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A Framework for Projecting Interest Rate Spreads and Volatilities January 2000

Several key questions offer a framework for examining the short-term financial instruments that could be used as benchmarks in interest rate formulas for the federal student-loan program. What are the characteristics of the instruments, and how are they similar to or different from each other? What determines the expected return on the instruments and, in turn, the differences, or spreads, between them? Why have those spreads narrowed in recent years and become less volatile? The answers to those questions bear on any decision to permanently replace Treasury securities with one of the alternative interest rates as a benchmark for lender yields in the student-loan program.
 

WHAT ARE THE INSTRUMENTS' MAJOR CHARACTERISTICS?

Treasury bills, commercial paper, and London interbank deposits of U.S. dollars are all part of the money market--that segment of the capital market encompassing short-term (one year or less) financial instruments. As noted earlier, markets for commercial paper and for London interbank deposits have been growing in recent years. That expansion as well as other characteristics of those instruments may strengthen the case for using their rates in the student-loan program.

Treasury Bills

Treasury bills, which the federal government issues (offers for sale) weekly to finance its deficits, are distinguished from other money market instruments by two features. First, they are perceived as "safe" investments, free from default, or credit, risk. Second, they have a high degree of liquidity--they can easily be sold for cash because they are readily accepted by investors in the United States and abroad, both in turbulent times and during normal economic and financial conditions.

Treasury bills are issued in denominations of up to $1 million with maturities of three months, six months, or one year. The Federal Reserve typically holds large amounts--recently, about $200 billion. It acquires and sells Treasury bills through dealers in government securities in the course of conducting the nation's monetary policy. Government security dealers are part of the secondary market for bills, intermediating between the Treasury and other holders, which include foreign governments and central banks, money market mutual funds, financial institutions, state and local governments, and individuals.

Once the largest of the three markets as measured by outstanding dollar volume, the market for Treasury bills now occupies second place, after the market for commercial paper (see Table 1). If federal surpluses persist, it could fall behind the London interbank dollar market as well over the next decade.
 

Commercial Paper

Dominating the money market since the 1980s, commercial paper is short-term, unsecured debt that firms use to finance immediate-cash needs. The securities are issued in maturities of up to nine months and in amounts of as much as several million dollars.⁽¹⁾ Issuers of commercial paper fall into two categories: financial companies and nonfinancial companies. Financial-company issuers, which account for about 80 percent of the commercial paper now outstanding, are mostly funding corporations of nonfinancial firms (for example, General Motors), finance companies, issuers of asset-backed securities (discussed below), funding subsidiaries of banks, and analogous foreign entities (see Table 2). (Because nonfinancial-company issuers make up such a small percentage of the market, they are not discussed here.) Commercial paper allows large firms to obtain cash directly from the money market instead of borrowing it from banks. Firms that are not large enough to sell their own commercial paper directly can still use the commercial paper market through intermediary dealers who in turn line up buyers.
 

Holders of commercial paper make up a broad range of investors. They include money market mutual funds (today, the predominant group of holders), retirement-related entities (trusts, public and private pension funds, and insurance companies), banks, and corporations (see Table 3). Foreign entities such as governments and central banks also hold commercial paper to keep their dollar holdings invested and earn a market rate of return.
 

Factors affecting both demand and supply have propelled the recent growth in the commercial paper market. Investors' increasing appetite for money market mutual funds has fueled demand for commercial paper, with the funds purchasing it as part of their investment portfolios. The explosive growth during the 1990s in information-related technologies has played a key role in that trend by facilitating transactions.

Financial innovations have been a similar linchpin in the growth of supply in the commercial paper market.⁽²⁾ One example is the increase in securitization--selling debt securities to investors and using groups of relatively homogeneous loans as collateral. Thus, financial companies may issue asset-backed commercial paper, using the money they expect from such receivables as credit card balances or automobile loans as collateral.⁽³⁾ Another example of innovation is the growth of interest rate swaps. A simple case might involve a company that owed a debt with a fixed rate of interest and that wished to convert it into debt with a floating rate. A sequence of commercial paper transactions is often used to make the switch.⁽⁴⁾

London Interbank Dollar Deposits

London interbank deposits of U.S. dollars are loaned to and borrowed by international banks in London. Such deposits come originally from other financial institutions, large corporations, individuals, and governments. Deposits are made in large amounts at fixed maturities (typically ranging from overnight to 12 months). The lending and borrowing that is the defining characteristic of the interbank market mostly reflects individual banks trying to manage cash flows and risk in their domestic and international operations.

