Chart of Interest Rates Automobile

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					Points of Interest is one of a series
of essays adapted from articles in
On Reserve, a newsletter for economic
educators published by the Federal
Reserve Bank of Chicago. The original
article was written by Keith Feiler
and revised by Tim Schilling.

For additional copies of this essay —
or for information about other Federal
Reserve publications on money and
banking, the financial system, the
economy, consumer credit, and
other related topics — contact:

Public Information Center
Federal Reserve Bank of Chicago
P.O. Box 834
Chicago, IL 60690-0834
Tel. (312) 322-5111
 Interest rates can significantly influence people’s
 behavior. When rates decline, homeowners rush to buy

 new homes and refinance old mortgages; automobile

 buyers scramble to buy new cars; the stock market soars,

 and people tend to feel more optimistic about the future.

    But even though individuals respond to changes in

 rates, they may not fully understand what interest rates

 represent, or how different rates relate to each other.

 Why, for example, do interest rates increase or decrease?

 And in a period of changing rates, why are certain rates

 higher, while others are lower?

% =                                                  ?
                     To answer these questions, we must separate movements in the general
                level of interest rates from differences in individual rates. As we can see in
                the chart below, rates rose steadily from 1979 to 1981 and generally fell after
                that, with a few upward turns to break the downward trend. Because interest
                rates tend to move together, we can characterize certain periods as times of
                high or low interest rates. For example, in 1981 the general level of interest
                rates was higher than the general level in 1993.
                     As we also can see in the chart, however, individual rates tend to differ,
                even though they are moving in the same general direction. Thus a 30-year
                Treasury bond may have a higher rate than a 3-month certificate of deposit.
                Similarly, a mortgage loan may have a lower rate than an automobile loan.
                     These similarities and differences are not determined by luck, coincidence,
                a world conspiracy of money barons, or even the Federal Reserve. Rather,
                they are determined by strong, impersonal economic forces in the market-
                place, which reflect the personal choices of millions of individual borrowers
                and lenders.
                     This publication is intended to help you better understand interest
                rates and how they are influenced by these economic forces. The first section,
                Levels of Interest, examines the forces that determine the general level of
                rates. This section discusses basic factors of supply and demand for funds
                and the function of banks and other similar institutions in meeting the
                needs of savers and borrowers. It also examines other factors such as fiscal
                policy and the actions of the Federal Reserve System.
                     The second section, Different Interests, examines the variations among
                individual rates, explaining why a 6-month Treasury bill may have one rate,
                business loans another, and home mortgages still a third. This section discusses
                the unique characteristics of each credit transaction, such as risk, rights, and
                tax considerations, and how these factors affect the decision-making process
                of borrowers and lenders.

    Interest Rate Trends
                                         Conventional Mortgage            3-month CDs
                                         30-year Treasury Bonds           3-month Treasury Bills



     1979     ’81      ’83     ’85      ’87      ’89       ’91     ’93      ’95       ’97          ’99

         Levels of Interest
         The Price of Credit                           price the borrower must pay for
                                                       the immediate use of the lender’s
         To understand the economic forces
                                                       funds. Put more simply, interest
         that drive (and sometimes are
                                                       rates are the price of credit.
         driven by) interest rates, we first
         need to define interest rates. An
         interest rate is a price, and like any        Supply and Demand
         other price, it relates to a transaction      As with any other price in our
         or the transfer of a good or service          market economy, interest rates are
         between a buyer and a seller. This            determined by the forces of supply
         special type of transaction is a loan         and demand, in this case, the supply
         or credit transaction, involving a            of and demand for credit. If the
         supplier of surplus funds, i.e., a            supply of credit from lenders rises
         lender or saver, and a demander of            relative to the demand from bor-
         surplus funds, i.e., a borrower.              rowers, the price (interest rate)
               In a loan transaction, the              will tend to fall as lenders compete
         borrower receives funds to use for            to find use for their funds. If the
         a period of time, and the lender              demand rises relative to the supply,
         receives the borrower’s promise to            the interest rate will tend to rise as
         pay at some time in the future.               borrowers compete for increasingly
               The borrower receives the bene-         scarce funds. The principal source
         fit of the immediate use of funds.            of the demand for credit comes from
         The lender, on the other hand, gives          our desire for current spending
         up the immediate use of funds, for-           and investment opportunities.
         going any current goods or services                The principal source of the
         those funds could purchase. In                supply of credit comes from savings,
         other words, lenders loan funds they          or the willingness of people, firms,
         have saved—surplus funds they do              and governments to delay spending.
         not need for purchasing goods or              Depository institutions such as
         services today.                               banks, thrifts, and credit unions, as
               Because these lenders/savers            well as the Federal Reserve, play
         sacrifice the immediate use of funds,         important roles in influencing the
         they ask for compensation in addition         supply of credit.
         to the repayment of the funds loaned.              Let’s examine these sources.
         This compensation is interest, the

