The Bond Market and Interest Rates

The economics of Money, Banking & Financial Markets; p 3-5

A security (also called a financial instrument) is a claim on the issuer's future income or assets (any financial claim or piece of property that is subject to ownership).  A bond is a debt secruity that promises to make payments periodically for a specified period of time.  The bond market is especially important to economic activity because it enables corporations and governments to borrow to finance their activities and because it is where interest rates are determined.  An interest rate is the cost of borrowing or price paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year)  There are many interest rates in the economy--mortgage interest rates, car loan rates, and interest rates on many different types of bonds.

 

Interest rates are important on a number of levels.  On a personal level, high interest rates could deter you from buying a hourse or a car because the cost of financing it would be high.  Conversely, high interest rates could encourage you to save because you can earn more interest income by putting aside some of your earnings as savings.  On a more general level, interest rates have an impact on the overall health of the economy because they affect not only consumers willingness to spend or save but also businesses' investment decisions.  High interest rates, for example, might cause a corporation to postpone building a new plant that would provide more jobs. 

 

Because changes in interest rates have important effects on individuals, financial institutions, businesses, and the overall economy, it is important to explain fluctuations in interest rates that have been substantial over the past 30 years.  For example, the interest rate on three-month Treasury bills peaked at over 16% in 1981.  The interest rate fell to 3% in late 1992 and 1993, rose to above 5% in the mid-to late 90's, fell below 1% in 2004, rose to 5% by 2007, only to fall to zero in 2008.

 

Because different interest rates have a tendency to move in unison, economists frequently lump interest rates together and refer to "the" interest rate... however interest rates on several types of bonds can differ substantially.  The interest rate on three-month Treasury bills, for example, fluctuates more than the other interest rates and is lower, on average.  The interest rate on Baa (medium-quality) corporate bonds is higher, on average, than the other interest rates, and the spread between it and the other rates became larger in the 1970's, narrowed in the 1990's, and rose briefly in the early 2000's, narrowed again, only to rise sharply starting in the summer of 2007.