Interest is the cost of borrowing money. It is often expressed as a percentage of the amount borrowed —this is the interest rate. As a lender of money, you receive interest as payment for providing the funds and taking on the risk of lending. As a borrower, you pay interest.
[Alex 00:00] Everyone knows interest rates. Let's make sure everyone understands interest rates. So to start, the first question I’ve got here is, what is interest and, by extension, interest rates?
[Michael 00:13] Good question. I mean, put simply interest is the cost of borrowing money. It's as simple as that. This is the same for people and businesses alike. It's commonly expressed as a percentage of the amount borrowed. This is the interest rate. When you are the lender of money, you receive the interest as payment for providing funds and taking on the risk of lending money out. An example of this is the return you receive when you invest in things like bonds, and GICs.
[Alex 00:42] So the other side of that, and when you're the borrower of money, so you're the one paying the interest. So think of the situation with mortgages, car loans and lines of credit. The interest rate is defined in the terms of the loan and is typically impacted by a variety of factors, the main three being: one, interest rate environment. In Canada, the Bank of Canada sets its overnight target rate to achieve sustainable inflation and employment targets. Generally, when this overnight target rate is higher, so too are interest rates.
[Michael 01:10] Next is the credit worthiness of the borrower. So the higher the risk of default or the lower the credit worthiness of the borrower, the lender needs to be compensated more through higher rates to take on the additional risk. Makes sense. The prime lending rate is the rate at which banks lend to their most creditworthy customers — think large companies.
[Alex 01:30] And thirdly is the term or the length of a loan. Generally speaking, the longer the loan, the more risk is assumed by the lender, there's more time for the borrower to default, and the greater the opportunity costs.
[Michael 01:40] That's great. From an investment management standpoint, what are we talking about when we're discussing interest rates?
[Alex 01:46] Mike, in the MD Market Watch blog and podcast, we regularly provide analysis on central bank interest rate policy in Canada, the target for the overnight rate and the U.S., the federal funds rate. And so why do we do this? Well, central banks use interest rates as a monetary policy tool to influence their respective economies. So generally, central banks will lower rates and increase money supply when the economy is struggling, and needs a little bit of support. And lower rates means cheaper money for people and businesses, stimulates borrowing, spending and investment, to hopefully kickstart a struggling economy. I think a great example of this was at the beginning of the pandemic, when central banks all around the world cut rates to emergency levels, to basically support the global economy.
[Michael 02:29] And of course, the other side of that is central banks will increase rates and reduce money supply when the economy is overheating, and needs to cool off. Higher rates means money is more expensive, lowering world demand. And a recent example of this is 2022 actually, when central banks around the world started to abandon emergency level rates brought about by the pandemic and started raising rates to combat elevated inflation. So when investing it's important to have an understanding of the interest rate environment, where rates are now and future expectations for those rates because it has a material impact on businesses one might invest in. Before we wrap up today's topic, let's explore the relationship between interest rates and bonds. Interest rates and bond prices share an inverse relationship, meaning when interest rates go up, bond prices go down, and vice versa. Why is this the case? It's simply a case of relative value. Take a $1,000 bond that pays 5% interest per year, for example. This bond will pay you $50 per year. Now let's assume interest rates move up and a new $1,000 bond now pays 10%, or $100 per year. As a result, no one will want the original 5% bond when they can easily get the 10% bond.
[Alex 03:41] Yeah, and this will, of course, cause that 5% bond to drop in price for anyone to consider purchasing it. So in the cases when interest rates go down, the opposite is true. Your original bond becomes more hotly demanded because it's paying more than what new bonds are paying, so that drives their prices up.