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The Companion Advisor:
General InterestWhat Are Interest Rates? When we talk about interest rates, what rate are we referring to or does it matter? For example, on the Bank of Canada website, I see data on yields for Treasury Bills, Treasury Bonds, Corporate Paper, Banker’s Acceptances, Mortgages, etc. How are these different rates related? All interest rates in the market are related. The yield on short term Treasury Bills sets a floor under all other yields, since the short term Treasury Bill is the risk-free security. In turn, the yield on the short term Treasury Bill is strongly influenced by the actions of the Bank of Canada in its conduct of monetary policy. Why should an investor care about interest rates? First, we need to know what might cause rates to change. Second, if there is a change in rates, we need to know the impact of the change on the price of stocks and bonds. Other decisions affected by this knowledge includes: should I buy long or short term bonds; should I buy or sell common stock; should I choose a fixed or floating rate on my mortgage; should I borrow to acquire more securities and if so, when? Interest rates reflect the price of money When we lend money to somebody else, we expect compensation from the borrower for the use of our resources. After all, when we lend money, we are deferring our own ability to consume and exposing ourselves to several forms of risk, all of which deserve some form of compensation. The compensation we receive is interest. The amount of interest we receive on any given investment will be driven by three basic factors: the real interest rate, expected future inflation and risk. We will look at each of these in turn, but first we want to deal with another perplexing issue, that being the large number of different rates quoted in the financial press. A visit to the Bank of Canada website (www.bankofcanada.ca) shows that yields are quoted on a large variety of different instruments. For example, on the website, we can find yields quoted for a variety of maturities of Government of Canada Treasury bills and Treasury bonds, a target for the Overnight Rate, yields on Banker’s Acceptances and GICs, the Bank rate, the prime rate, mortgage rates and yields on corporate paper, among others. We do not need to know the intricacies of each of these to appreciate that there are many different interest rates that are important. There is no one rate that is universally accepted as “the” interest rate for a country, although some are more frequently quoted by the press than others. For example, the prime rate, which is the rate banks charge to their best customers, is often quoted in the financial press. The yield on short-term Treasury bills is another statistic that is often quoted, as is the Bank of Canada’s target for the Overnight Rate. This is not as confusing as it might seem, because all interest rates are informally tied together. We can consider the yield on Government of Canada Treasury bills as a base rate, as it sets a floor under all other interest rates or yields in the market. Since Treasury bills have no default risk and a short term to maturity, they are often used as a proxy for the risk-free rate of return. Given this status as the risk-free security, it is only natural that the yield on Treasury bills should set a floor under all other yields. When the yield on Treasury bills goes up, all other yields will adjust upwards as well. I like to use the analogy of a freight train. When the engine first starts moving, there is a momentary delay before the car behind it begins to move. Each car in the train has a short delay before it too begins to be pulled along the track. Interest rates respond in exactly the same way. If the Bank of Canada pushes up the yield on short-term Treasury bills, all other interest rates will react, just like the freight train slowing starting out of the yard.
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, Fiscal Agents Money Management Newsletter
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