What Determines Interest Rates?

Points ofInterest

• Why is the rate on your car loanhigher than a business loan?

• Why is the rate you would pay for ahome mortgage different than it wasten years ago?

• How do your savings and spendinghabits affect interest rates?

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

www.frbchi.org

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?

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% = ?

To answer these questions, we must separate movements in the generallevel of interest rates from differences in individual rates. As we can see inthe chart below, rates rose steadily from 1979 to 1981 and generally fell afterthat, with a few upward turns to break the downward trend. Because interestrates tend to move together, we can characterize certain periods as times ofhigh or low interest rates. For example, in 1981 the general level of interestrates 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-yearTreasury 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 borrowersand 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 ofrates. This section discusses basic factors of supply and demand for fundsand the function of banks and other similar institutions in meeting theneeds of savers and borrowers. It also examines other factors such as fiscalpolicy and the actions of the Federal Reserve System.

The second section, Different Interests, examines the variations amongindividual rates, explaining why a 6-month Treasury bill may have one rate,business loans another, and home mortgages still a third. This section discussesthe unique characteristics of each credit transaction, such as risk, rights, andtax considerations, and how these factors affect the decision-making processof borrowers and lenders.

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01979 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99

5

10

15

20

Percent

Interest Rate Trends

Conventional Mortgage

30-year Treasury Bonds

3-month CDs

3-month Treasury Bills

The Price of CreditTo understand the economic forcesthat drive (and sometimes aredriven by) interest rates, we firstneed to define interest rates. Aninterest rate is a price, and like anyother price, it relates to a transactionor the transfer of a good or servicebetween a buyer and a seller. Thisspecial type of transaction is a loanor credit transaction, involving asupplier of surplus funds, i.e., alender or saver, and a demander ofsurplus funds, i.e., a borrower.

In a loan transaction, theborrower receives funds to use fora period of time, and the lenderreceives the borrower’s promise topay at some time in the future.

The borrower receives the bene-fit of the immediate use of funds.The lender, on the other hand, givesup the immediate use of funds, for-going any current goods or servicesthose funds could purchase. Inother words, lenders loan funds theyhave saved—surplus funds they donot need for purchasing goods orservices today.

Because these lenders/saverssacrifice the immediate use of funds,they ask for compensation in additionto the repayment of the funds loaned.This compensation is interest, the

price the borrower must pay forthe immediate use of the lender’sfunds. Put more simply, interestrates are the price of credit.

Supply and DemandAs with any other price in ourmarket economy, interest rates aredetermined by the forces of supplyand demand, in this case, the supplyof and demand for credit. If thesupply of credit from lenders risesrelative to the demand from bor-rowers, the price (interest rate) will tend to fall as lenders competeto find use for their funds. If thedemand rises relative to the supply,the interest rate will tend to rise asborrowers compete for increasinglyscarce funds. The principal sourceof the demand for credit comes fromour desire for current spendingand investment opportunities.

The principal source of thesupply of credit comes from savings,or the willingness of people, firms,and governments to delay spending.Depository institutions such asbanks, thrifts, and credit unions, aswell as the Federal Reserve, playimportant roles in influencing thesupply of credit.

Let’s examine these sources.

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Levels of Interest

Supply

SupplyDemand

Demand

%%

The Source of DemandConsumption. At one time oranother, virtually all consumers,businesses, and governmentsdemand credit to purchase goodsand services for current use. Inthese loans, borrowers agree to payinterest to a lender/saver becausethey prefer to have the goods orservices now, rather than waitinguntil some time in the future when,presumably, they would have savedenough for the purchase. To describethis preference for current consump-tion, economists say that borrowershave a high rate of time preference.Expressed simply, people withhigh rates of time preference preferto purchase goods now, rather thanwait to purchase future goods—an automobile now rather than anautomobile at some time in thefuture, a current vacation opportu-nity rather than a future opportunity,and present goods or servicesrather than those in the future.

