Bonds and interest rates
Interest rates sit underneath almost every other market. They set the cost of borrowing for governments, companies and households, and they help decide what investors are willing to pay for stocks and which currencies they want to hold. This lesson starts with bonds, because bond markets are where most interest rates are set.
What a bond is
A bond is a loan you can buy and sell. The borrower (a government or company) promises to pay a fixed amount of interest, called the coupon, at regular intervals, and to repay the original amount, called the face value or principal, on a set date called maturity.
Suppose a government issues a 10-year bond with a face value of $1,000 and a 4% coupon. It pays $40 a year for ten years and repays $1,000 at the end. US government bonds are called Treasuries. Short-term ones (a year or less) are called bills, medium-term ones notes and long-term ones bonds, but people often call them all "bonds".
What yield means
A bond's yield is the return you earn if you buy it at today's price and hold it to maturity, expressed as a yearly percentage. When people say "the 10-year yield is 4%", they mean the return the market currently demands for lending to the US government for ten years.
Yields are often quoted in basis points. One basis point is one hundredth of a percentage point, or 0.01%. A yield moving from 4.00% to 4.25% has risen 25 basis points.
Why prices and yields move in opposite directions
The coupon on an existing bond is fixed. So when market rates change, the only thing that can adjust is the bond's price.
Suppose you own the 4% bond above, and new 10-year bonds now pay 5%. No one will pay you $1,000 for a bond paying $40 a year when a new one pays $50. Your bond's price has to fall until its yield is competitive with the new bonds. Now suppose rates fall instead and new bonds pay only 3%. Your $40 coupon is now attractive, and buyers will pay more than $1,000 for it.
So when yields rise, existing bond prices fall, and when yields fall, prices rise. Longer-maturity bonds move more for the same change in yield, because their fixed coupons run for longer.
Who sets interest rates
A central bank sets a country's short-term policy rate. In the United States that is the Federal Reserve (the Fed), whose Federal Open Market Committee (FOMC) sets a target range for the federal funds rate, the rate banks charge each other for overnight loans. The FOMC holds eight scheduled meetings a year. Other central banks, such as the European Central Bank, the Bank of England and the Bank of Japan, do the same for their currencies.
Longer-term yields, such as the 10-year Treasury yield, are set by the bond market. They reflect what investors expect short-term rates to do over the years ahead, plus expected inflation and extra compensation for the uncertainty of lending for longer. That's why longer-term yields often move before a central bank acts, as expectations change.
The yield curve is a line connecting yields across maturities, from short to long. Normally longer maturities yield more. When short-term yields are above long-term yields, the curve is said to be inverted, which markets watch as a possible sign that investors expect rates, and perhaps growth, to fall.
Why rates move stocks
A share's value rests on the cash a company is expected to earn in the future. To compare future money with money today, investors discount it using an interest rate. When rates rise, future earnings are worth less today, and the effect is largest for companies whose profits are expected far in the future. Higher rates also raise borrowing costs for companies and consumers, and make safe bonds a more attractive alternative to stocks. Falling rates work in the other direction. These are tendencies, not rules: on any given day other news can matter more.
Why rates move currencies
Money tends to flow toward places where it earns more, for a given level of risk. If US yields rise relative to European yields, holding dollars becomes more rewarding than holding euros, other things being equal, which can push the dollar up against the euro. In practice, currency traders watch the difference between countries' rates, and especially changes in what markets expect central banks to do next. Lesson 4 picks this up.
Where to see rates on PYE Markets
The Rates page shows US Treasury yields and other rates from the Federal Reserve Bank of St. Louis (FRED), with the date of each figure. Watching how the 2-year and 10-year yields change alongside stocks and the dollar is one of the best ways to build intuition for how these markets connect.
Key terms
- Bond
- A tradeable loan that pays a fixed coupon and repays its face value at maturity.
- Coupon
- The fixed interest payment a bond makes.
- Yield
- The yearly return from buying a bond at today's price and holding it to maturity.
- Basis point
- One hundredth of a percentage point (0.01%).
- Central bank
- The institution that sets a country's short-term policy interest rate, such as the Federal Reserve.
- Yield curve
- Yields plotted across maturities; "inverted" when short-term yields exceed long-term ones.
Next lesson: Lesson 4: Currencies: pairs, pips and why EUR/USD moves
General education, not investment advice.