Interest rates on London interbank dollar deposits are quoted on an offer-and-bid basis. The rate asked by the lender is the offer rate--LIBOR, for London interbank offer rate. The rate on funds wanted by the borrower is the bid rate--LIBID, for London interbank bid rate. The British Bankers' Association compiles a measure of LIBOR from a sample of market participants that changes as conditions warrant (see Table 4 for the 1999 panel of contributing banks).
 

As noted earlier, LIBOR is used as a reference rate for loans made by private financial institutions operating both internationally and domestically. Its role stems from London's global prominence as a financial center and the U.S. dollar's preeminence in financial transactions.⁽⁵⁾ Further enhancing its importance is the proliferation of financial innovations (such as interest rate swaps) that require a reference rate acceptable among borrowers and lenders throughout the financial world.

The London interbank dollar market is about half the size of the commercial paper market and is expanding more slowly. Since 1980, the market has grown about 5.2 percent annually compared with annual growth in the commercial paper market of 10.9 percent. How the launching of the Euro currency and other aspects of monetary unification in Europe will affect the future growth of the London interbank dollar market is not known.
 

WHAT DETERMINES THE INSTRUMENTS' YIELDS AND SPREADS?

Spreads between the interest rates on Treasury bills, commercial paper, and London interbank deposits depend on the comparative risk of investing in those instruments and the return, or yield, expected from them. (Specifically, yield is the average annual rate of return on a security over the period it is held.) The characteristics of the participants that issue, market, and hold the instruments and the institutional and legal arrangements governing them and the markets all help to determine risks and returns. Generally, the gaps between interest rates widen when monetary policy becomes tighter (the cost of credit rises) or more volatile, or when inflation or expectations of inflation increase. On those occasions, differences in the riskiness of the three instruments intensify, and the interest rate spreads correspondingly widen.

Treasury Bills

Interest rates on Treasury bills are usually the lowest of the three short-term rates. They are influenced mainly by expectations about inflation, by overall conditions of demand and supply in the markets for credit and goods, and by perceptions about risk and uncertainty. The interest paid on Treasury bills includes an inflation premium--compensation for any expected loss of purchasing power. At the same time, however, Treasury bill rates probably have only a small or no liquidity premium--compensation for holding bills instead of cash--because holders have a ready market in which to sell the bills, should they need cash before the maturity date. (For large transactions, the bills themselves could be used as payment.) Also missing from the interest rate paid on Treasury bills is a credit-risk premium--compensation to offset the chance that the issuer might default--because of the superior credit standing of the federal government. In fact, during turbulent financial times, investors' increased desire for default-free assets tends to produce particularly low interest rates on Treasury bills compared with money market instruments issued by the private sector.

Commercial Paper

Several features of commercial paper lead to differences between its interest rates and those paid on Treasury bills (see Table 5). The rates paid on money invested in commercial paper are generally higher, in part because they include a credit-risk premium. The premium is necessary because holders of commercial paper assume that its issuers could encounter unexpected financial difficulties that might jeopardize their solvency or, at the least, their ability to honor their obligations on time.
 

Commercial paper is also less liquid than Treasury bills--paper holders might not readily find a buyer, should they wish to sell before their holdings reach maturity. At the same time, however, purchasers normally expect to hold commercial paper until it matures. As a result, analysts consider that in ordinary financial circumstances, commercial paper's lesser liquidity relative to Treasury bills has little effect on its interest rates.⁽⁶⁾

Credit and liquidity premiums vary with the economy's cyclical position, including the cyclical stance of monetary policy. As a result, spreads between commercial paper and Treasury bill rates vary in a similar fashion, shrinking during periods of economic expansion, when concerns about credit risk recede, and at times expanding abruptly during economic downturns, when financial difficulties surface (see Figure 1). Similarly, the spread widens when the Federal Reserve tightens monetary policy by trimming the money supply, thus reducing liquidity in the money market. Tighter monetary policy not only causes liquidity premiums to rise but also may elicit investors' fears about credit risk.
 