Although lenders/saversgenerally have lower rates of timepreference than borrowers, theytoo tend to prefer current goodsand services. As a result, they askfor the payment of interest to en-courage the sacrifice of immediateconsumption. As a lender/saver,for example, one would prefer not tospend $100 now only if the moneywas not needed for a current pur-chase and one could receive morethan $100 in the future.

Investment. In the use of funds forinvestment, on the other hand, timepreference is not the sole factor.Here consumers, businesses, andgovernments borrow funds only

if they have an opportunity theybelieve will earn more—that is,create a larger income stream—than they will have to pay on theloan, or than they will receive insome other activity.

Say, for example, a widgetmanufacturer sees an opportunityto purchase a new machine thatcan reasonably be expected to earna 20 percent return, i.e., produceincome from the manufacture ofwidgets equal to 20 percent of thecost of the machine. The manu-facturer will borrow funds only ifthey can be obtained at an interestrate less than 20 percent.

What borrowers are willing topay, then, depends principally ontime preferences for current con-sumption and on the expected rateof return on an investment.

The Source of SupplyThe supply of credit comes fromsavings—funds not needed or usedfor current consumption. When wethink of savings, most of us thinkof money in savings accounts, butthis is only part of total savings.

All funds not currently used to purchase goods and services arepart of total savings. For example,insurance premiums, contributionsto pension funds and social security,funds set aside to purchase stocksand bonds, and even funds in ourchecking accounts are savings.

Since most of us use funds inchecking accounts to pay for currentconsumption, we may not considerthem savings. However, funds inchecking accounts at any time areconsidered savings until we transferthem out to pay for goods andservices.

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Most of us keep our savings infinancial institutions like insurancecompanies and brokerage houses,and in depository institutions suchas banks, savings and loan associa-tions, credit unions, and mutualsavings banks. These financialinstitutions then pool the savingsand make them available to peoplewho want to borrow.

This process is called financialintermediation. This process ofbringing together borrowers andlenders/savers is one of the mostimportant roles that financial insti-tutions perform.

Banks and DepositCreationDepository institutions, which forsimplicity we will call banks, aredifferent from other financial insti-tutions because they offer trans-action accounts and make loans by lending deposits. This depositcreation activity, essentially creatingmoney, affects interest rates becausethese deposits are part of savings,the source of the supply of credit.

Banks create deposits by mak-ing loans. Rather than handingcash to borrowers, banks simplyincrease balances in borrowers’checking accounts. Borrowers canthen draw checks to pay for goodsand services. This creation of check-ing accounts through loans is justas much a deposit as one we mightmake by pushing a ten-dollar billthrough the teller’s window.

With all of the nation’s banksable to increase the supply of creditin this fashion, credit could con-ceivably expand without limit.Preventing such uncontrolledexpansion is one of the jobs of theFederal Reserve System (the Fed),our central bank and monetaryauthority. The Fed has the respon-sibility of monitoring and influenc-ing the total supply of money and credit.

The General Level of RatesThe general level of interest rates is determined by the interaction ofthe supply and demand for credit.

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Savings

SavingsAccounts

InsurancePremiums

PensionFunds

SocialSecurity

Stocks andBonds

CheckingAccounts

When supply and demand interact,they determine a price (the equili-brium price) that tends to berelatively stable. However, we haveseen that the price of credit is not nec-essarily stable, implying that some-thing shifts the supply, the demand,or both. Let’s examine severalfactors that influence these shifts.

Expected Inflation. As we havealready seen, interest rates state therate at which borrowers must payfuture dollars to receive currentdollars. Borrowers and lenders, how-ever, are not as concerned aboutdollars, present or future, as theyare about the goods and servicesthose dollars can buy, the purchas-ing power of money.

Inflation reduces the purchas-ing power of money. Each percent-age point increase in inflationrepresents approximately a 1percent decrease in the quantity of real goods and services that canbe purchased with a given numberof dollars in the future. As a result,

lenders, seeking to protect theirpurchasing power, add the expectedrate of inflation to the interest ratethey demand. Borrowers are willingto pay this higher rate because theyexpect inflation to enable them torepay the loan with cheaper dollars.