                           Supply             Demand

Demand                                                                             Supply

                            %                  %
    The Source of Demand                     if they have an opportunity they
                                             believe will earn more—that is,
    Consumption. At one time or
                                             create a larger income stream—
    another, virtually all consumers,
                                             than they will have to pay on the
    businesses, and governments
                                             loan, or than they will receive in
    demand credit to purchase goods
                                             some other activity.
    and services for current use. In
                                                  Say, for example, a widget
    these loans, borrowers agree to pay
                                             manufacturer sees an opportunity
    interest to a lender/saver because
                                             to purchase a new machine that
    they prefer to have the goods or
                                             can reasonably be expected to earn
    services now, rather than waiting
                                             a 20 percent return, i.e., produce
    until some time in the future when,
                                             income from the manufacture of
    presumably, they would have saved
                                             widgets equal to 20 percent of the
    enough for the purchase. To describe
                                             cost of the machine. The manu-
    this preference for current consump-
                                             facturer will borrow funds only if
    tion, economists say that borrowers
                                             they can be obtained at an interest
    have a high rate of time preference.
                                             rate less than 20 percent.
    Expressed simply, people with
                                                  What borrowers are willing to
    high rates of time preference prefer
                                             pay, then, depends principally on
    to purchase goods now, rather than
                                             time preferences for current con-
    wait to purchase future goods—
                                             sumption and on the expected rate
    an automobile now rather than an
                                             of return on an investment.
    automobile at some time in the
    future, a current vacation opportu-
    nity rather than a future opportunity,   The Source of Supply
    and present goods or services            The supply of credit comes from
    rather than those in the future.         savings—funds not needed or used
         Although lenders/savers             for current consumption. When we
    generally have lower rates of time       think of savings, most of us think
    preference than borrowers, they          of money in savings accounts, but
    too tend to prefer current goods         this is only part of total savings.
    and services. As a result, they ask           All funds not currently used
    for the payment of interest to en-       to purchase goods and services are
    courage the sacrifice of immediate       part of total savings. For example,
    consumption. As a lender/saver,          insurance premiums, contributions
    for example, one would prefer not to     to pension funds and social security,
    spend $100 now only if the money         funds set aside to purchase stocks
    was not needed for a current pur-        and bonds, and even funds in our
    chase and one could receive more         checking accounts are savings.
    than $100 in the future.                      Since most of us use funds in
    Investment. In the use of funds for      checking accounts to pay for current
    investment, on the other hand, time      consumption, we may not consider
    preference is not the sole factor.       them savings. However, funds in
    Here consumers, businesses, and          checking accounts at any time are
    governments borrow funds only            considered savings until we transfer
                                             them out to pay for goods and

Savings                                Checking             Insurance
                                       Accounts             Premiums

                             Pension                              Social
                              Funds                              Security
                                              Stocks and

