Interest Rate Components: Inflation, Liquidity, and Risk

Interest rates are the “price” that lenders charge for lending their money to borrowers. There are many interest rate components, each reflecting a form of compensation to the lender.

Defining Interest Rate Components

The interest rate components are the factors that determine the interest rate for investments.

Interest Rate Components

Real Interest Rates

One of the interest rate components is the real interest rate, which is the compensation, over and above inflation, that a lender demands to lend his money.

Since a lender is giving the use of his or her money to someone else, he or she is giving up or “forgoing” spending that money or “consuming”. Obviously, the lender would not be interested in giving the use of his money to someone else for nothing in return. This compensation is called the “real interest rate.” Economists have attributed the movement in interest rates to changes in inflation, or its expected level. However, there is now evidence that “real interest rates” change substantially and in short periods of time. This rate increases when the demand for capital and borrowing is high in an economy, and falls when it is low.

Inflation

Another of the interest rate components is inflation, which is defined as the change in the level of prices. Most of the time, people mean the “Consumer Price Index” or “CPI” when they discuss inflation within a country. This is the change in the price “shopping basket” of consumer goods for a country that the national statistics agency has sampled over time on a monthly basis. The “core CPI” is the change in prices without the food and energy components. Since food and energy prices are volatile, the “core CPI” is thought to be a more accurate measure of underlying inflation.

The main challenge in measuring inflation as the change in level of prices is establishing which prices to use for the calculation. National statistics agencies usually measure various inflation rates, the Consumer Price Index among them. Since economists, market strategists, and politicians are usually concerned with changes in consumer prices, the CPI is the most frequently used measure of price change. Across a country, however, prices vary with market conditions, availability, transportation costs and other factors.

All factors considered, the CPI in most modern industrial countries is thought to be a fairly accurate reflection of the change in the retail price level. This is important since CPI is used to index government pensions and benefits, as well as tax brackets. The CPI is also used to convert the nominal national accounting statistics, such as “Gross National Product” to a “real” or after-inflation basis. With the issuing of inflation-linked bonds, CPI has also been used to calculate the principal increase for this “real” bond.

Liquidity Risk Premium

The liquidity risk premium is a third consideration for interest rate components and can be described as the compensation that a lender receives for investing funds in something that is difficult to sell.

Let’s say you invest in a five year bond of Kamikaze Corporation at 8%. You hold it for the first two years of the term and then your spouse wants to redecorate, or go on vacation. You decide to sell this bond on the secondary market and phone your broker. The broker giggles. What? It seems that the Kamikaze Corporation, after showing initial promise, took a big dive in profitability. The best bid he can muster is $50 per $100 par value. This doesn’t necessarily mean that the bond won’t pay its interest, only that the situation is not clear. A buyer has to be lured in by a very large price discount. Normally, the liquidity risk premium is thought of in terms of yield. A good quality, but less liquid, corporate bond might have 5-10 basis points between the bid and ask yield. When markets are highly volatile, the differential even on Canada bonds can be quite wide.

Credit Risk

A final aspect of interest rate components is credit risk: the risk that the loan or bond won’t be repaid as scheduled, or at all.

National governments are thought to be the best credit risks, as they have the power of taxation and monetary authority. This means that they can levy taxes or print money to pay their debts. Provincial and municipal governments also have sources of tax revenue. The corporate sector must pay their obligations out of their cash flows, which depend on their business conditions and success. Investors assess these issuers, often using credit rating agencies that rate issuers on their capacity to repay their debts. Issuers deemed to have a low chance of default are called “investment grade.” Those with “speculative qualities” are called “less than investment grade” or “junk bonds.” The lower the quality, the higher the interest rate or yield necessary for an issuer to pay.

Overview of Interest Rate Components

All of these interest rate components are important in determining the rate for bond investments. While some are arguably more important than others, all are important aspects to consider for the potential investor.

4 years ago