Interest Rate Sensitivity
It occurs when the growth or decline in real interest rates impacts the pricing and value of fixed-income assets.
Interest rate sensitivity occurs when either increasing or decreasing interest rates directly impact the pricing of fixed-income assets in any given market.
This sensitivity has to do with the duration, or amount of time, that the asset is held. Long-term investment strategies usually have to deal with and are subject to, the ebbs and flows of fluid interest rate environments.
The United States Federal Reserve Bank, also known as the Fed, has been a case study on interest rate sensitivity over the past year. On March 17th, 2022, the Fed initiated a 25 basis point increase.
This added .25% to the established .25% interest rate from the Covid-19 pandemic.
The goal of the rate hike was to counteract the effects of inflation on the US economy, which had increased the costs of goods across the board in the United States. This ultimately disrupted the economy as prices became more expensive than normal.
Since the March 2022 rate hike of 25 bps, the Fed has increased the federal funds rate further by 475 basis points, or 4.75%, to 5.25% as of May 3rd, 2023.
This rate represents the interest rate established by the Fed at which commercial banks lend and borrow their monetary reserves on a daily basis.
This remarkable jump from a near 0% interest rate back in the first quarter of 2022 to over 5% at the beginning of the second quarter of 2023 has had a tremendous impact on fixed-income assets, whose valuation and cash flow are dependent on the discount rate at which they are financed at.
The pandemic-era low-interest rate environment created a dangerous precedent for the finance industry, as greed and ambition took hold of those looking to capitalize on the optimal lending atmosphere where debt was virtually free.
As rates came back up to hedge inflation, the consequences of these financial decisions came to light. This article will explore the nuances of interest rate sensitivity and how the varying sensitivities impact particular assets in the United States.
Key Takeaways
- Interest Rate Sensitivity occurs when the growth or decline in real interest rates impacts the pricing and value of fixed-income assets.
- Multiple types of interest rate risks include pricing, repricing, and basis risks.
- Various sources of interest rate sensitivities include funding sources, mortgage banking operations, and fee-income businesses.
- Three methods of calculating interest rate sensitivity are the GAP Analysis Model, the economic value of equity / net economic value models, and the net interest income simulation model.
- Since the 1980s, the global interest rate decline can be partially attributed to the aging population, the global saving glut, and income inequality.
Understanding Interest Rate Sensitivity
Interest rate sensitivity is the degree to which changes in interest rates affect and adversely impact an asset in terms of its value and income through cash flows.
Specifically regarding fixed-income assets, the asset is considered a more risky and volatile investment if interest rates rise. If interest rates fall, that same asset would be considered more stable and less risky for investors seeking safe cash flow.
Investors profit from fixed-income assets through the interest rates and appreciation of the asset’s value over time. These income prices depend on the rate and pricing of third-party capital costs and fluctuate when these rates increase or decrease.
Upon the initial purchase of an asset, the sale price is determined by that asset's current and prevailing market value. As the market's interest rates fluctuate, the value of the purchased asset follows suit, and prices correlate to the rate change within the market.
The trends of the market inversely impact asset prices. Increased market rates cause prices of fixed-income assets to depreciate due to the cost of capital increases.
On the other hand, decreased market rates cause fixed-income assets to appreciate due to the lower costs of external capital.
Types of Interest Rate Risk
Interest rate sensitivity, or risk, can arise from a plethora of sources. From an Institutional financer’s perspective, several components impacting sensitivity include pricing, repricing, and basis risks.
1. Pricing Risk
Pricing risk occurs when the value of an asset changes when interest rates change. When interest rates decrease, the value of an institution’s rights on that asset decreases as the revenue they receive from interest rate-related fees deflates.
2. Repricing Risk
Repricing risk is the chance that either assets or liabilities will be repriced at different times or amounts, adversely impacting an institution’s profits, capital, or overall financial health.
Note
In a long-term scenario, repricing forces an adjustment to current projections and impacts long-term yields and returns.
3. Basis Risk
Basis risk is the possibility that other markets will not move in harmony or in a predictable fashion relative to the market with which an asset is directly associated.