FIGURE 1. INTEREST RATE SPREADS FOR ONE-MONTH AND THREE-MONTH COMMERCIAL PAPER

SOURCE: Congressional Budget Office using data from the Board of Governors of the Federal Reserve.

NOTES: Spreads (the differences between rates) are computed against the rate for three-month Treasury bills. Interest rates have been converted to bond-equivalent yields.

Commercial paper is defined here as short-term debt issued by financial companies.

When financial markets move from normal to turbulent periods, credit and liquidity premiums both tend to increase substantially as potential purchasers of commercial paper become more averse to risk and seek a "safe haven" in instruments such as Treasury bills. In recent years, several episodes of turbulence or shocks have significantly affected the spreads shown in Figures 1 through 5. Those events include:

• The end of the system of fixed exchange rates, which was established in 1944 at Bretton Woods, New Hampshire, and collapsed in mid-1971;
  
  
• The dramatic hikes in petroleum prices in 1973 and 1979, the first accompanied by insolvencies among banks and industrial corporations and the second by loan defaults among developing countries;
  
  
• The dollar crisis of 1978 that compelled the United States to borrow $30 billion from Japan, Germany, and Switzerland to restore international confidence in the exchange value of the dollar; and
  
  
• The financial turmoil of 1998 comprising the collapse of many Asian economies, default by the government of Russia, and failure of the hedge fund Long-Term Capital Management (despite the Nobel-laureate economists and financial-industry notables among its directors and executives).

London Interbank Dollar Deposits

Spreads between LIBOR and rates on three-month Treasury bills are generally larger than those between commercial paper and Treasury bills, although the gaps have narrowed over the past few years (see Figures 2 and 3). Interest rates on London interbank dollar deposits include liquidity and credit-risk premiums similar to those embedded in commercial paper rates. As a result, LIBOR should also vary with overall interest rates, inflation, and monetary policy. But the interbank nature of LIBOR leads to higher liquidity and credit-risk premiums for interbank deposits than for commercial paper.
 

FIGURE 2. INTEREST RATE SPREADS FOR ONE-MONTH LONDON INTERBANK DOLLAR DEPOSITS AND ONE-MONTH COMMERCIAL PAPER

SOURCE: Congressional Budget Office using data from the Board of Governors of the Federal Reserve and the British Bankers' Association.

NOTE: Spreads (the differences between rates) are computed against the rate for three-month Treasury bills. Interest rates have been converted to bond-equivalent yields.

a. The rate on London interbank dollar deposits is known as LIBOR--the London interbank offer rate.

b. Commercial paper is defined here as short-term debt issued by financial companies.

FIGURE 3. INTEREST RATE SPREADS FOR THREE-MONTH LONDON INTERBANK DOLLAR DEPOSITS AND THREE-MONTH COMMERCIAL PAPER

SOURCE: Congressional Budget Office using data from the Board of Governors of the Federal Reserve and the British Bankers' Association.

NOTE: Spreads (the differences between rates) are computed against the rate for three-month Treasury bills. Interest rates have been converted to bond-equivalent yields.

a. The rate on London interbank dollar deposits is known as LIBOR--the London interbank offer rate.

b. Commercial paper is defined here as short-term debt issued by financial companies.

Three factors apparently account for the larger LIBOR spreads, although no systematic analysis has quantified the factors' relative importance. First, the London interbank market for dollar deposits is closely linked to the U.S. interbank market for federal funds--the reserves that banks have on deposit at the Federal Reserve and that they buy and sell among themselves (see Figure 4). For example, a U.S. bank is required to hold a certain amount of cash in reserve in proportion to its deposits. It can meet that requirement by borrowing federal funds from another bank in the United States or by borrowing Eurodollars from a bank in London. London interbank dollars, federal funds, and commercial paper all trade on an unsecured basis--no collateral is required--and that feature leads to added credit-risk premiums, relative to the rate on Treasury bills. Compared with issuers of commercial paper, especially nonbank financial institutions such as finance companies, banks typically operate with much higher leverage (higher levels of debt to equity), which might also lead to higher credit-risk premiums on interbank rates.⁽⁷⁾
 

FIGURE 4. INTEREST RATE SPREADS FOR FEDERAL FUNDS, ONE-MONTH LONDON INTERBANK DOLLAR DEPOSITS, AND ONE-MONTH COMMERCIAL PAPER

SOURCE: Congressional Budget Office using data from the Board of Governors of the Federal Reserve and the British Bankers' Association.