If lenders expect, for example,an eight percent inflation rate for thecoming year and otherwise desire a four percent return on their loan,they would likely charge borrowers12 percent, the so-called nominalinterest rate (an eight percent infla-tion premium plus a four percent“real” rate).

Borrowers and lenders tend tobase their inflationary expectationson past experiences which theyproject into the future. When theyhave experienced inflation for along time, they gradually build theinflation premium into their rates.Once people come to expect a certainlevel of inflation, they may have toexperience a fairly long period at adifferent rate of inflation before theyare willing to change the inflationpremium.

The effect of an inflationpremium can be seen in the chartat right. Although the chart tracksthe consumer price index or CPIand the constant maturity 3-yearTreasury note rate, one could usealmost any inflation measure andinterest rate and see a similarpattern. As inflation rose through thelate 1970s, it came to be “expected”by lenders as well as borrowers.This “inflation expectation” can beseen by the fact that investors inTreasury notes were demanding arelatively high inflation premiumin the early 1980s, even after infla-tion reached its apex. This was

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The Fed and Bank Reserves

The Fed affects the general level of interest rates by influencingthe total supply of money and credit that banks can create. Whenbanks create checkbook deposits, they create money as well ascredit since these deposits are part of the money supply.

The Fed exerts this influence on the supply of money andcredit by affecting bank reserves. These reserves are funds thatbanks are required to hold in the form of either cash in their ownvaults or as a balance at a Fed Bank.

Banks are required to hold a level of reserves equal to aproportion of deposits on their books. For example, a requiredreserve ratio of 10 percent means that a bank must set asideone dollar for every ten deposit dollars. In other words, a bankcannot owe ten deposit dollars unless it holds one reserve dollar.Hence legal reserve requirements, combined with the given levelof reserves, set limits on the amount of credit banks can offer.

partially due to the fact thatrelatively high levels of inflationwere fresh in the memories ofborrowers and lenders, and therewas uncertainty as to how seriouspolicymakers would be in pursuinglower levels of inflation. In 1984,for example, it took only a slightincrease in inflation to cause a rela-tively rapid increase in interest rates.

For most of the 1980s, inflationwas relatively low and interestrates continued their downwardtrend with the gap between ratesand inflation narrowing. As thememory of high inflation receded,so did pressure for a high inflationpremium, as indicated by the rela-tively modest rise in rates wheninflation flared in 1990. Inflationaryexpectations had been reduced, agoal sought by many monetarypolicymakers. Indeed, Fed ChairmanAlan Greenspan has stated thatprice stability would be achievedwhen the expectation of futureprice changes plays no role in thedecisionmaking of businesses andhouseholds.

Economic Conditions. All busi-nesses, governmental bodies, andhouseholds that borrow fundsaffect the demand for credit. Thisdemand tends to vary with generaleconomic conditions.

When economic activity is ex-panding and the outlook appearsfavorable, consumers demand sub-stantial amounts of credit to financehomes, automobiles, and othermajor items, as well as to increasecurrent consumption. With thispositive outlook, they expect higherincomes and as a result are generallymore willing to take on futureobligations. Businesses are alsooptimistic and seek funds to financethe additional production, plants,and equipment needed to supplythis increased consumer demand.All of this makes for a relativescarcity of funds, due to increaseddemand.

On the other hand, when salesare sluggish and the future looksgrim, consumers and businessestend to reduce their major purchases,and lenders, concerned about therepayment ability of prospectiveborrowers, become reluctant to

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

15

12

9

6

3

0

Percent

1945

5¢

1995

95¢

2045

Inflation

?

3-year Treasury Constant MaturityCPI Year-to-year Change

Effect of Inflation Premium

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lend. As a result, both the supplyof and demand for credit may fall.Unless they both fall by the sameamount, interest rates are affected.

Federal Reserve Actions. As wehave seen, the Fed acts to influencethe availability of money and creditby adjusting the level and/or priceof bank reserves. The Fed affectsreserves in three ways: by settingreserve requirements that banksmust hold, as we discussed earlier;by buying and selling governmentsecurities (usually U.S. Treasurybonds) in open market operations;and by setting the “discount rate,”which affects the price of reservesbanks borrow from the Fed throughthe “discount window.”

