1.5 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

Federal Funds Rate: Rate banks charge each other overnight. Set by: Federal Reserve (target). Current Typical Level: 4-5% range (2025)

Prime Rate: Rate banks charge their best customers. Set by: Banks (typically fed funds + 3%). Current Typical Level: approx. 8%

Discount Rate: Rate Fed charges banks for direct loans. Set by: Federal Reserve. Current Typical Level: Above fed funds

SOFR: Secured Overnight Financing Rate (replaced LIBOR). Set by: Market-determined. Current Typical Level: Tracks fed funds closely

Treasury Rates: Yields on U.S. government securities. Set by: Market forces. Current Typical Level: Varies by maturity

The Federal Funds Rate

The federal funds rate is the benchmark for short-term rates in the economy:

1. Fed sets a target range (e.g., 5.25%-5.50%)

2. Prime rate typically = Fed funds + 3%

3. Other consumer rates adjust accordingly

4. 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: New bonds issued with higher coupons; Existing bonds (lower coupons) less attractive; Existing bond prices fall

When Rates Fall: New bonds issued with lower coupons; Existing bonds (higher coupons) more attractive; 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:

Short (1-3 years): Less sensitive. Example: Money market funds, short-term bonds

Intermediate (4-7 years): Moderate. Example: Medium-term bond funds

Long (10+ years): Most sensitive. Example: Long-term Treasury bonds

Rule of Thumb

For every 1% change in interest rates, a bond's price changes approximately equal to its duration:

3-year duration: 1% Rate Increase approx. 3% price decline; 1% Rate Decrease approx. 3% price increase

10-year duration: 1% Rate Increase approx. 10% price decline; 1% Rate Decrease approx. 10% price increase

20-year duration: 1% Rate Increase approx. 20% price decline; 1% Rate Decrease approx. 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

Normal (Upward-Sloping): Long-term rates greater than short-term rates. What It Signals: Economic expansion expected; investors demand premium for longer commitments

Flat: Rates similar across maturities. What It Signals: Uncertainty or transition; economy may be changing direction

Inverted (Downward-Sloping): Short-term rates greater than long-term rates. What It Signals: Potential recession ahead; historically reliable predictor

Humped: Intermediate rates highest. What It Signals: Mixed signals; less common

Why the Yield Curve Predicts Recessions

An inverted yield curve has preceded every U.S. recession since 1970:

1. Investors expect the Fed to cut rates in the future due to economic weakness

2. They lock in current long-term rates before they fall

3. This demand for long-term bonds pushes long-term rates down

4. Short-term rates remain high due to current Fed policy

5. 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 minus Yield on Treasury bond of same maturity

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

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:

Borrowing costs: Higher costs for companies lead to lower profits

Consumer spending: Higher mortgage/loan payments lead to less spending

Valuations: Future earnings worth less (higher discount rate)

Competition: Bonds become more attractive vs. stocks

Sector Sensitivity

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:

1. Inverse relationship between interest rates and bond prices

2. Duration as a measure of interest rate sensitivity

3. Yield curve shapes and their economic implications

4. Inverted yield curve as recession predictor

5. Credit spreads and what they indicate

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 greater than short-term rates (expansion expected)

- Inverted yield curve: short-term rates greater than 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