NOTE: Spreads (the differences between rates) are computed against the rate for three-month Treasury bills. Interest rates have been converted to bond-equivalent yields.

a. The rate on London interbank dollar deposits is known as LIBOR--the London interbank offer rate.

b. Commercial paper is defined here as short-term debt issued by financial companies.

Risk related to a borrower's nation may be a second reason for the larger LIBOR/Treasury bill spreads. A bank's home country might itself be a source of risk because of its economic and financial circumstances, its regulatory policies for financial institutions, or its political situation, any or all of which could cause the bank to be willing to pay a premium for the funds it borrows through the interbank market. That premium could influence the LIBOR measure since LIBOR is compiled by averaging rates from banks with different home countries. The size of the premium can be expected to vary over time.

Banks' reserve requirements and deposit insurance premiums are a third factor that could drive a wedge between LIBOR and interest rates on commercial paper. However, research has been unable to determine with statistical precision the strength of that factor's effect.⁽⁸⁾
 

WHY HAVE SPREADS NARROWED IN RECENT YEARS?

In the mid-1980s, LIBOR/Treasury bill spreads started moving closer to commercial paper/Treasury bill spreads, resulting in a narrow gap throughout the 1990s between LIBOR and commercial paper. Since the early 1990s, LIBOR/commercial paper spreads have averaged about 23 basis points for three-month maturities and about 15 basis points for one-month maturities (see Figure 5).
 

FIGURE 5. INTEREST RATE SPREADS BETWEEN ONE-MONTH AND THREE-MONTH LONDON INTERBANK DOLLAR DEPOSITS AND ONE-MONTH AND THREE-MONTH COMMERCIAL PAPER

SOURCE: Congressional Budget Office using data from the Board of Governors of the Federal Reserve and the British Bankers' Association.

NOTE: Spreads (the differences between rates) are computed on a bond-equivalent basis.

a. The rate on London interbank dollar deposits is known as LIBOR--the London interbank offer rate. Commercial paper is defined here as short-term debt issued by financial companies.

Favorable circumstances in the money markets throughout the 1990s probably explain much of the behavior of LIBOR/commercial paper spreads. Monetary policy has become progressively more stable: the federal funds rate has become less volatile compared with past decades, and the Federal Reserve has provided more information so that market participants can anticipate changes in policy. (Whether the reduced volatility in the federal funds rate stems mostly from improved monetary policy or is a by-product of a less volatile economic environment is an open question that is not addressed here.) With less volatility, overall liquidity and credit-risk premiums may have dropped, thus narrowing the differences between such premiums on LIBOR and commercial paper rates. Another contribution to smaller LIBOR/ commercial paper gaps may be low overall interest rates, which have also benefited the money markets and helped shrink the spreads between most short-term rates.

The integration of domestic and international financial markets has probably also helped whittle down spreads between LIBOR and commercial paper rates. Technological advances in computers and telecommunications enable issuers and holders of securities to shift back and forth between the Eurodollar market, the commercial paper market, and other domestic and foreign money and capital markets, with the result that spreads have contracted relative to their past levels. Advances in financing methods have also played a role. For example, the expanding market for interest rate swaps has tightened the connections between commercial paper and London interbank markets.

Yet another factor in the narrowing of LIBOR/commercial paper spreads could be the lapse of some of the regulatory influences cited earlier. For example, reserve requirements imposed by the Federal Reserve on funds borrowed abroad were eliminated in 1990. Further shrinkage may have come from falling insurance premiums on bank deposits: since the mid-1990s, insurance funds administered by the Federal Deposit Insurance Corporation have been replenished, and banks have increased their capital. No doubt other reasons could be found as well.
 

WHAT DETERMINES THE SPREADS' VOLATILITIES?

Strikingly, interest rate spreads have become less volatile as they have narrowed. Most of the decline in volatility has occurred since the mid-1980s (see Table 6 and Figure 6).
 