These “tools” of monetarypolicy influence the supply ofcredit, but do not directly impactthe demand for credit. Because theFed directly affects only one side ofthe supply and demand relationship,it cannot totally control interest rates.Nevertheless, monetary policyclearly does affect the general levelof interest rates.

Fiscal Policy. Federal, state andlocal governments, through theirfiscal policy actions of taxation and spending, can affect either thesupply of or the demand for credit.If a governmental unit spends lessthan it takes in from taxes and othersources of revenue, as many havein recent years, it runs a budgetsurplus, meaning the governmenthas savings. As we have seen, sav-ings are the source of the supply of credit. On the other hand, if agovernmental unit spends morethan it takes in, it runs a budgetdeficit, and must borrow to makeup the difference. The borrowingincreases the demand for credit,contributing to higher interest ratesin general.

Interest RatePredictionsThe level of interest rates influencespeople’s behavior by affectingeconomic decisions that determinethe well-being of the nation: howmuch people are willing to save,and how much businesses are will-ing to invest.

With so many important deci-sions based on the level of interestrates, it is not surprising that peoplewant to know which way rates aregoing to move. However, with somany diverse elements influencingrates, it is also not surprising thatpeople are not able to predict thedirection of these movementsprecisely.

Even though we are not ableto predict accurately and consis-tently how interest rates will move,these movements are clearly notrandom. To the contrary, they arestrictly controlled by the mostcalculating master of all—theeconomic forces of the market.

11%

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Different InterestsAs we have seen, certain factorsaffect the general level of interestrates. But why do the rates vary fordifferent transactions? For example,on a typical day at a local financialinstitution, a lending officer mightapprove a $20,000 loan to the localschool board for emergency repairson the school’s furnace and chargethe board 8 percent interest for theuse of the funds. Later, the bankermight approve a used-car loan for$4,000, at 11 percent interest, to bepaid in three years, and a smallbusiness loan for $17,000, at 8.5 per-cent interest, for a term of four years.

Meanwhile, the bank’s invest-ment officer submits a bid for atwo-year Treasury note on whichthe bank wants to receive 6 percentinterest, and purchases a 15-yeargeneral obligation municipal bondissued by the local city government.The bank will receive 8 percentinterest on this bond. At the nextdesk, the new accounts officeropens an interest-paying checkingaccount, which will pay a customer1.5 percent interest.

Credit TransactionsAs different as all these transactionsmay at first appear, they are thesame in one respect—they all in-volve borrowing and lending funds.Each transaction has a lender, whoexchanges funds for an asset in theform of an IOU or credit, and aborrower who exchanges the IOUfor funds. Because credit, the IOU,is being bought and sold, these arecalled credit transactions. Most ofus can easily see that the loan officeris providing credit—the bank islending money to the school board,the person buying the used car, andthe businessperson.

The other transactions are alsocredit transactions, although wegenerally think of them in differentterms. We usually refer to the pur-chase of a Treasury note or a muni-cipal bond as making an investment,but they are credit transactionsbecause the bank is loaning moneyto the federal and city governments.By investing in the note and bond,the bank makes funds availabledirectly to the government (or in-directly by replacing the previousholder of the government’s debt).The bank, in return, receives inter-est payments from the government.

When the new accounts officeropened the checking account forthe customer, the bank gained theuse of funds. This, too, is a credittransaction in which the customeris the lender and the bank is theborrower. To compensate for the useof funds, the bank pays interest.3 years

Degrees of InterestAlthough all the transactions at the bank that morning were credittransactions, they all involveddifferent interest rates, differentprices of credit. As with other pricesin a free market system, interest ratesare determined by many factors.As we’ve seen, some factors aremore or less the same for all credittransactions. General economicconditions, for example, cause allinterest rates to move in the samedirection over time.

Other factors vary for differentkinds of credit transactions, causingtheir interest rates to differ at anyone time. Some of the most impor-tant of these factors are:• different levels and kinds of risk;• different rights granted to

borrowers and lenders, and• different tax considerations.Let’s examine each of these.