For example, suppose deposit rates under one index change by 25 basis points and a different index rate changes by 50 basis points. In that case, this poses a risk to any asset marketable across several indexes.
Sources of Interest Rate Risk
As explained above, there are multiple types of sensitivities regarding interest rate risk. There are also several sources of this sensitivity, which includes funding sources, mortgage banking operations, and fee-income business.
1. Funding Sources
One source of interest rate sensitivity relates to where the investment capital comes from and the structure it is funded. If a source of capital is federally funded, long-term, and fixed rate, it may be subject to repricing or basis point risks.
A short-term loan with a floating rate (the rate corresponding to the market rate) is also subject to risks. If interest rates increase, the cost of capital increases due to the loan structure. How your loan is structured impacts risks.
2. Mortgage Banking Operations
Another source of interest rate risk comes from mortgage banking operations. The operational capacity of institutional capital impacts pricing risk within their loan pipeline and portfolio of assets they service, creating further risks.
Note
Fluctuating interest rates impact both current asset values and future income relating to fees and business volume.
3. Fee-Income Business
Fee-income businesses such as mortgage institutions rely heavily on transactional and loan-based fees to generate revenue. These fees are based on the rates of returns on the assets they are invested in.
The changing interest rates impact returns, affecting the amount of fees accrued and, ultimately, institutional cash flow.
How to Measure Interest Rate Sensitivity
A changing interest rate environment can be effectively measured through various methodologies. Having accessibility to accurate information in a timely fashion is critical for institutions to measure how changing interest rates will impact their balance sheets and income.
Three models used to measure interest rate sensitivity are the GAP Analysis Model, the economic value of equity / net economic value models, and the net interest income simulation model.
The GAP Analysis model calculates the difference between the quantity of rate-sensitive assets and rate-sensitive liabilities, which will collectively be repriced during a particular future timeframe. This chart is dependent on the future direction of interest rates.
C ρ = ( A r - L r ) × △ i
where
- Cρ = changes in profitability
- Ar = risk-sensitive assets
- Lr = risk-sensitive liabilities
- Δi= change in interest rates
Net Income affect for GAP Analysis
| Assumed Rate Direction | Result of GAP Analysis | Effect on Net Income |
|---|---|---|
| Increased | RSA > RSL | Positive |
| Increased | RSA < RSL | Negative |
| Decreased | RSA > RSL | Negative |
| Decreased | RSA < RSL | Positive |
- RSA = Rate Sensitive Assets
- RSL = Rate Sensitive Liabilities
This method of measuring sensitivity is limited because it doesn’t account for basis risk or non-linear yield–shifts. Incorporating other calculations may be necessary depending on the complexity of your holdings and investment activity.
1. Economic Value of Equity (EVE) / Net Economic Value (NEV) models
The Economic Value of Equity (EVE) / Net Economic Value (NEV) models represent the net present value of an institution’s assets, liabilities, and cash flows not represented on their balance sheets.
Note
These models are also limited in the sense that future cash flows are hard to predict when using financial instruments with no defined maturity date. These models are effective in helping institutions assess interest rate risk in an ever-changing environment.
These models are used to measure an institution's long-term interest rate risk by quantifying the impact of changes in future cash flow interest rates through stress testing and sensitivity analysis.
2. Net Interest Income Simulation models
These models calculate the impact of interest rate changes on net interest income. This model effectively captures repricing, basis points, yield curves, and option risk. The simple calculation for net interest income is interest income minus interest expense.
An institution’s balance sheet is taken through various interest rate situations and stresses tested and compared to its static baseline. Higher outcome variance represents a higher interest rate risk within the balance sheet.
The Changing Interest Sensitivity of The US Economy
Real interest rates on US Government securities have steadily declined in the United States since their height in the early 1980s. This decline has occurred in other countries as well.
The decline in median short-term interest rates since the 80s has been about 3 percentage points, with long-term interest rates experiencing a 3.7 percentage point falloff, respectively.
Policymaking and Government regulation through the US Federal Reserve and central banks has both contributed to and convoluted the interpretation of the change in interest rates over time.