         Most of us keep our savings in                 Banks create deposits by mak-
    financial institutions like insurance         ing loans. Rather than handing
    companies and brokerage houses,               cash to borrowers, banks simply
    and in depository institutions such           increase balances in borrowers’
    as banks, savings and loan associa-           checking accounts. Borrowers can
    tions, credit unions, and mutual              then draw checks to pay for goods
    savings banks. These financial                and services. This creation of check-
    institutions then pool the savings            ing accounts through loans is just
    and make them available to people             as much a deposit as one we might
    who want to borrow.                           make by pushing a ten-dollar bill
         This process is called financial         through the teller’s window.
    intermediation. This process of                     With all of the nation’s banks
    bringing together borrowers and               able to increase the supply of credit
    lenders/savers is one of the most             in this fashion, credit could con-
    important roles that financial insti-         ceivably expand without limit.
    tutions perform.                              Preventing such uncontrolled
                                                  expansion is one of the jobs of the
                                                  Federal Reserve System (the Fed),
    Banks and Deposit
                                                  our central bank and monetary
                                                  authority. The Fed has the respon-
    Depository institutions, which for            sibility of monitoring and influenc-
    simplicity we will call banks, are            ing the total supply of money
    different from other financial insti-         and credit.
    tutions because they offer trans-
    action accounts and make loans
    by lending deposits. This deposit
                                                  The General Level
    creation activity, essentially creating       of Rates
    money, affects interest rates because         The general level of interest rates
    these deposits are part of savings,           is determined by the interaction of
    the source of the supply of credit.           the supply and demand for credit.

                          When supply and demand interact,            lenders, seeking to protect their
                          they determine a price (the equili-         purchasing power, add the expected
                          brium price) that tends to be               rate of inflation to the interest rate
                          relatively stable. However, we have         they demand. Borrowers are willing
                          seen that the price of credit is not nec-   to pay this higher rate because they
                          essarily stable, implying that some-        expect inflation to enable them to
                          thing shifts the supply, the demand,        repay the loan with cheaper dollars.
                          or both. Let’s examine several                   If lenders expect, for example,
                          factors that influence these shifts.        an eight percent inflation rate for the
                          Expected Inflation. As we have              coming year and otherwise desire
                          already seen, interest rates state the      a four percent return on their loan,
                          rate at which borrowers must pay            they would likely charge borrowers
                          future dollars to receive current           12 percent, the so-called nominal
                          dollars. Borrowers and lenders, how-        interest rate (an eight percent infla-
                          ever, are not as concerned about            tion premium plus a four percent
                          dollars, present or future, as they         “real” rate).
                          are about the goods and services                 Borrowers and lenders tend to
                          those dollars can buy, the purchas-         base their inflationary expectations
                          ing power of money.                         on past experiences which they
                               Inflation reduces the purchas-         project into the future. When they
                          ing power of money. Each percent-           have experienced inflation for a
                          age point increase in inflation             long time, they gradually build the
                          represents approximately a 1                inflation premium into their rates.
                          percent decrease in the quantity            Once people come to expect a certain
                          of real goods and services that can         level of inflation, they may have to
                          be purchased with a given number            experience a fairly long period at a
                          of dollars in the future. As a result,      different rate of inflation before they
                                                                      are willing to change the inflation
                                                                           The effect of an inflation
The Fed and Bank Reserves                                             premium can be seen in the chart
The Fed affects the general level of interest rates by influencing    at right. Although the chart tracks
the total supply of money and credit that banks can create. When      the consumer price index or CPI
banks create checkbook deposits, they create money as well as         and the constant maturity 3-year
credit since these deposits are part of the money supply.             Treasury note rate, one could use
                                                                      almost any inflation measure and
     The Fed exerts this influence on the supply of money and
                                                                      interest rate and see a similar
credit by affecting bank reserves. These reserves are funds that
                                                                      pattern. As inflation rose through the
banks are required to hold in the form of either cash in their own    late 1970s, it came to be “expected”
vaults or as a balance at a Fed Bank.                                 by lenders as well as borrowers.
     Banks are required to hold a level of reserves equal to a        This “inflation expectation” can be
proportion of deposits on their books. For example, a required        seen by the fact that investors in
reserve ratio of 10 percent means that a bank must set aside          Treasury notes were demanding a
one dollar for every ten deposit dollars. In other words, a bank      relatively high inflation premium
                                                                      in the early 1980s, even after infla-
cannot owe ten deposit dollars unless it holds one reserve dollar.
                                                                      tion reached its apex. This was
Hence legal reserve requirements, combined with the given level
of reserves, set limits on the amount of credit banks can offer.

