Simply put, interest rates are the price of borrowed money. If a business or consumer wants to borrow money, they must pay the price: interest. The interest rate charged is determined by the borrower's credit rating, the prevailing interest rates, and the term of the loan.
Interest Rate Continuum
A borrower may need money for any period from one day to 30 years. Many banks and financial institutions regularly borrow money overnight to balance their books to comply with compulsory government capital ratios. A corporation may issue a bond for 5, 10 or 30 years, depending on its needs. After one year, a 30-year bond will have 29 years left until maturity, then 28--all the way down to zero when it matures. Once issued, bonds trade in the secondary market and each one is priced accordingly along the interest rate continuum, which goes from one day to 30 years.
Investors use interest rate benchmarks that help them assess the general interest rate environment and various levels of interest rates: 1 month, 3 months, 6 months, 1 year, 5 years, 10 years, 30 years; but it's important to remember that there are bonds with maturities in between that are priced accordingly.
No "Official" Boundaries
The difference between short- and long-term interest rates is approximate. Typically, anything maturing in less than a year represents a short-term rate. Money market funds typically invest in short-term debt instruments that mature in 100 days or less. A 30-year bond will clearly have a long-term interest rate, but a 5-year or 7-year bond would be called a medium-term bond, although there is no such thing as a medium-term interest rate.
Interest Rate Comparisons
When investors compare interest rates, they usually compare securities of similar maturities. Obviously, all 3-month Treasury Bills will carry the same interest rate, but it will be different from a 3-month interest rate on high grade corporate bonds or municipal bonds.
When represented graphically, the typical interest rate continuum is a graph that starts in the lower left-hand corner and goes into the upper right-hand corner, with the horizontal axis representing maturities and the vertical axis representing the yield. In a normal interest rate environment, short-term interest rates are lower than long-term interest rates because the longer the term, the higher the risk that investors take with their money by locking it in. This curve is a normal curve, although its shape may change to reflect various economic conditions: the curve can be steep or flat, or bend at various benchmarks. Every once in a while, short--term interest rates become higher than long-term interest rates, causing the curve to invert. An inverted yield curve is an indication of abnormal economic conditions that often precede recessions.
- "The All-Season Investor"; Martin J. Pring; 1992
- "Business Cycles and Their Causes"; Wesley Clair Mitchell; 1959