Part 3:  Risk Free rates and the Price of Investments, The Yield Curve, The Fed, Inflation and Matching Investments

By Bob Peters || December 1, 2022

What I hope you take away from this blog post

-The price of Fixed Income investments decreases as interest rates paid by the US Government increases.

-The borrower is contractually obligated to make fixed payments on a fixed rate loan but the investor of that loan can lose principal if interest rates increase and the investor needs to sell.

-Matching the investment with the goal is important to avoid selling investments at a loss.

-The yield curve represents the cost of borrowing between 1 month and 30 years.

-The Federal Reserve has only two jobs:  maximizing employment and maintaining price stability.

-The Fed fights high inflation by raising short term interest rates (Fed Funds) making it more expensive to borrow.

-Some investing options for short, intermediate and long-term goals for your consideration.

As the Risk-Free Rate increases, the value of all other assets decreases…the opposite is also true

The US Government borrows between 1 month and 30 years.  Of all the different maturities between 1 month and 30 years used to determine the risk-free rate for the purpose of measuring the relative value of equity investments is the 10-year Treasury Bond.

The value of an investment like a stock or bond is the future value of all cash flows from that business or debt obligation.  In the case of a bond, it is all future principal and interest payments until maturity (ie. 30 years of mortgage payments). In the case of a share of a business (stock), it is an estimate of all future cash distributions received for as long as that business will be in existence.  In both cases you discount these future cash payments by a rate higher than the then current risk-free rate.

So, in simple terms, as the US government needs to pay investors more, the discount rate for all other assets needs to go higher.  As the risk-free rate increases, the value of all other assets decreases…the opposite is also true.  Bill Ackman does a nice job of illustrating this concept in the Assessing Risk section (13:05-14:50) of the Big Think, Everything You Need to Know About Finance and Investing in Under an Hour video.

Here is the important concept utilizing our bond example.  I’m going to use an example of a 7-year, interest only loan where each month the borrower would pay the rate of interest with no additional amount going towards reducing the principal balance of the loan.  It’s a simple way to show how an investor buying a bond can “lose” a portion of their investment when the risk-free rate increases.  In most cases you (as a borrower) will want to obtain a loan that requires periodic principal payments but more on that later.  On to our example.

If you get a fixed rate 7-year interest only loan, the monthly payments you will make do not change over 7 years because the interest rate you will have negotiated is a fixed rate of interest.  You know with 100% certainty the monthly payment.  The day you borrow the money, an investor was willing give you that loan in exchange for your agreement to pay 84 monthly payments of interest including the entire principal balance on the maturity date.  Everyone is happy.

Now, fast forward a year and the interest rate on 6 year US Government debt has risen by 1% (100 basis points).  A second investor approaches the first investor willing to buy your loan so she would be entitled to receive the remaining 6 years of your fixed monthly payments. The second investor balks at paying what the original investor paid (recall, the first investor “paid” the full loan amount you borrowed).  Why?  Because 6 years of your fixed monthly future payments needs to be discounted at a higher rate.  Why?  Because the discount rate used for all investments must be a premium to the current risk-free rate.   If the US Government pays more for borrowing, every other investment should pay investors a higher return.  We know in this example that there is 100 percent certainty in the amount of future cash payments so the only way for the second investor to earn a higher rate of return is to pay the first investor less money for the loan.

Let’s put some numbers together to illustrate…Sam the Borrower, Jill the initial Lender/Investor and Ian the second Investor of Sam’s loan

-Sam borrows $30,000 from Jill.

-Jill is an investor looking to earn a fixed rate of return and agrees to lend Sam $30,000 with an interest rate of 5%.  Sam will pay Jill $125 per month ($30,000 multiplied by .05 equals $1,500 per year in interest divided by 12 months per year equals $125 per month).

-The day that Jill lends Sam the money, investors can buy the US Government bonds with 7 years until maturity (the risk-free rate) and receive an interest rate of 3.5% (remember that there is always a premium expected to be earned over the risk-free rate.  In this case, Jill is receiving a 1.5% (150 basis points) premium over the risk-free rate.

-The duration of Jill’s investment in Sam’s loan is 7 years.

Date:  January 1, 2023 (one year later)

-Jill’s circumstances changed and she now would like to sell Sam’s $30,000 loan to a raise cash for other purposes.  Remember, when Jill made the loan to Sam she became the investor in Sam’s loan.