                  partially due to the fact that               Economic Conditions. All busi-
                  relatively high levels of inflation          nesses, governmental bodies, and
Inflation         were fresh in the memories of                households that borrow funds
                  borrowers and lenders, and there             affect the demand for credit. This
                  was uncertainty as to how serious            demand tends to vary with general
   5¢             policymakers would be in pursuing
                  lower levels of inflation. In 1984,
                                                               economic conditions.
                                                                    When economic activity is ex-
  1945            for example, it took only a slight           panding and the outlook appears
                  increase in inflation to cause a rela-       favorable, consumers demand sub-
                  tively rapid increase in interest rates.     stantial amounts of credit to finance
                       For most of the 1980s, inflation        homes, automobiles, and other
                  was relatively low and interest              major items, as well as to increase
                  rates continued their downward               current consumption. With this
                  trend with the gap between rates             positive outlook, they expect higher
  95 ¢            and inflation narrowing. As the              incomes and as a result are generally
  1995            memory of high inflation receded,            more willing to take on future
                  so did pressure for a high inflation         obligations. Businesses are also
                  premium, as indicated by the rela-           optimistic and seek funds to finance
                  tively modest rise in rates when             the additional production, plants,
                  inflation flared in 1990. Inflationary       and equipment needed to supply
                  expectations had been reduced, a             this increased consumer demand.
                  goal sought by many monetary                 All of this makes for a relative
                  policymakers. Indeed, Fed Chairman           scarcity of funds, due to increased
   ?              Alan Greenspan has stated that               demand.
  2045            price stability would be achieved                 On the other hand, when sales
                  when the expectation of future               are sluggish and the future looks
                  price changes plays no role in the           grim, consumers and businesses
                  decisionmaking of businesses and             tend to reduce their major purchases,
                  households.                                  and lenders, concerned about the
                                                               repayment ability of prospective
                                                               borrowers, become reluctant to

  Effect of Inflation Premium
                                                                   3-year Treasury Constant Maturity
                                                                   CPI Year-to-year Change




   1979     ’81      ’83       ’85       ’87       ’89       ’91      ’93       ’95        ’97         ’99

     lend. As a result, both the supply          Fiscal Policy. Federal, state and
     of and demand for credit may fall.          local governments, through their
     Unless they both fall by the same           fiscal policy actions of taxation
     amount, interest rates are affected.        and spending, can affect either the
     Federal Reserve Actions. As we              supply of or the demand for credit.
     have seen, the Fed acts to influence        If a governmental unit spends less
     the availability of money and credit        than it takes in from taxes and other
     by adjusting the level and/or price         sources of revenue, as many have
     of bank reserves. The Fed affects           in recent years, it runs a budget
     reserves in three ways: by setting          surplus, meaning the government
     reserve requirements that banks             has savings. As we have seen, sav-
     must hold, as we discussed earlier;         ings are the source of the supply
     by buying and selling government            of credit. On the other hand, if a
     securities (usually U.S. Treasury           governmental unit spends more
     bonds) in open market operations;           than it takes in, it runs a budget
     and by setting the “discount rate,”         deficit, and must borrow to make
     which affects the price of reserves         up the difference. The borrowing
     banks borrow from the Fed through           increases the demand for credit,
     the “discount window.”                      contributing to higher interest rates
          These “tools” of monetary              in general.
     policy influence the supply of
     credit, but do not directly impact          Interest Rate
     the demand for credit. Because the          Predictions
     Fed directly affects only one side of
                                                 The level of interest rates influences
     the supply and demand relationship,
                                                 people’s behavior by affecting
     it cannot totally control interest rates.
                                                 economic decisions that determine
     Nevertheless, monetary policy
                                                 the well-being of the nation: how
     clearly does affect the general level
                                                 much people are willing to save,
     of interest rates.
                                                 and how much businesses are will-
                                                 ing to invest.
                                                      With so many important deci-
                                                 sions based on the level of interest
                                                 rates, it is not surprising that people
                                                 want to know which way rates are
                                                 going to move. However, with so
                                                 many diverse elements influencing
                                                 rates, it is also not surprising that
                                                 people are not able to predict the
                                                 direction of these movements
                                                      Even though we are not able
                                                 to predict accurately and consis-
                                                 tently how interest rates will move,
                                                 these movements are clearly not
                                                 random. To the contrary, they are
                                                 strictly controlled by the most
                                                 calculating master of all—the
                                                 economic forces of the market.

