Rate Debate

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

Why do bond interest rates go higher? The short answer is that creditors are less willing to take risk, and therefore demand more premium in order to lend. But what factors lead to creditor risk aversion?

One factor is future inflation expectations. If lenders perceive potential for increasing prices (e.g., devalued currency) in the future, then they will demand a higher coupon to compensate for the reduced purchasing power of the principal and interest returned to them down the road.

Another factor is general capacity to lend. Creditors may lack investment capital due to previous practices (e.g., excessive lending or borrowing against their book). If so, then lenders will raise the price of further lending to compensate for their balance sheet risk.

A third factor is creditworthiness of the borrower. Creditors will demand more premium if borrowers carry more risk of default. Think junk bonds.

When rates head higher, as they have for govies over the past week, the knee jerk explanation that pundits commonly assign to the phenomenon commonly relates to the first factor noted above. Higher rates are typically explained as heightened inflation expectations.

But the latter two factors, those less cited by the pundits, are tied to a deflationary environment. And in a world drowning in debt, these two factors seem to merit more attention.

Don't automatically connect higher interest rates to potential for more inflation.