How Does a Falling Federal Funds Rate Affect Debt Securities?

What follows is a transcript of the video above.

Let’s Try a Practice Question:

For an investor expecting the federal funds rates to fall, which of the following investments would be most appropriate?

1. Treasury Bills
2. Treasury Rates
3. Treasury Bonds
4. Commercial Paper

Let’s work through this together. Treasury Bonds are the best way to think about what an interest rate is. If interest rates are falling, what do we know about bond prices? Keep in mind the inverse relationship: When interest rates are going down, bond prices are going up. So, what they are asking you is, which type of bond is going to increase the most as interest rates fall? Think about that. There are two key factors that make a bond more sensitive to changing rates: one is interest rate risk, and the other is finding which bonds are more susceptible to interest rate risk. The correct answer is Treasury Bonds, choice “C.”

Which Bonds Are More Volatile?

Long-term bonds and low coupon bonds are more volatile. Long-term low coupon bonds, including zeros, would be the most volatile. If you think about the different Treasuries, which of the three is going to have the lower and the longest term? Treasury bonds, remember, are 30 years, while notes are between 2 to 10 years. Bills are a year or less. Treasury bonds are the longest term, so they are going to be the most volatile. As the rates fall, because they are the most volatile, they are going to increase the most in price.

What Is the Federal Funds Rate?

The federal funds rate is the rate that banks charge one another for overnight loans. With federal funds, think about it just as a proxy for interest rates in the market. You can assume that the fed funds rate is declining.

What Is Commercial Paper?

Commercial paper is an unsecured promissory note, issued by corporations at a discount. It typically has a maximum maturity of 270 days. The maximum maturity of commercial paper is a good testable point to note for the SIE exam. Why 270 days? Because if it is 270 days or less, it is exempt from SEC registration.