-Enter Ian our second investor.  Ian would like to buy a 6 year fixed income debt security and believes Sam will pay his loan on time each month.  Ian wants to make Jill an offer to buy Sam’s loan.  At the time Ian makes Jill the offer to purchase the loan the cost that the US Government is paying on its debt obligations that mature in 6 years has risen to 4.5% over this past year.  Ian would like a 1.5% premium over the risk-free rate but Sam is contractually obligated to make payments of $125 representing a 5% interest rate.

-The only solution to provide Ian with a 6% yield (1.5% premium above the then current 4.5% risk free rate) on a loan that pays 5% is for Jill to sell the $30,000 loan to Ian for an amount less than $30,000.  How much less?  Answer:  The amount necessary to provide a 6% return to give Ian the 1.5% premium over the risk-free rate he desires.  The exact amount is $25,000 and can be determined with a little algebra or the use of a calculator.  Hint:  Sam pays $1,500/year in interest for a total remaining interest to be paid over the remaining six years of $9,000.  Ian is looking for a return of 6%.  Ian takes $9,000 and divides it by .36 (the sum of his desired 6% yield, or .06, multiplied by the number of years, 6, Ian will receive interest payments) to calculate $25,000 in principal…the amount he is willing to pay for Ian’s contractual stream of $125 monthly payments.

In this scenario, Jill would lose $5,000 on her bond investment, excluding the $1,500 she earned in interest the first year.  Here is a takeaway:  If Jill held onto to Sam’s loan for the full 7 year original term she would have received a 5% return and 100% of her principal. Instead, she realized a $5,000 loss because she needed the cash for other purposes.  We suspect that Jill confused short term vs. intermediate term buckets.  In retrospect, Jill should have invested her $30,000 in a shorter term investment like the Vanguard Cash Reserves Federal Money Market Fund ticker: VMRXX or Fidelity Government Cash Reserves ticker:  FDRXX.

Interest Rates…the Yield Curve

The US Government issues (aka sells via regular auctions) debt instruments to investors to fund the operations of the government.  As mentioned earlier, the term of these instruments generally ranges from 1 month to 30 years which is referred to as the yield curve.  For many years, notwithstanding that Congress has taxing authority, the amount that the government spends exceeds the tax revenues it receives from tax payers.  This “deficit” is paid for by the government issuing debt obligations in the form of Treasury Bills, Treasury Notes and Treasury Bonds.  If you and I tried to do this we would be bankrupt so one big takeaway…don’t spend more than you earn.

You may ask why, if the US Government has taxing authority, would we have deficit spending.  It’s because our elected officials have chosen not to cover the cost of our spending by raising taxes, or cut spending, and instead borrow the difference between taxes received and our total spending.

Treasury Bills are debt instruments that mature within one year, Treasury Notes mature between 2-10 years and Treasury Bonds mature in 10, 20 or 30 years.  You and I can own any one of these instruments directly or, thru a pooling of many individual Bills, Notes and Bonds in an Exchange Traded Fund or Mutual Fund.  In addition to the government, consumers and businesses borrow and these loans are owned by a financial institution (i.e a bank or credit union) or sold to individual and institutional (retirement, pension, corporate) investors.  There is one more very important debt instrument called Fed Funds which you and I can’t buy.

Federal Reserve and Fed Funds

US Banks are regulated by the Federal Reserve Bank (the Fed) which is an independent entity authorized by Congress with only two mandates:  To achieve maximum employment (the lowest unemployment rate possible) AND maintain price stability (stable and low inflation).  Two tools that the Federal Reserve uses to meet this dual mandate are; 1) adding money supply (or reducing money supply) and 2) dictating the rate of interest on Fed Funds.  An analogy for the money supply is like air in a balloon.  When the Federal Reserve feels that the economy needs stimulas to create more jobs, it can add to the amount of money into the economy just like adding air inside of a balloon.  Conversely, when the Federal Reserve feels that the economy is too hot causing inflation, they can reduce the amount of money in the economy just like letting air of the balloon.  How the Federal Reserve does this is interesting but a level of detail not necessary at this time.

The Federal Reserve pays banks the Fed Funds rate on each banks’ reserves that are deposited with the Federal Reserve.  We don’t need to go into more of the detail but suffice it to say that the Fed Funds rate determines the lowest rate for the shortest borrowing that has the backing of the US Government.  As such the price of Treasury Bills, the next shortest US Government debt obligation, is very highly correlated with the Fed Funds rate.

