General

How are interest rates set?

There are a number of factors that determine interest rates.

Interest rates can be influenced by the supply and demand for loans and credit, and are often lowered or increased on a short-term basis by central banks in an effort to stabilise economies. This, in turn, can have an impact on a wide range of areas including mortgages, borrowing, pensions and savings.

Central banks set short-term target interest rates that will directly impact what interest you earn when you save or are charged when you borrow. In the UK, the most important interest rate is the base rate which is set by the Bank of England’s monetary policy committee, which aims to keep inflation low and steady.

Central banks usually increase interest rates to raise the cost of borrowing and slow down economic activity and inflation. They will cut interest rates to achieve the opposite and stimulate growth.

While very short-term interest rates are set or heavily influenced by central banks, interest rate levels for longer maturities (e.g. 5 years or 10 years) fluctuate constantly to reflect supply and demand dynamics and, most importantly, expectations of central banks’ future decisions and growth and inflation outlook. The shorter the maturity, the more important central banks’ actions are in explaining interest rates. The longer, the more important other factors such as economic growth and inflation become.

What are central banks and what do they do?

A central bank is a financial institution responsible for managing a country or group of countries’ monetary policy. Central banks also oversee the monetary system through supervisory and regulatory powers and ensure financial stability. In most developed countries, they are independent from the government to prevent political interference.

The Bank of England is the UK’s central bank while in the USA, it is the US Federal Reserve, also known as the Fed. One of the key features of a central bank, which distinguishes it from other banks, is its legal monopoly status on issuing coins and banknotes, allowing it to increase the monetary supply.

Central banks’ primary goal is to maintain price stability by targeting a specific level of inflation over the medium term (2% in most developed countries). Sometimes, central banks also have a goal to maximise employment and act as a lender of last resort to distressed banks or financial institutions.

Central banks have three monetary policy tools to achieve these goals.

Firstly, they can increase or decrease short-term interest rates to either slow down or stimulate economic activity by making borrowing more or less expensive. When inflation is caused by excess demand, this tool can be effective at bringing inflation levels lower.

Secondly, they control money supply by buying and selling various financial instruments such as government and corporate bonds or foreign currencies. For example, an expansionary or ‘supportive’ policy means a central bank increases the amount of money in circulation by purchasing government debt – this is also known as ‘quantitative easing’.

Finally, they set reserve requirements, which stipulate how much money commercial banks need to have available for immediate withdrawal. Lowering the reserve requirements frees up some funds and allows banks to increase lending, which in turn should support economic activity.

What are equities?

To hold equities – through either the purchase or transfer of shares – is to own part of a company.

In return for increased financial performance by the company, the investor will receive a return or profit: either in the form of dividends, usually paid at set periods dependent on company performance, or via an increase in the share price.

Equities offer the potential for significant returns if the company exceeds the market’s expectations, but the value of shares can fall. Therefore, investment in stocks and shares requires an acceptance of investment risk.

Investment can be made in publicly listed companies or private companies. A publicly listed company is listed on a stock exchange.

A public company's market value, or market cap, is determined by multiplying a company’s number of existing shares by the value of a share i.e., a company that trades at £15 per share and has 1 million shares has a market value of £15,000,000.

What are ‘Gilts’?

A gilt or ‘gilt-edged security’ is a government bond. In the UK they are issued by HM Treasury and listed on the London Stock Exchange. The term gilt is also issued in India and other Commonwealth countries.

Typically, they have a very low risk of default and a corresponding low rate of return. This is because the British Government has never failed to make interest or principal payments on gilts as they fall due. Their name comes from the original certificates issued by the British government which had gilded edges.

The gilt market is comprised of two different types of securities – conventional gilts and index-linked gilts.

Conventional gilts are the simplest form of government bond. These types of gilts promise to pay a fixed coupon rate at set time intervals, such as every six months, until the maturity rate, at which point the holder receives the final coupon payment and the return of the principal. Conventional gilts represent the majority of government debt and about 75% of the gilt portfolio.

Index-linked gilts (IGs) represent bonds with borrowing rates and principal payments linked to changes in the inflation rate. This means that both the coupons and the principal paid on redemption of these gilts are adjusted to take account of accrued inflation since the gilt was first issued. They differ from conventional gilts in that the semi-annual coupon payments and the principal are adjusted in line with the UK Retail Prices Index (RPI). They form around 25% of the gilt portfolio.

Due to their low risk, gilt-edged bonds have yields that are well below those offered by more speculative bonds. As such, they are given a top rating by credit rating services such as Standard & Poor's and Moody's and often used by conservative investors whose top priority is capital preservation.

What are interest rates?

An interest rate tells you how high the cost of borrowing is or how high the rewards are for saving.

It is the amount a lender charges a borrower and is a percentage of the amount loaned. A borrower that is considered low risk by the lender may have a lower interest rate, while a borrower that is considered high risk may have a to pay a higher interest rate on the loan.

The interest rate on a loan is typically noted on an annual basis, known as the annual percentage rate (APR). The higher the percentage, the more the borrower must pay back for a loan of a given size.

If you’re a saver, the savings rate tells you how much money will be paid into your account, as a percentage of your savings. The higher the savings rate, the more will be paid into your account for a given sized deposit over a specific period of time.

The interest rate charged by banks is determined by several factors. In the UK, the Bank of England sets a ‘base rate’, and each bank uses it to determine the APR range they offer. When the central bank sets base interest rates at a high level the cost of debt rises. When the cost of debt is high, it discourages people from borrowing and can slow consumer demand. Interest rates can often rise in response to economic growth and inflation.

What are ‘Treasuries’?

Treasury securities, also known as Treasuries, are government bonds issued by the United States Treasury Department.

