Interest rates are relative, so there is no arbitrary point at which an interest rate is proclaimed "high." Interest rates on various financial instruments such as bonds are constantly shifting, and they naturally trend higher or lower over time. In any given period, interest rates on particular securities can fluctuate significantly higher or lower than they were at an earlier date.
Interest rates vary with the risk of an investment such as lower, yet virtually risk-free treasury bond interest yield as compared to "junk" or high-yield bonds. These bonds pay very high interest rates to investors because they must be compensated for taking on the excessive riskiness of these investments.
The U.S. bond market is made up of a hierarchy of fixed-income securities whose interest rates increase along with maturity -- the bond's life measured in months or years -- and underlying risk. As maturities rise, so do defaults. Toward the riskier end of the hierarchy sit high-yield bonds -- an informal moniker for bonds with low performance ratings (and higher default risk), according to industry bond rating agencies such as Fitch Ratings and Moody's Investor Services. With these investment vehicles, interest rates can be high relative to interest rates on comparable, yet safer securities or relative to historical interest rates.
Prime Lending Rate as a Basis
The prime rate is an example of a "low" interest rate. It is a closely watched benchmark representing the interest rate at which commercial banks make loans to their most creditworthy clients. It is driven by the federal funds rate, which is the rate at which banks lend money to each other. Other types of loans, such as mortgages and personal loans, are based on the prime rate, to which a premium is added to reflect additional default risk.
The prime rate at the end of 2014 was 3.25 percent, a historical low that reflects a gradual decrease from when the prime rate peaked at 18.87 percent at the end of 1981. The prime rate rose during the late 1970s and remained high through the 1980s due to inflationary pressures and high unemployment rates; the government responded to these forces by using monetary policy to increase interest rates.
During this period, interest rates continued to rise due to high inflation rates exacerbated by oil embargoes. The economy was viewed as highly unstable, and the perceived risks led lenders to continuously increase rates in response to fears of higher defaults. During the 1990s, the domestic economy showed many signs of a strong recovery. Inflation declined and corporate earnings rose, while the emergence of high technology led to production gains across the economy. By 2005, the prime lending rate had fallen to 6.19 percent and, by 2009, to 3.25 percent, where it remains at the time of publication.
Factors Behind Higher Interest Rates
Macroeconomic factors, along with shocks to the global economy, led to dramatic interest-rate rises. In the short term, one bond issuer's interest rates may be higher than a peer company's interest rates based on the following factors:
- Type of issuer: If the issuer's industry experiences a downturn, lenders are less willing to lend to industry members and interest rates rise due to perceived higher industry default risk.
- Creditworthiness: Higher credit and default risk result in higher interest rates -- again, to compensate the lender for assuming additional risk_._
- Maturity: Longer maturities require higher interest rates, because defaults increase over longer periods.
- Embedded options: If the company has the option to repurchase the bond early, this makes it less valuable to investors, who require higher interest rates to invest in this type of a bond relative to a comparable bond with no such features.
- Liquidity: Investors greatly value liquidity (the ability to quickly sell an investment and receive the proceeds from the sale), because it provides financial flexibility, particularly in times of crisis. If there is not a ready market for the bonds, this makes it difficult, or even impossible, to sell, which is reflected in a liquidity premium -- an increase in the interest rate attributable to the lack of liquidity.