The Yield Battlefield

Matt Ford  Jun 04, 2009 12:20 pm

The Yield Battlefield
 
Rising interest rates are not necessarily due to inflationary phenomena.
 

 

You're begging me to go
You're making me stay
Why do you hurt me so bad?
--Pat Benatar


Why do interest rates rise? A commonly offered answer relates to heightened inflation expectations. If lenders perceive that the future purchasing power of a currency will decline, then they will demand higher yields to compensate for the reduced purchasing power of the capital returned to them down the road.

But other factors could drive rates higher as well.

One relates to general lending capacity. Previous investment activities may find creditors carrying close to a full book of risky assets. Additional capital for lending purposes may be scarce. Moreover, the leverage employed by Institutions such as Bank of America (BAC), Citigroup (C), and Morgan Stanley (MS) requires tighter risk management to ensure adequate reserves. As such, lenders may raise the price (interest rate) of their lending capital to compensate for increased balance sheet risk.

Another factor is creditworthiness of the borrower. Lenders will demand more premium if they perceive that borrowers carry more risk of default. Think junk bonds.

While higher interest rates are often perceived as tied to inflation, the latter two factors noted above are more closely linked to deflationary contexts. They serve as a drag on debt creation.

In a debt-laden world, make sure you see both sides of the trade when you spy interest rates heading higher.

19 of 20 (95%) found this helpful
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Comments (3) See All Comments »
06-04-2009, 12:40 pm
really interesting; had never thought of this like that

thank you matt!
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06-04-2009, 12:49 pm
Screw me once, shame on me. Screw me twice, it's the price of the first one. Welcome to an unstatble deflationary world where you pay once and then again and again.Let's hope we can derive some value form investment grade corporate bonds
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06-04-2009, 12:50 pm
Indeed.

I tried to posit the same last week. Most responses were of the "you can't have it both ways" variety. "Rising AND falling rates cannot signify deflation." "You're cherrypicking.&qu
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