Discussion

This week we are learning about interest rates and valuation models for bonds and stocks. The underlying concept is all based on the time value of money: The “value” of a financial asset is the present value of all future cash flows. That present value is based on the “appropriate discount rate”, which is the required rate of return on the financial asset.

Changes in value of financial assets, and bonds in particular, is the topic for this discussion. The US Federal Reserve Board (the Fed) has increased interest rates, specifically the federal funds rate (the rate banks charge other banks, usually for overnight loans).

Fed interest rate today 2022-present: The Fed’s latest moves in an era of soaring inflation

Rate hikes 2022-present

+75 basis points

+75 basis points

+75 basis points

+50 basis points

+25 basis points

+25 basis points

+25 basis points

+25 basis points

Source: Fed’s board of governors

As you can see from the data above, interest rates increased by 5% between March 2022 and July 2023. With these changes, there was a ripple effect felt across the economy. The value of bond portfolios held by banks as well as individual investors dropped, the “cost” of borrowing money increased across the board from car loans to mortgage loans as well as business loans.

For your discussion this week, I’d like for you to pick a sector or topic and discuss the impact of the interest rate increases. Below are examples of directions you could take:

Personally(Never put personal info in the post that you are uncomfortable with!! Speak in generalities if you prefer, the point is to apply the interest rate change impacts to your post.

How have the interest rate changes impacted on your purchase decisions – maybe it is to delay a major purchase (car or house maybe).

What about the buy vs. rent decision? There have been articles on how the relative economics have changed recently.

Have you modified investment allocations in your portfolio or IRA/401K investments?

Banking sector:

Pick a bank that has failed or was purchased by another bank because of problems with their bond portfolio or similar situation. What was the underlying problem at the bank? What was the outcome? Yes, a deeper discussion of SVB is acceptable here as long as you cite an additional outside credible source. The number of troubled banks is limited.

Corporate sector:

Pick a company that may have had to change their plans on raising funds because of required higher coupon rates. Maybe the company has experienced changes in its sales because consumers are holding off on spending.

Maybe discuss a firm that has had a hard time getting loans because of high rates.

There are a lot of different directions you can go with your post, but no matter what you choose (even personal) you MUST have at least one credible outside source (remember that Investopedia and Wikipedia are not considered reliable). As with any discussion, be sure to reread the grading rubric before posting.

Bottom line:

What aspect are you discussing? What changed, and why? How did decisions or outcomes change from what would have been expected without the interest rate increases? The “so what” is where I’m looking for. Go beyond “interest rates went up, bond prices went down”.

How the Fed’s rate hikes spelled trouble for banks like SVB

From Marketplace (NPR)
How the Fed’s rate hikes spelled trouble for banks like SVB
Sabri Ben-Achour, Mar 21, 2023
Note from Dr. Kendall: This article provides a simple explanation to how bond prices are impacted by
interest rate changes.
You know, at the root of all this banking turmoil — the runs on banks, the collapse, the potential
reworking of how bank insurance works, the political fighting — is one seemingly simple economic
phenomenon: When interest rates go up, bond values go down. That’s what’s got a bunch of these banks
into trouble.
But why is that? What does the Federal Reserve raising interest rates have to do with the value of bonds
sitting in bank vaults?
OK, let’s say you buy a bond. And you know it’s a bond, so it gives you payments; they’re called coupons.
Say you pay $1,000 for a 10-year bond, where you get paid 5%. These payments are locked in; they’re
part of the bond. No matter what, you get $50 a year.
But then, something happens. The Fed raises interest rates, and that pushes up interest rates all over the
economy — including for new bonds, the ones printed just today.
Let’s say these new bonds give you 10% now, or $100 a year. How do you feel about that old bond giving
you just 5%? You’d rather have a better bond and you might just sell the original.
But here is the problem: “The price of the bond is determined by what other people are willing to pay,”
said Eric Winograd, U.S. economist at AllianceBernstein.
You might have paid $1,000 for it to get $50 a year. But who’s going to give you what you paid for it when
there are better alternatives? Nobody, that’s who.
“So the price of your 5% bond has to go down,” said Steve Laipply, who coheads bond ETFs for Blackrock.
Now, your bond is still gonna crank out those $50 payments every year come hell or high water.
“The cash flows can’t change, but the price can,” Laipply said.
You can choose to hold on to your bond, collect that low yield and receive the principal back at maturity.
But if you need to sell that bond in midstream, and someone buys your bond for less than its original
value, you’re going to take a loss. That’s what happened to the banks that were forced to sell to cover
withdrawals.
But for the buyer, it’s just as if the bond had a higher return for them. They buy it for half price, but
they’re still getting the same $50 payouts. For them, the return is just as good as a new bond.
So, that is why bond prices fall when interest rates go up: When interest rates rise on new bonds, the
older lower yield bonds have to compensate by getting cheaper.
“And that’s what we saw all throughout all of last year,” said Marvin Loh, a senior strategist at State
Street Global Markets. “Bond prices went down as interest rates were rising.”
And that’s where the banks got in trouble. They had invested in bonds, the value went down, some of
them hadn’t covered their risk as banks usually do, and we got the mess we’re in now.