The Federal Reserve incorporated rate hikes in the early 80s to combat inflationary pressures, similar to the rate hikes following the pandemic in 2020.
The effects of policymaking have been difficult to differentiate from other factors influencing interest rates. However, actions taken by the central bank have been the biggest factor in heightened rates in the early 80s and more recently.
Most research surrounding the steady decline in interest rates on government debt over the past four decades has focused on factors that have shifted the supply of and demand for saving.
Note
Several long-run factors, such as the slowdown in output growth, demographic forces like slowing labor force growth and an aging population, an abundance of saving on a global scale, a shortage of risk-free assets, and overall static sentiments when it comes to investing.
Other than a decline in global interest rates, explanations have been sought as to why relative demand has shifted away from more risky assets towards safer, risk-free, and highly liquid assets. This shift has ultimately led to an increase in risk premiums.
The slowing of growth can be attributed to slowing population growth and an aging population. Demographic forces drive the overall sentiments towards saving and the more stagnant investing environment.
Economic theory points to the interest rate being correlated with the growth rate of real output. This specified output has declined within prominent economies since the early 1980s. This slowdown defines the decline in interest rates.
Some see the growth trend continuing to be low in the coming decades, while others project the trend growth to increase.
An Aging Population
The global population is growing increasingly older, according to many data sources. The median ages of both global and US populations have consistently risen since the early 70s.
With regards to the US, the baby boom, which represents the period after World War II up until the mid-1960s, there was a spike in the birthrate, contributing to the domestic aging population today.
There has not been another significant spike in birth rate since, and birth rates have continuously declined.
It is predicted that median ages will continue to increase through at least the year 2100. This has a long-term impact on financial sensitivities.
It impacts interest rates because as people grow older, they are less likely to be working or in the labor force and more likely to be wasting their savings.
As people grow older, they accrue more and more savings, and upon retirement, those savings begin to dwindle slowly due to the cost of living and their lack of income.
Note
The past 40 years have seen a larger portion of the global population involved in saving money, lowering global interest rates. As the world ages, less of the population is in the labor force, slowing the growth rate and increasing the capital-to-labor ratio.
The increase in capital-to-labor ratio ultimately lowers the marginal product of capital, or the additional production a firm sees when capital is added to operations. This also puts downward pressure on interest rates.
Both the transition to savings and the aging population has effectively contributed about 1-2% of the decline in global interest rates since the 80s. As life expectancy increases, combined with decreasing birth rates, this trend is projected to continue for several years.
Global Savings Glut
The global savings supply has increased since the early 2000s, where initial increases can be attributed to the Financial Crisis in Asia during the 90s and the shifting sentiments to invest in emerging-market economies.
The rise in oil prices, the increase in other commodity prices in the 2000s, and the shift of capital to growing, high-saving economies such as China also enhanced the saving rate.
This phenomenon has been defined as the global savings glut, which ultimately forced downward pressures on global interest rates.
This glut was not invested in a diversified manner; it was funneled primarily into US-based assets deemed safe, risk-free investments.
This has caused a decline in these asset returns larger than those of riskier assets, like equities, due to the amount of capital invested in such investments.
When demand for safe government-backed assets surpasses the current supply, it is observed that the private sector intervenes by supplying deemed safe assets as an alternative investment.
This presented many unforeseen risks, such as the global financial crisis of 2008, which led to a risk reassessment of securities and a decline in the global supply of risk-free assets, ultimately lowering interest rates.
Note
A decline in investing impacts the global rate decline, lowering demand for debt. An increase in savings supply, a decrease in investment demand, and the relative price of capital goods have declined since the 50s.
The global savings glut has been determined to have caused an impact of .25% out of the 4% overall decline in global interest rates over the past 40 years.
Another key factor that has contributed to declining interest rates has been income inequality.
As higher-income households hold an increasing amount of investment capital relative to lower-income households, the overall increase in savings available for investment has pushed down interest rates.
The growing income inequality has effectively been responsible for around one-fifth of the overall 4% decline in global interest rates.
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