Levels of RiskRisk refers to the chance that some-thing unfavorable may happen. If you go skydiving, the risks youassume are obvious. When youpurchase a financial asset, say bylending funds to a corporation bypurchasing one of its bonds, youalso take a risk—a financial risk.Something unfavorable couldhappen to your money—you couldlose all of it if the company issuingthe security goes bankrupt, or youcould lose part of it if the asset’sprice goes down and you have tosell before maturity.

Different people are willing toaccept different levels of risk. Somepeople will not go skydiving underany circumstances, while others

will go at the drop of a hat.In credit transactions, too, peopleare willing to accept different levelsof risk. However, most people arerisk averse; that is, they prefer notto increase risks with their moneyunless they receive increasedcompensation.

To illustrate, let’s say we have achoice of buying two debt securities,which are bonds or IOUs issued by corporations or governmentsseeking to borrow funds. Onesecurity pays (meaning, we willreceive) a certain five percentinterest, while the other has a 50percent chance of paying eightpercent interest and a 50 percentchance of paying two percent. Whichsecurity should we buy? If we arerisk averse investors/lenders, wewould choose the security payingthe certain five percent, because wewould not view the uncertainty ofreturn on the second security as anadvantage.

If, on the other hand, the secondsecurity has a 50 percent chance ofpaying 15 percent interest and a 50 percent chance of paying twopercent, we might be inclined tobuy it because we might considerthe higher potential return to beworth the risk.

Even though lenders are will-ing to accept different levels ofrisk, they want to be compensatedfor taking the risk. Therefore, assecurities differ in level of risk,their interest rates tend to differ.Generally, interest rates on debtsecurities are affected by three kindsof risk:• default risk,• liquidity risk, and• maturity risk.

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Cha

ra

cte

r

CapitalA P

Default RiskFor any number of reasons, even themost well-intentioned borrowersmay not be able to make interestpayments or repay borrowed fundson time. If borrowers do not maketimely payments, they are said tohave defaulted on loans. Whenborrowers do not make interestpayments, lenders’ returns (theinterest they receive) are reducedor wiped out completely; whenborrowers do not repay all or partof the principal, the lenders’ returnis actually negative.

All loans are subject to defaultrisk since borrowers may die, gobankrupt, or be faced with un-foreseen problems that preventpayments. Of course, default riskvaries with different people andcompanies; nevertheless, no one is free from risk of default.

While investors/lenders acceptthis risk when they loan funds, theyprefer to reduce the risk. As a result,many borrowers are compelled tosecure their loans; meaning, theygive the lender some assurancesagainst default. Frequently, theseassurances are in the form of collat-eral, some physical object the lendercan possess and then sell in theevent of default. For automobile

loans, for example, the car usuallyserves as collateral. Other assurancescould include a cosigner, anotherperson willing to make payment if the original borrower defaults.Generally speaking, because securedloans are comparatively less risky,they carry a lower interest rate thanunsecured loans.

As a borrower, the federalgovernment offers firm assurancesagainst default. As a result of thepower to tax and authority to coinmoney, payments of principal andinterest on loans made to (or secu-rities purchased from) the U.S.government are, for all practicalpurposes, never in doubt, makingU.S. government securities virtuallydefault-risk free. Since investorstend to be risk averse and U.S.government securities are all butfree from default risk, they generallycarry a lower interest rate thansecurities from corporations.

Similarly, other types of bor-rowers represent different levels ofrisk to the lender. In each case, thelender needs to evaluate what arecommonly called “the three Cs” of character, capital, and capacity.Character represents the borrower’shistory with previous loans. Ahistory containing bankruptcies,

repossessions, consistently late or missed payments, and courtjudgments may indicate a higherrisk potential for the lender.Capital represents current financialcondition. Is the borrower currentlydebt-free, or relatively so in com-parison with assets? They mayrepresent a party with “thrifty”habits, who can take on additionaldebt without imposing an undueburden on other assets. Capacityrepresents the future ability toservice the loan, i.e., make princi-pal and interest payments. Income,job stability, regular promotions,and raises are all indicators to be considered.

