Extra Point

April 2003

by Jack Tenney, Publisher

Interest Rates

So, what's with interest rates?

I remember attending a seminar at Babson College in Wellesley, Mass., in 1980 when I heard a wonderful explanation of interest rates from an earnest young professor.

Interest rates, he explained, are composed of four factors: risk, inflation, real growth and "e."

Risk was easy enough to understand. All other factors being equal (time, collateral, repayment terms and the like), one would expect to receive more interest from a loan to a small business than to the federal government. The higher the risk, the higher the rate. Credit-rating agencies like Fitch, Moody's or Standard & Poors assign credit ratings to debt issuers. Investment-grade bonds carry high ratings; junk bonds get low ratings. Investment-grade bonds have lower coupon values than junk bonds. The risk spread can be pretty broad: from near zero for Treasury bonds to as much as six points (or 600 basis points) for a thinly capitalized corporate bond.

Inflation was pretty easy to understand. If you define inflation as an index that relates the cost of a basket of goods now to the same basket of goods then (and then is defined as the time into the future when debt is to be repaid), it is, as I say, a pretty easy concept to understand. However, since the future is largely unknown, there is this little yield-curve thing that tries to handicap forward-looking inflation factors. I guess.

Now, we're talking real growth. According to the Babson guru, real growth is gross national product (GNP), or maybe he said domestic national product (DNP). Either way, it makes sense that lenders who earned only a risk premium and inflation wouldn't gain anything if they didn't get a little taste. Since real growth has averaged less than 3 percent for the past 60 years (didn't I read that somewhere?) risk and inflation typically would account for the lion's share of an interest rate. Not that there's anything wrong with real growth, of course.

So, what's with "e"?

"e" apparently is an unknown effect skewing the rate a few basis points up or down. It is, at once, small enough to be ignored, but necessary in order to legitimatize the professor's interest rate theory.

At the time of his lecture, the GNP and DNP were in recession by nearly 6 percent (600 basis points), and inflation was a scorching 21 percent. According to the professor, the risk-free rate of return on Treasury notes should have been 15 percent, making the prime rate around 18 percent and the risk-adjusted rates even higher. Those were the days when you left your credit card payment in your money market fund to make two points on the arbitrage.

Today, real growth is around a point, inflation is, maybe, that. One-year Treasury bills yield somewhere around that sum with the diff being "e" or a few basis points.

However, if you neglect to pay your zero-interest credit card balance to earn a point in your money fund, you'll get whacked with a penalty and your credit card interest rate will jump to 1980 levels. Meanwhile, you'll need to keep a million in your money fund to offset the fees.

Maybe "e" stands for eek!