Investing 101

**Tldr:**

- Interest is the extra amount of money a borrower has to pay on top of the loaned amount
- Interest rate is the rate of interest paid over the borrowed amount
- Interest rates can be thought of as “the cost of borrowing” 
- Entire economies are affected by changes in interest rates 

The talk of the town…a topic that once would have resulted in you being a loner now seems to be on the tip of every investor’s tongue. So what are interest rates?

Rates is a broad term that encompassess a lot of instruments that have to do with paying interest.

**Types of interest-rate based securities**

The three main categories of rates-based products include Government Bonds, Interest Rates Swaps and Corporate Bonds.

Whilst conceptually different, these types of securities have one key point in common: one party agrees to borrow money for X time and give it back at the end, whilst paying interest in between.

So at the end of the day all rates products are similar to borrowing a personal loan from the bank, paying interest and then giving them back the amount borrowed.

**How does interest work**

The key metric for these products is the interest rate, which can be thought of as the “cost of borrowing,” aka, the amount you would have to pay on top of the amount you want to borrow.

For example, if you wanted to borrow $100 and the interest rate was 5%, you would have to pay back $105. As the borrower, the interest rate is the cost of debt and for the lender, it’s their rate of return. The lender requires compensation for lending money because they are losing out on investing that money somewhere else (opportunity cost). 

On a larger scale, companies need to borrow money from banks to fund projects and hence, interest rates determine how much the company can afford to borrow. As market interest rates increase, it becomes more expensive to borrow money. As a result, it becomes tougher for firms to borrow money and build those projects which accelerate their value.

 Without growth, profits are falling which is causing the market value of companies to fall too. The opposite is true too (as you may have noticed post March 2020). With interest rates at almost zero, the market saw a boom in growth as it became very cheap to borrow money, hence allowing the economy to easily grow. 

Another catalyst for lowering stock prices when interest rates rise is the increase in demand for fixed income instruments like bonds (because of their less risky nature), which lowers the demand for stocks. 

**Setting interest rates and fighting inflation**

So how are interest rates determined? The central bank (in the US’ case, the Federal Reserve) sets interest rates by taking into account the state of the economy. It is one of the tools used by the government to control people’s spending/saving habits, growth of the economy and overall inflation. 

To combat inflation, the FED might increase the reserve requirement for banks which limits the amount of money that can be loaned out and increases the demand for credit. When interest rates are high, people would rather grow their money by saving compared to when interest rates are low, stocks promise better returns than the savings rate (helping boost the economy). 

While everyone prefers lower interest rates, this leads to a disequilibrium as demand exceeds supply, and causes inflation. Coupled with a pandemic, this leads to further hiccups in the global supply chain, affecting the entire economy. 


Interest is the extra amount of money a borrower has to pay on top of the loaned amount.

Interest Rates

Bonds and Fixed Income

**Bonds - Corporate & Government (treasury) & Municipal**

Bonds vary in maturity and risk. 

Corporate bonds encompass investment grade bonds with a rating between AAA to BBB. Compared to government bonds, corporate bonds carry additional risk and hence, additional return to compensate the investor for taking on that risk. These kinds of bonds are issued by large corporations and maintain a level of safety but still provide higher returns than government bonds. 

Shorter term bonds like Treasury notes are government bonds with lower yields because of their lower interest rate risk and higher liquidity. Longer duration bonds like Treasury bills are exposed to more interest rates move and hence more interest rate risk. However, interest rates on government bonds are expected to decrease as the economy weakens so there may be too little income to be gained here. 

Municipal bonds are issued by branches of the government - a city, state or government agency. These bonds are usually tax-free and investors buy them for their tax benefits. However, the market is dominated by small investors which makes the municipal bonds market not as efficient as other bond markets. 

**Fixed income ETFs or Mutual Funds**

By investing in bond ETFs and mutual funds, the investor does not have to choose a single government or corporate bond. By purchasing ETFs and mutual funds, investors skip paying premiums and even get a discount for buying a large number of bonds. The Vanguard Long-Term Bond ETF provides investors with broad exposure, potentially higher returns and lesser risk. 

**High-yield bonds**

A high-yield bond is described by its higher yield and higher risk than a normal fixed-income bond. It’s also known as a junk bond because its credit rating classifies it as non-investment grade. Investors purchase this asset to gain a competitive expected rate of return, similar to investing in the equity market but with lesser volatility. However, these bonds come with a high default risk as they are issued by companies with high debt ratios. Sometimes these bonds may just be from companies which lost good credit ratings due to previous defaults. 

**Preferred Stock (kinda)**

Preferred stock contains characteristics that would classify it as both an equity and fixed income security. On top of that, preferred stocks are impacted by changes in interest rates. For example, when interest rates fall, the value of preferred stock increases and continues to provide dividend payments, almost in a coupon payment form. Preferred stock is also issued by larger-scale companies like insurance companies and banks - so they carry more guarantee of performance than buying common stock in a small capitalization asset. 



Types of Fixed Income Instruments

Interest Rates