As they are backed by the credit of the US government and have the highest credit rating (AAA) of all debt securities, Treasuries are considered low risk. However, they can be impacted by inflation and changes in interest rates. They make twice yearly interest payments and are considered liquid, which means they can be converted easily into cash.

Treasuries are divided into three categories based on maturity date, Treasury Bills, Treasury Notes and Treasury Bonds.

Treasury bills (T-bills) mature in one year or less and do not pay a coupon rate so are known as zero-coupon bonds. Income is generated by issuing the bond at a discounted price compared to its face value, or par value.

Treasury notes (T-notes) on the other hand, mature in 2, 3, 5, 7, or 10 years and make coupon payments twice a year, either at a fixed or floating rate. The 10-year Treasury is the most notable Treasury as it is used when calculating the slope of the yield curve.

Treasury bonds (T-bonds) are the longest-term bonds and mature in 20 or 30 years. These typically offer the highest coupon payments but since bond prices are inversely linked to interest rates, these are also the most volatile Treasury.

Another type of Treasury is Treasury Inflation-Protected Securities (TIPS) which are indexed to the rate of inflation on a daily basis as measured by the Consumer Price Index (CPI). During periods of high inflation, the price of these bonds climbs, though subsequently the price falls when there is deflation. As with other Treasuries, TIPS also offer a coupon.

What does the Bank of England do?

The Bank of England (BoE) is the central bank of the United Kingdom. The BoE has several functions:

overseeing monetary policy
issuing currency and supervising payment services
regulating UK banks and other financial firms
maintaining a resilient UK financial system.

The BoE was initially founded in 1694 as a private bank to raise funds for the government. It began issuing bank notes in England and Wales in 1844 and was nationalised in 1946 following World War II. In 1997, the government transferred its authority over to the BoE’s Monetary Policy Committee (MPC) which then became responsible for setting the UK’s benchmark interest rate.

Today, the bank’s main objective is to manage the state of the economy and maintain price stability. It does this through its MPC, which has a primary mandate of keeping the annual inflation rate at 2% (as at January 2023). This 2% level is determined by the UK Government, but the BoE is independent in its decision making.

The MPC manages inflation by setting the core interest rate at which it lends to the banks, and by buying (or selling) assets. This process is called monetary policy.

The MPC convenes eight times a year to set rates. After a series of preliminary meetings, the committee's nine members vote on whether to increase, reduce or hold interest rates.

Increasing interest rates, also known as tightening monetary policy, is designed to reduce inflation by making borrowing more expensive, giving people less money to spend and therefore lowering demand. Antithetically, if the Bank cuts rates, also referred to as loosening or easing policy, borrowing becomes cheaper and people may be inclined to spend more, which in turn boosts the economy but can push prices up.

The Bank can also provide economic stimulus through asset purchases. This policy is known as quantitative easing (QE). Here the Bank purchases government bonds and other securities on the open market, providing banks with more liquidity, which further lowers interest rates and enables them to lend with easier terms.

What is a bond

Bonds are loans that can be bought and sold by investors. It’s important to note that a bond and a bond fund are two totally different investment vehicles - the focus here is on investment in a single bond. For an investor, a bond should be viewed as a loan, either to a government or a company.

In very plain terms, the borrower offers the investor an IOU, with the promise of repayment in full of the original loan after an agreed fixed period, called the maturity date, as well as periodic interest payments over the life of the bond.

Bonds are mainly split into two types: corporate bonds – issued by companies – and government bonds, for example, ‘gilts’ in the UK or US ‘treasuries’, which are long term investments, or US ‘T-bills’, which are short-term investment bonds issued for a year or less.

Governments across the globe issue bonds, with government bonds often referred to as sovereign bonds.

Bonds usually pay interest returns, also known as coupon rates, every six months or semi-annually.

So, an example of a coupon rate payment would be, where there is an expected annual coupon rate payment of 10% on the original investment, 5% of that annual rate would be received semi-annually.

Government bonds can be issued in their domestic currency or in a foreign currency. Government bonds issued in the domestic currency are less risky than corporate bonds. This is primarily because a country is very unlikely to default. A country’s government can more easily raise money through other borrowing sources or through taxation, but can also print money to pay debt obligations in their domestic currency.

Corporates however, can be at a higher risk of defaulting on paying investors coupons, or repaying investors original loans, because of potential market risk which could – for example – lead to a company becoming bankrupt.

For an investor this is called the default risk.

It’s therefore vital that corporate bond investors check the credit rating of a company before making their investment, via credit rating agencies such as Standard & Poor’s (S&P): Moody’s Investor Services (Moody’s) or Fitch IBCA (Fitch), as well as undertaking further company research.

The benefit of investing in corporate bonds is, generally, the higher coupon rate received due to a higher default risk than that associated with domestic currency government bonds.

What is a bond yield?

Bond yield is the return on capital you receive when you invest in a bond. The yield depends on both the price of the bond and the interest coupon paid on the bond.

However, the value of a bond – which is often referred to as the face value of the bond – can rise or fall dependent on market or economic conditions.

It’s important to note that the higher the value of a bond the lower the yield and vice-versa: bond yields are determined by dividing the coupon by the bond’s market price. Therefore, as a bond price increases, its yield falls.

Here is a straightforward example of how this works:

Taking a £1,000 bond investment with a 10 per cent yield (£100), let’s look at a scenario where the bond price has fallen to £950. If the bond sells today at £950 it is selling at a discount.

Therefore, the current yield is £100 divided by £950 = 0.105. As a percentage this would be 10.5 per cent.

Should the price of the bond increase to £1,050, the current yield becomes £100 divided by £1,050 = 0.095. Which as a percentage would be 9.5 percent.