When the Federal Reserve raises the Fed Funds rate it becomes more expensive for consumers and businesses to borrow money so the demand for loans declines.  Also, the profitability of your employer declines as their interest costs rise along with the cost of short-term borrowings.  When employers make less money, they will look at freezing new hiring and implementing layoffs.  By raising the Fed Funds rate, the Federal Reserve is essentially trying to slow economic activity.  There is only one reason why the Federal Reserve would want to slow economic activity: a concern that there is no longer price stability.  Said another way, the Fed would raise the Fed Funds rate if they felt that the rate of inflation was higher than it should be.

Letting air out of the balloon

Today is a perfect example.  The Federal Reserve has set a target of 2% for the rate of inflation.  While the rate of inflation can be above or below 2% for short periods of time, the Fed will manage the Fed Funds rate up (in the case of above target inflation) or down (in the case of below target inflation).  Because of heightened inflation that was not short term in nature, the Fed has been raising rates frequently and aggressively.  Just this year the Fed Funds rate has increased from .08% to 3.83% thru November 30 and the market expectation is for rates to increase by another .5-.75% by the end of the year.

What does this mean for you?

-Inflation is bad as it essentially is a tax on consumers through higher prices of goods and services.

-To cause inflation to come back down the Federal Reserve will be increasing the Fed Funds rate until consumer demand for products and services declines.  That is the painful part.

-Businesses make less money when the cost of borrowed money goes up.  As business profits decline, businesses cut back on expenses including hiring new employees.  As employees lose their jobs they feel less wealthy and cut back spending.  This results in reduced demand for products and services offered by businesses.  When demand for services declines the rate of inflation is reduced.  Consumers that borrow money where the interest rate is variable such as a credit card or adjustable rate mortgage have less discretionary money to spend.

-The increase in Fed Funds rate may lead to a recession (defined as 2 consecutive quarters of negative Gross Domestic Product).

-One thing to be mindful about: Recessions often result in businesses that cut back hiring and/or layoff workers.  This might be a time to think about how secure your employment is and what you might do to increase your value to your employer. 

A few considerations for matching the appropriate investment with the time horizon

I’ve listed specific investments options here but, you will need to determine if these funds are appropriate based on your own circumstances. 

• Basic Needs and other purchases you anticipate for the next 1-3 months (Cash in a bank account)
• Expenses such as short-term savings goals that you expect to incur from 3-36 months (Money Market Funds like Vanguard Cash Reserves Federal Money Market Fund ticker: VMRXX or Fidelity Government Cash Reserves ticker: FDRXX).
• Expenses associated with intermediate term goals you expect to incur between 36-60 months (an intermediate term bond fund like Vanguard Intermediate-Term Investment Grade Fund ticker: VFIDX).
• Longer term investments that are 5+ years in the future…saving for a child’s education, a vacation home, a big purchase or when you desire to pursue a phase of life where earning income is not necessary. Some folks may call this “phase” retirement but it can be pursuing volunteerism, lower compensated employment to satisfy your passion, etc. The point here is that longer term investments don’t go up every week, month or year.  There are periods of time where the current market value is much less than what it was last week, month or year.  Over a longer period of time (5+ years) a diversified portfolio of these assets is likely to grow.  I would suggest you look at the Vanguard Total Stock Market Index Fund: (ticker VTI) but note that the current value of this can drop 20, 30, 40% over any given year but…over the long term, you will have a high likelihood of achieving 8-10% annualized return.  The key is to keep investing regularly.
• Here is a big takeaway: Even though long-term goals are matched with long term investments it’s soooo important to start saving and investing early in life.  The more you can fund your long-term bucket early in life, the less you will need to fund later!  The power of compounding interest can be found at 21:35-24:52 of the Big Think, Everything You Need to Know About Finance and Investing in Under an Hour video. It requires deferred gratification to do this but you will have a much better chance of achieving Financial Security.

You can do this!

Match your savings and investments with your short, intermediate and long-term needs.  You can do this.  You don’t need (or, I would suggest, want) to pick individual stocks.  The key is to start early, regularly invest, match your investments with the time horizon of your needs and push back against your biases that may cause you to make poor financial decisions.  You really can do this!