Liquidity RiskIn addition to default risk, liquidityrisk affects interest rates. If a secu-rity can be quickly sold at close to its original purchase price, it ishighly liquid; meaning, it is lesscostly to convert into money thanone that cannot be sold at a priceclose to its purchase price. There-fore, it is less risky than one with awide spread between its purchaseprice and its selling price.

To illustrate, let’s say that wehave a choice between purchasingan infrequently-traded security ofan obscure company, and a broadly-

traded security of a well-knowncompany, which we know we cansell easily at a price close to ourpurchase price. If we are risk averse,we would choose the security fromthe well-known company if bothwere paying the same interest rate.

To encourage us to buy itssecurity, the obscure company mustpay a higher rate to compensate usfor the difficulty we will experienceif we want to sell.

Maturity RiskCredit transactions usually involvelending/borrowing funds for anagreed upon period of time. At theend of that time the loan is said tohave matured and must be repaid.The length of maturity is a source ofanother kind of risk—maturity risk.

Long-term securities are sub-ject to more risk than short-termsecurities because the future isuncertain and more problems canarise the longer the security isoutstanding. These greater risksusually, but not always, result inhigher rates for long-term securitiesthan for short-term securities.

To illustrate, let’s examine U.S.government securities—Treasurybills (with original maturities ofone year or less), Treasury notes(with original maturities of two toten years), and Treasury bonds(with original maturities of overten years). These securities arequite similar, except in length ofmaturity. As we have seen, U.S.government securities are virtuallydefault-risk free, and because thereis such a large and active marketfor them, they are also virtuallyliquidity-risk free.

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If default and liquidity werethe only kinds of risk in holdinggovernment securities, we wouldbe inclined to think that they allwould have the same interest rate.However, because of maturity risk,short-term Treasury bills usuallypay less (have a lower interest rate)than longer-term Treasury notesand bonds.

Different RightsRisk is not the only reason credittransactions can have different ratesof interest. As we have seen, certainassurances, such as securing loans,also affect rates. Typically, borrowerswrite these assurances into their debtsecurities specifying the rights ofboth borrower and lender. Becausethese rights differ, debt securitiestend to pay different rates of inter-est. Let’s look at some of theserights in the more common debtsecurities.

Coupon and zero-coupon bonds.Most debt securities promise torepay the amount borrowed (theprincipal) at the end of the lengthof the loan, and also pay interest atspecified times, such as every six

months, throughout the term of the loan. Some of these bonds areissued with attached coupons,which lenders can clip and send inevery six months or year to collectthe interest that is due.

Zero-coupon bonds, however,make no interest payments through-out the life of the loan. Rather thanpay interest, these bonds are soldat a price well below their statedface value. Although not usuallythought of in such terms, a savingsbond is like a zero-coupon bond in that it renders one payment atmaturity.

Even though zero-couponbonds make no interest payments,investors/lenders still need toknow the return on these bonds so they can compare it to thereturn on a coupon bond or otheralternative investment. To figurethe return, or yield, investors com-pare the difference between theirpurchase price and selling price.

Since zero-coupon bondsprovide lenders no compensationuntil the end of the loan period,borrowers issuing these bonds tendto pay a higher rate than borrowersissuing coupon bonds.

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1 Year Treasury Bill

Time to Maturity

Interest Rate

5 Year Treasury Note 15 Year Treasury Bond

% %%Maturity Risk

Convertible bonds. Some borrowerssell bonds that can be convertedinto a fixed number of shares ofcommon stock. With convertiblebonds, a lender (bondholder) canbecome a part owner (stockholder)of the company by converting thebond into the company’s stock.Because investors generally viewthis right as desirable, borrowerscan sell convertible bonds at alower interest rate than they wouldotherwise have to pay for a similarbond that was not convertible.