   Different Interests
   As we have seen, certain factors           Credit Transactions
   affect the general level of interest
                                              As different as all these transactions
   rates. But why do the rates vary for
                                              may at first appear, they are the
   different transactions? For example,
                                              same in one respect—they all in-
   on a typical day at a local financial
                                              volve borrowing and lending funds.
   institution, a lending officer might
                                              Each transaction has a lender, who
   approve a $20,000 loan to the local
                                              exchanges funds for an asset in the
   school board for emergency repairs
                                              form of an IOU or credit, and a
   on the school’s furnace and charge
                                              borrower who exchanges the IOU
   the board 8 percent interest for the
                                              for funds. Because credit, the IOU,
   use of the funds. Later, the banker
                                              is being bought and sold, these are
   might approve a used-car loan for
                                              called credit transactions. Most of
   $4,000, at 11 percent interest, to be
                                              us can easily see that the loan officer
   paid in three years, and a small
                                              is providing credit—the bank is
   business loan for $17,000, at 8.5 per-
                                              lending money to the school board,
   cent interest, for a term of four years.
                                              the person buying the used car, and
        Meanwhile, the bank’s invest-
                                              the businessperson.
   ment officer submits a bid for a
                                                   The other transactions are also
   two-year Treasury note on which
                                              credit transactions, although we
   the bank wants to receive 6 percent
                                              generally think of them in different
   interest, and purchases a 15-year
                                              terms. We usually refer to the pur-
   general obligation municipal bond
                                              chase of a Treasury note or a muni-
   issued by the local city government.
                                              cipal bond as making an investment,
   The bank will receive 8 percent
                                              but they are credit transactions
   interest on this bond. At the next
                                              because the bank is loaning money
   desk, the new accounts officer
                                              to the federal and city governments.
   opens an interest-paying checking
                                              By investing in the note and bond,
   account, which will pay a customer
                                              the bank makes funds available
   1.5 percent interest.
                                              directly to the government (or in-
                                              directly by replacing the previous

                                              holder of the government’s debt).
                                              The bank, in return, receives inter-
                                              est payments from the government.
                                                   When the new accounts officer
                                              opened the checking account for
                                              the customer, the bank gained the
                                              use of funds. This, too, is a credit
                                              transaction in which the customer
                                              is the lender and the bank is the
                                              borrower. To compensate for the use

3 years                                       of funds, the bank pays interest.

     Degrees of Interest                       will go at the drop of a hat.
                                               In credit transactions, too, people
     Although all the transactions at
                                               are willing to accept different levels
     the bank that morning were credit
                                               of risk. However, most people are
     transactions, they all involved
                                               risk averse; that is, they prefer not
     different interest rates, different
                                               to increase risks with their money
     prices of credit. As with other prices
                                               unless they receive increased
     in a free market system, interest rates
     are determined by many factors.
                                                    To illustrate, let’s say we have a
     As we’ve seen, some factors are
                                               choice of buying two debt securities,
     more or less the same for all credit
                                               which are bonds or IOUs issued
     transactions. General economic
                                               by corporations or governments
     conditions, for example, cause all
                                               seeking to borrow funds. One
     interest rates to move in the same
                                               security pays (meaning, we will
     direction over time.
                                               receive) a certain five percent
           Other factors vary for different
                                               interest, while the other has a 50
     kinds of credit transactions, causing
                                               percent chance of paying eight
     their interest rates to differ at any
                                               percent interest and a 50 percent
     one time. Some of the most impor-
                                               chance of paying two percent. Which
     tant of these factors are:
                                               security should we buy? If we are
     • different levels and kinds of risk;
                                               risk averse investors/lenders, we
     • different rights granted to
                                               would choose the security paying
        borrowers and lenders, and
                                               the certain five percent, because we
     • different tax considerations.
                                               would not view the uncertainty of
     Let’s examine each of these.
                                               return on the second security as an
     Levels of Risk                                 If, on the other hand, the second
     Risk refers to the chance that some-      security has a 50 percent chance of
     thing unfavorable may happen.             paying 15 percent interest and a
     If you go skydiving, the risks you        50 percent chance of paying two
     assume are obvious. When you              percent, we might be inclined to
     purchase a financial asset, say by        buy it because we might consider
     lending funds to a corporation by         the higher potential return to be
     purchasing one of its bonds, you          worth the risk.
     also take a risk—a financial risk.             Even though lenders are will-
     Something unfavorable could               ing to accept different levels of
     happen to your money—you could            risk, they want to be compensated
     lose all of it if the company issuing     for taking the risk. Therefore, as
     the security goes bankrupt, or you        securities differ in level of risk,
     could lose part of it if the asset’s      their interest rates tend to differ.
     price goes down and you have to           Generally, interest rates on debt
     sell before maturity.                     securities are affected by three kinds
          Different people are willing to      of risk:
     accept different levels of risk. Some     • default risk,
     people will not go skydiving under        • liquidity risk, and
     any circumstances, while others           • maturity risk.

