Readers have a lot of interest in interest rates

John W. Schoen Senior producer • Profile • E-mail

There's a lot of interest in rates this week. James is peeved that he's making so little on his savings: shouldn't rates be higher to encourage savings? Richard, meanwhile, is wondering what happens to the value of his bonds if rates go up.

I don’t understand why banks are paying so little interest on CDs and savings accounts. You’d think in these tough times they’d want more people to save money in their banks and offer them better rates as incentive to do it. The rates they are offering today are pathetic.
— James M., Miami, Fla.

The “they” you’re talking about in this case is the Federal Reserve, which pretty much gets to set short-term interest rates wherever it wants.

And while the folks down at the Fed are happy we’re all saving more these days (which we all are), they don’t set interest rates to please savers. In normal times, their job is to 1) keep inflation under control and 2) keep the economy growing at a healthy rate — not too fast, not too slow.

Alas, these are not normal times down at the Fed. The lenders who are taking your deposits are still trying to whittle down a mountain of bad loans they made to people who couldn’t pay them back. In normal times, bankers who screw up have to take their losses and move on. But since the scope of the screw-up was so widespread, and the banks that screwed up were so huge, the government decided they were “too big to fail.” History will have to determine whether that was the right call.

To keep them from failing, the Fed has made money extremely cheap for banks to borrow, which they can then lend out — for mortgages, credit cards, car loans, etc. — at higher rates. Sometimes much higher.

The difference is profit for the banks, which they’re using to fill that big hole of losses they created by making dumb loans and investments.

Unfortunately, until the government comes up with a rational set of regulations to keep the banks from making these dumb loans and investments, there’s no reason to believe it can’t happen all over again.

If interest rates rise what effect will that have on bond prices?
— Richard O., Fairport Harbor, Ohio

They will go down. Bond prices and interest rates go in opposite directions. Here’s why:

Bonds come with a fixed rate (sometimes called the “coupon” because you used have to clip little coupons from the paper bond and send them in to get your interest payment). But the “yield” changes according to how much the issuer has to pay at auction to get investors and savers to part with their money.

If you buy a bond today that pays 4.5 percent (the rate on the latest 30-year Treasury sold at auction August 17), you’ll get $45 a year for every $1,000 worth of face value of the bond, paid in quarterly installments. If you hold onto the bond until it matures, you’ll get $45 a year for 30 years and then get all your money back in August, 2039.

But maybe you need the money before then. If so, you can sell the bond to someone else (that’s why there’s a “bond market”). Let’s say you sell it three years from now, when the bonds sold at the latest auction are paying 6 percent. Anyone else with $1,000 to invest could buy a fresh bond and get $60 a year, every year, until the bond matures. Why would they buy your bond for $1,000 — when it only pays $45 a year?

They won’t. What happens is the price of your bond falls to a level that keeps the “yield” the same as a new bond. Your bond now sells for $750 because your $45 fixed payment represents a 6 percent return on the money from whoever buys your bond. (The math: 6 percent of $750 is $45.)

The reverse is also true: if bond prices go down, interest rates go up (and vice versa). There are all kinds of reasons why bond prices go up or down, based on whether investors think they are a good place to keep their money (we’ll leave that for another column).

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