Call provisions. Some bonds arecallable after a specified date; thatis, the borrower has the right topay off part or all of it before thescheduled maturity date. Unlikeconvertible bonds which givecertain rights to the lenders, callprovisions give borrowers certainrights, the right to call the bond. As a result, borrowers must pay ahigher interest rate than on similarsecurities without a call provision.

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Tax Considerations

In addition to the level and kinds of risk and the different rightsgranted by different debt securities, taxes also play a significantrole in affecting rates of return.

To illustrate, let’s say you borrow $1,000 for a year at 10percent interest. At the end of the year, you pay the $1,000 principalplus $100 interest. However, if the lender is in a 25 percent taxbracket, the lender will pay $25 in taxes on that $100. Thus, the lender’s actual after-tax yield is reduced from 10 percent to7.5 percent.

Different debt securities carry different tax considerations.Corporate bonds (loans to corporations) are subject to local, state,and federal taxes. U.S. government securities are subject tofederal taxes, but exempt from local and state taxes. Municipalbonds are exempt from federal taxes, and in some states, exemptfrom local taxes.

Taking taxes into consideration, a lender will receive moreafter-tax interest income from a municipal bond paying 10 percentthan from a corporate bond paying the same rate. This specialtax-exempt status of municipal bonds enables state and localgovernments to raise funds at a relatively lower interest cost.

On the other hand, for corporations to attract lenders, theymust pay a higher rate of interest to compensate for taxes.

$1,000

Initial Investment

$1,100

$100 pre-tax return(Principal plus 10% interest

after one year)

$1,075

$75 return after taxes(At 25% tax rate)

Of course, borrowers will call(redeem) only when it is to theirbenefit. For example, when thegeneral level of interest rates falls,the borrower can call the bondspaying high rates of interest andreborrow funds at the lower rate.

As partial compensation to the lender, the borrower often hasto pay a penalty to call a bond.Naturally, a borrower will call abond only if the advantages ofdoing so outweigh the penalty. Inother words, interest rates wouldhave to fall sufficiently to compen-sate for the penalty before a bor-rower would call a bond.

Municipal bonds. Municipal bondsare debt securities issued by localand state governments. Usuallythese governmental bodies issueeither general obligation bonds orrevenue bonds.

General obligation bonds, themore common type, are issued fora wide variety of reasons, such asbuilding schools and providingsocial services. They are secured by the general taxing power of the issuing government.

Revenue bonds, on the otherhand, are issued to finance a specificproject—building a tollway, forexample. The interest and principalare paid exclusively out of thereceipts that the project generates.

Both kinds of municipal bondsare considered safe. However,because general obligation bondsare secured by the assets of theissuing government and the powerof that government to tax, they are usually considered safer thanrevenue bonds, whose paymentsmust come out of receipts of thespecific project for which the bond

is issued. As a result, general obliga-tion bonds usually pay a lower rateof interest than revenue bonds.

Efficient AllocationWith so many different interestrates and so many different factorsaffecting them, it may seem thatborrowing and lending would be hopelessly complicated and in-efficient. In reality, however, thevariety of interest rates reflects the efficiency of the market inallocating funds.

In analyzing investmentopportunities, lenders look for aninterest rate high enough to accountfor all their risks, rights, and taxes,as we have discussed. If the projectwill not pay that rate, they will lookfor other investments. For theirpart, borrowers will undertakeonly projects with returns highenough to cover at least the cost of borrowed funds.

The market, then, serves toassure that only worthwhile projectswill be funded with borrowed funds.In other words, market forces anddifferences in interest rates worktogether to foster the efficientallocation of funds.

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

The ABCs of Figuring InterestPublic Affairs DepartmentFederal Reserve Bank of Chicago230 South LaSalle St.Chicago, IL 60604http://www.frbchi.org

Controlling Interest(Reprint due summer 2000)Public Affairs DepartmentFederal Reserve Bank of Chicago230 South LaSalle St.Chicago, IL 60604http://www.frbchi.org

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Additional Readings

Federal Reserve Bank of Chicago230 South LaSalle StreetChicago, IL 60604-1413Phone: 312-322-5111Fax: 312-322-5515Web: http://www.frbchi.org October 2000 30m