           Default Risk                              loans, for example, the car usually
                                                     serves as collateral. Other assurances
           For any number of reasons, even the
                                                     could include a cosigner, another
           most well-intentioned borrowers
                                                     person willing to make payment
           may not be able to make interest
                                                     if the original borrower defaults.
           payments or repay borrowed funds
                                                     Generally speaking, because secured
           on time. If borrowers do not make
                                                     loans are comparatively less risky,
           timely payments, they are said to
                                                     they carry a lower interest rate than
           have defaulted on loans. When
                                                     unsecured loans.
           borrowers do not make interest
                                                           As a borrower, the federal
           payments, lenders’ returns (the
                                                     government offers firm assurances
           interest they receive) are reduced
                                                     against default. As a result of the
           or wiped out completely; when
                                                     power to tax and authority to coin
           borrowers do not repay all or part
                                                     money, payments of principal and
           of the principal, the lenders’ return
                                                     interest on loans made to (or secu-
           is actually negative.
                                                     rities purchased from) the U.S.
                 All loans are subject to default
                                                     government are, for all practical
           risk since borrowers may die, go
                                                     purposes, never in doubt, making
           bankrupt, or be faced with un-
                                                     U.S. government securities virtually
           foreseen problems that prevent
                                                     default-risk free. Since investors
           payments. Of course, default risk
                                                     tend to be risk averse and U.S.
           varies with different people and
                                                     government securities are all but
           companies; nevertheless, no one
                                                     free from default risk, they generally
           is free from risk of default.
                                                     carry a lower interest rate than
                 While investors/lenders accept
                                                     securities from corporations.
           this risk when they loan funds, they
                                                           Similarly, other types of bor-
           prefer to reduce the risk. As a result,
                                                     rowers represent different levels of
           many borrowers are compelled to
                                                     risk to the lender. In each case, the
           secure their loans; meaning, they
                                                     lender needs to evaluate what are
           give the lender some assurances
                                                     commonly called “the three Cs”
           against default. Frequently, these
                                                     of character, capital, and capacity.
           assurances are in the form of collat-
                                                     Character represents the borrower’s
           eral, some physical object the lender
                                                     history with previous loans. A
           can possess and then sell in the
                                                     history containing bankruptcies,
           event of default. For automobile

