Federal Reserve (target) | 4-5% range (2025) |
| Prime Rate | Rate banks charge their best customers | Banks (typically fed funds + 3%) | ~8% |
| Discount Rate | Rate Fed charges banks for direct loans | Federal Reserve | Above fed funds |
| SOFR | Secured Overnight Financing Rate (replaced LIBOR) | Market-determined | Tracks fed funds closely |
| Treasury Rates | Yields on U.S. government securities | Market forces | Varies by maturity |
The Federal Funds Rate
The federal funds rate is the benchmark for short-term rates in the economy:
- Fed sets a target range (e.g., 5.25%-5.50%)
- Prime rate typically = Fed funds + 3%
- Other consumer rates adjust accordingly
- Eventually affects mortgages, auto loans, credit cards, business loans
Interest Rates and Bond Prices: The Inverse Relationship
This is one of the most important relationships in finance—and a favorite topic on securities exams:
Bond prices and interest rates move in opposite directions.
Why the Inverse Relationship?
| When Rates Rise | When Rates Fall |
|---|---|
| New bonds issued with higher coupons | New bonds issued with lower coupons |
| Existing bonds (lower coupons) less attractive | Existing bonds (higher coupons) more attractive |
| Existing bond prices fall | Existing bond prices rise |
Example
You own a bond paying 4% interest. Market rates rise to 5%:
- Who would pay full price for your 4% bond when they can buy a new 5% bond?
- Your bond's price must fall until its yield matches current market rates
Conversely, if rates fall to 3%:
- Your 4% bond is now more attractive than new bonds
- Your bond's price rises
Duration: Measuring Interest Rate Sensitivity
Duration measures how sensitive a bond's price is to changes in interest rates:
| Duration | Rate Sensitivity | Example |
|---|---|---|
| Short (1-3 years) | Less sensitive | Money market funds, short-term bonds |
| Intermediate (4-7 years) | Moderate | Medium-term bond funds |
| Long (10+ years) | Most sensitive | Long-term Treasury bonds |
Rule of Thumb
For every 1% change in interest rates, a bond's price changes approximately equal to its duration:
| Bond Duration | 1% Rate Increase | 1% Rate Decrease |
|---|---|---|
| 3-year | ~3% price decline | ~3% price increase |
| 10-year | ~10% price decline | ~10% price increase |
| 20-year | ~20% price decline | ~20% price increase |
Investment Implication: When expecting rates to rise, shorten duration. When expecting rates to fall, extend duration to capture price appreciation.
The Yield Curve
The yield curve plots interest rates of bonds (typically Treasury securities) across different maturities. It provides crucial insights into economic expectations.
Types of Yield Curves
| Shape | Description | What It Signals |
|---|---|---|
| Normal (Upward-Sloping) | Long-term rates > short-term rates | Economic expansion expected; investors demand premium for longer commitments |
| Flat | Rates similar across maturities | Uncertainty or transition; economy may be changing direction |
| Inverted (Downward-Sloping) | Short-term rates > long-term rates | Potential recession ahead; historically reliable predictor |
| Humped | Intermediate rates highest | Mixed signals; less common |
Why the Yield Curve Predicts Recessions
An inverted yield curve has preceded every U.S. recession since 1970:
- Investors expect the Fed to cut rates in the future due to economic weakness
- They lock in current long-term rates before they fall
- This demand for long-term bonds pushes long-term rates down
- Short-term rates remain high due to current Fed policy
- Result: short-term rates exceed long-term rates (inversion)
The Federal Reserve Bank of New York uses the yield curve slope to calculate recession probability.
Credit Spreads
Credit spread = Yield on corporate bond − Yield on Treasury bond of same maturity
| Spread Behavior | What It Signals |
|---|---|
| Widening spreads | Growing credit concerns; investors demanding more compensation for risk |
| Narrowing spreads | Improving confidence; risk appetite increasing |
| High-yield (junk) bonds | Widest spreads; most sensitive to economic conditions |
Economic Signal: Widening credit spreads often precede or accompany recessions as investors become more risk-averse.
Impact on Different Investments
Bonds
| Rate Change | Bond Price Effect | Duration Effect |
|---|---|---|
| Rates rise 1% | Prices fall | Longer duration = larger decline |
| Rates fall 1% | Prices rise | Longer duration = larger gain |
Stocks
Higher interest rates typically hurt stocks through multiple channels:
| Channel | Effect |
|---|---|
| Borrowing costs | Higher costs for companies → lower profits |
| Consumer spending | Higher mortgage/loan payments → less spending |
| Valuations | Future earnings worth less (higher discount rate) |
| Competition | Bonds become more attractive vs. stocks |
Sector Sensitivity
| Sector | Rate Sensitivity | Explanation |
|---|---|---|
| Utilities | High (negative) | High debt levels; dividend stocks compete with bonds |
| Real Estate/REITs | High (negative) | Higher financing costs; compete with bonds for yield |
| Financials | Complex | May benefit from wider lending margins, but loan losses may rise |
| Technology | High (negative) | Future earnings heavily discounted at higher rates |
| Consumer Staples | Low | Defensive; less affected by rate changes |
In Practice: How Investment Advisers Apply This
When rates are rising:
- Review client bond portfolios for excessive duration
- Consider shorter-duration bonds or floating-rate securities
- Evaluate rate-sensitive equity sectors for potential underweights
- Discuss with clients that "safety" of long-term bonds includes interest rate risk
When rates are falling:
- Consider extending duration to capture price appreciation
- Look for opportunities in rate-sensitive sectors
- Recognize that rate cuts often signal economic concerns
- Consider refinancing recommendations for client debt
Yield curve monitoring:
- Watch for yield curve inversion as recession warning
- Steepening curve (long rates rising faster) may signal inflation concerns
- Flattening curve may signal slowing growth expectations
On the Exam
The Series 65 exam frequently tests:
- Inverse relationship between interest rates and bond prices
- Duration as a measure of interest rate sensitivity
- Yield curve shapes and their economic implications
- Inverted yield curve as recession predictor
- Credit spreads and what they indicate
Expect 2-3 questions on interest rates. A common question format is: "When interest rates rise, bond prices..."
Key Takeaways
- Bond prices move inversely to interest rates—this is fundamental
- Duration measures interest rate sensitivity; longer duration = greater sensitivity
- Normal yield curve: long-term rates > short-term rates (expansion expected)
- Inverted yield curve: short-term rates > long-term rates (recession warning)
- Inverted yield curves have predicted every recession since 1970
- Credit spreads widen during economic stress
- Rising rates generally hurt both bonds (directly) and stocks (through valuation and cost effects)
- Investment advisers should monitor the yield curve as an economic indicator
When interest rates rise, what typically happens to existing bond prices?
An inverted yield curve, where short-term rates exceed long-term rates, is considered a signal of:
Which bond would experience the LARGEST price decline if interest rates rose by 1%?
1.6 Global Economic Factors
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