                             A P
 C   apital
     repossessions, consistently late          traded security of a well-known
     or missed payments, and court             company, which we know we can
     judgments may indicate a higher           sell easily at a price close to our
     risk potential for the lender.            purchase price. If we are risk averse,
     Capital represents current financial      we would choose the security from
     condition. Is the borrower currently      the well-known company if both
     debt-free, or relatively so in com-       were paying the same interest rate.
     parison with assets? They may                   To encourage us to buy its
     represent a party with “thrifty”          security, the obscure company must
     habits, who can take on additional        pay a higher rate to compensate us
     debt without imposing an undue            for the difficulty we will experience
     burden on other assets. Capacity          if we want to sell.
     represents the future ability to
     service the loan, i.e., make princi-
                                               Maturity Risk
     pal and interest payments. Income,
     job stability, regular promotions,        Credit transactions usually involve
     and raises are all indicators to          lending/borrowing funds for an
     be considered.                            agreed upon period of time. At the
                                               end of that time the loan is said to
                                               have matured and must be repaid.
     Liquidity Risk                            The length of maturity is a source of
     In addition to default risk, liquidity    another kind of risk—maturity risk.
     risk affects interest rates. If a secu-         Long-term securities are sub-
     rity can be quickly sold at close         ject to more risk than short-term
     to its original purchase price, it is     securities because the future is
     highly liquid; meaning, it is less        uncertain and more problems can
     costly to convert into money than         arise the longer the security is
     one that cannot be sold at a price        outstanding. These greater risks
     close to its purchase price. There-       usually, but not always, result in
     fore, it is less risky than one with a    higher rates for long-term securities
     wide spread between its purchase          than for short-term securities.
     price and its selling price.                    To illustrate, let’s examine U.S.
           To illustrate, let’s say that we    government securities—Treasury
     have a choice between purchasing          bills (with original maturities of
     an infrequently-traded security of        one year or less), Treasury notes
     an obscure company, and a broadly-        (with original maturities of two to
                                               ten years), and Treasury bonds
                                               (with original maturities of over
                                               ten years). These securities are
                                               quite similar, except in length of
                                               maturity. As we have seen, U.S.
                                               government securities are virtually
                                               default-risk free, and because there
                                               is such a large and active market
                                               for them, they are also virtually
                                               liquidity-risk free.

                                          Maturity Risk
Interest Rate

      %1 Year Treasury Bill
                                  %% 5 Year Treasury Note

                                          Time to Maturity
                                                                     15 Year Treasury Bond

                         If default and liquidity were        months, throughout the term of
                    the only kinds of risk in holding         the loan. Some of these bonds are
                    government securities, we would           issued with attached coupons,
                    be inclined to think that they all        which lenders can clip and send in
                    would have the same interest rate.        every six months or year to collect
                    However, because of maturity risk,        the interest that is due.
                    short-term Treasury bills usually              Zero-coupon bonds, however,
                    pay less (have a lower interest rate)     make no interest payments through-
                    than longer-term Treasury notes           out the life of the loan. Rather than
                    and bonds.                                pay interest, these bonds are sold
                                                              at a price well below their stated
                                                              face value. Although not usually
                    Different Rights
                                                              thought of in such terms, a savings
                    Risk is not the only reason credit        bond is like a zero-coupon bond
                    transactions can have different rates     in that it renders one payment at
                    of interest. As we have seen, certain     maturity.
                    assurances, such as securing loans,            Even though zero-coupon
                    also affect rates. Typically, borrowers   bonds make no interest payments,
                    write these assurances into their debt    investors/lenders still need to
                    securities specifying the rights of       know the return on these bonds
                    both borrower and lender. Because         so they can compare it to the
                    these rights differ, debt securities      return on a coupon bond or other
                    tend to pay different rates of inter-     alternative investment. To figure
                    est. Let’s look at some of these          the return, or yield, investors com-
                    rights in the more common debt            pare the difference between their
                    securities.                               purchase price and selling price.
                    Coupon and zero-coupon bonds.                  Since zero-coupon bonds
                    Most debt securities promise to           provide lenders no compensation
                    repay the amount borrowed (the            until the end of the loan period,
                    principal) at the end of the length       borrowers issuing these bonds tend
                    of the loan, and also pay interest at     to pay a higher rate than borrowers
                    specified times, such as every six        issuing coupon bonds.

                        Convertible bonds. Some borrowers            Call provisions. Some bonds are
                        sell bonds that can be converted             callable after a specified date; that
                        into a fixed number of shares of             is, the borrower has the right to
                        common stock. With convertible               pay off part or all of it before the
                        bonds, a lender (bondholder) can             scheduled maturity date. Unlike
                        become a part owner (stockholder)            convertible bonds which give
                        of the company by converting the             certain rights to the lenders, call
                        bond into the company’s stock.               provisions give borrowers certain
                        Because investors generally view             rights, the right to call the bond.
                        this right as desirable, borrowers           As a result, borrowers must pay a
                        can sell convertible bonds at a              higher interest rate than on similar
                        lower interest rate than they would          securities without a call provision.
                        otherwise have to pay for a similar
                        bond that was not convertible.

                                          Tax Considerations
                                          In addition to the level and kinds of risk and the different rights
                                          granted by different debt securities, taxes also play a significant
         Initial Investment               role in affecting rates of return.
                                               To illustrate, let’s say you borrow $1,000 for a year at 10
                                          percent interest. At the end of the year, you pay the $1,000 principal
                                          plus $100 interest. However, if the lender is in a 25 percent tax
                                          bracket, the lender will pay $25 in taxes on that $100. Thus,
                                          the lender’s actual after-tax yield is reduced from 10 percent to
                                          7.5 percent.
                                               Different debt securities carry different tax considerations.
                                          Corporate bonds (loans to corporations) are subject to local, state,
       $100 pre-tax return                and federal taxes. U.S. government securities are subject to
     (Principal plus 10% interest
            after one year)               federal taxes, but exempt from local and state taxes. Municipal
                                          bonds are exempt from federal taxes, and in some states, exempt
                                          from local taxes.
                                               Taking taxes into consideration, a lender will receive more
                                          after-tax interest income from a municipal bond paying 10 percent

           $1,075                         than from a corporate bond paying the same rate. This special
                                          tax-exempt status of municipal bonds enables state and local
                                          governments to raise funds at a relatively lower interest cost.
                                               On the other hand, for corporations to attract lenders, they
     $75 return after taxes
                                          must pay a higher rate of interest to compensate for taxes.
        (At 25% tax rate)

     Of course, borrowers will call      is issued. As a result, general obliga-
(redeem) only when it is to their        tion bonds usually pay a lower rate
benefit. For example, when the           of interest than revenue bonds.
general level of interest rates falls,
the borrower can call the bonds
                                         Efficient Allocation
paying high rates of interest and
reborrow funds at the lower rate.        With so many different interest
     As partial compensation to          rates and so many different factors
the lender, the borrower often has       affecting them, it may seem that
to pay a penalty to call a bond.         borrowing and lending would
Naturally, a borrower will call a        be hopelessly complicated and in-
bond only if the advantages of           efficient. In reality, however, the
doing so outweigh the penalty. In        variety of interest rates reflects
other words, interest rates would        the efficiency of the market in
have to fall sufficiently to compen-     allocating funds.
sate for the penalty before a bor-            In analyzing investment
rower would call a bond.                 opportunities, lenders look for an
                                         interest rate high enough to account
Municipal bonds. Municipal bonds
                                         for all their risks, rights, and taxes,
are debt securities issued by local
                                         as we have discussed. If the project
and state governments. Usually
                                         will not pay that rate, they will look
these governmental bodies issue
                                         for other investments. For their
either general obligation bonds or
                                         part, borrowers will undertake
revenue bonds.
                                         only projects with returns high
     General obligation bonds, the
                                         enough to cover at least the cost
more common type, are issued for
                                         of borrowed funds.
a wide variety of reasons, such as
                                              The market, then, serves to
building schools and providing
                                         assure that only worthwhile projects
social services. They are secured
                                         will be funded with borrowed funds.
by the general taxing power of
                                         In other words, market forces and
the issuing government.
                                         differences in interest rates work
     Revenue bonds, on the other
                                         together to foster the efficient
hand, are issued to finance a specific
                                         allocation of funds.
project—building a tollway, for
example. The interest and principal
are paid exclusively out of the
receipts that the project generates.
     Both kinds of municipal bonds
are considered safe. However,
because general obligation bonds
are secured by the assets of the
issuing government and the power
of that government to tax, they
are usually considered safer than
revenue bonds, whose payments
must come out of receipts of the
specific project for which the bond

     Additional Readings
     For information about how to order these materials, contact the Federal
     Reserve Bank of Chicago’s Public Information Center, 230 South LaSalle St.,
     Chicago, IL 60604, (312) 322-5111.

     The ABCs of Figuring Interest
     Public Affairs Department
     Federal Reserve Bank of Chicago
     230 South LaSalle St.
     Chicago, IL 60604

     Controlling Interest
     (Reprint due summer 2000)
     Public Affairs Department
     Federal Reserve Bank of Chicago
     230 South LaSalle St.
     Chicago, IL 60604

Federal Reserve Bank of Chicago
230 South LaSalle Street
Chicago, IL 60604-1413
Phone: 312-322-5111
Fax: 312-322-5515
Web:        October 2000 30m

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