FIGURE 6. VOLATILITY OF INTEREST RATE SPREADS FOR ONE-MONTH LONDON INTERBANK DOLLAR DEPOSITS AND ONE-MONTH COMMERCIAL PAPER

SOURCE: Congressional Budget Office using data from the Board of Governors of the Federal Reserve and the British Bankers' Association.

NOTES: Spreads (the differences between rates) are computed against the rate for three-month Treasury bills. Interest rates have been converted to bond-equivalent yields.

Volatility is computed as the average over the indicated period of the moving, four-quarter, sample standard deviation. Data are drawn from the first quarter of 1972 through the fourth quarter of 1998.

a. The rate on London interbank dollar deposits is known as LIBOR--the London interbank offer rate.

b. Commercial paper is defined here as short-term debt issued by financial companies.

What has caused that drop? Developments in the financial markets are unlikely to be the whole answer. (In fact, events such as the Asian financial turmoil and Russian debt default have had the opposite effect.) The recent sharp decline in inflation could be a factor by helping to improve the overall investment climate in financial markets. The drop in inflation coincided with the decline in volatility, just as the surges in inflation in the 1970s and early 1980s coincided with jumps in volatility (see Figure 7).
 

FIGURE 7. INFLATION AND THE VOLATILITY OF INTEREST RATE SPREADS FOR ONE-MONTH LONDON INTERBANK DOLLAR DEPOSITS

SOURCE: Congressional Budget Office using data from the Board of Governors of the Federal Reserve, the British Bankers' Association, and the Department of Commerce.

NOTES: Spreads (the differences between rates) are computed against the rate for three-month Treasury bills. Interest rates have been converted to bond-equivalent yields.

Volatility is computed as the average over the indicated period of the moving, four-quarter, sample standard deviation.

a. The rate on London interbank dollar deposits is known as LIBOR--the London interbank offer rate.

b. Measured as the consumer price index for all urban consumers.

Inflation affects interest rates through several channels. Sustained low inflation helps financial markets work more efficiently and leads businesses to focus on improving productivity and efficiency. Eventually, profitability rises, balance sheets are strengthened, and people attach less risk to investing for the long term. All of those developments ultimately contribute to less volatility in returns on assets and in interest rates.⁽⁹⁾ Consequently, when the economy receives an unanticipated shock, such as those occurring in 1998 in Asia and elsewhere, companies that issue commercial paper and banks that borrow in the London interbank market are not perceived to be in jeopardy. Because interest rates associated with those markets do not react as adversely as they might otherwise, volatility is less.

Factors such as inflation and the economic shocks discussed above are all part of the model CBO has developed for projecting alternative interest rates and their volatilities. Such projections anchor CBO's estimates of the cost of proposals for changing the benchmark used in the student-loan program.

1. Maturities of more than nine months would trigger registration requirements of the Securities and Exchange Commission.

2. Further discussion of the role of financial innovation and information technologies can be found in Dusan Stojanovic and Mark D. Vaughan, "The Commercial Paper Market: Who's Minding the Shop," Regional Economist, Federal Reserve Bank of St. Louis (April 1998).

3. See Barbara Kavanagh, Thomas Boemio, and Gerald Edwards Jr., "Asset-Backed Commercial Paper Programs," Federal Reserve Bulletin, vol. 78, no. 2 (February 1992), pp. 107-116.

4. Marcia Stigum describes swaps and other innovations in The Money Market, 3rd ed. (Homewood, Ill.: Business One Irwin, 1990).

5. See Stephen Valdez, An Introduction to Western Financial Markets (London: MacMillan Press Ltd., 1993).

6. For further discussion of the liquidity premium, see Frank Fabozzi, "Private Money Market Instruments," in Frank Fabozzi and T. Dessa Fabozzi, eds., The Handbook of Fixed Income Securities, 4th ed. (New York: Irwin Professional Publishing, 1995).

7. At the same time, however, a participant in the London interbank market has access to its home country's central bank, which might help reduce the premium if such access limits the bank's risk of default.

8. See Richard C. Marston, International Financial Integration: A Study of Interest Differentials Between the Major Industrial Countries (Cambridge: Cambridge University Press, 1995).

9. For additional discussion, see the statement of Alan Greenspan, Chairman, Board of Governors of the Federal Reserve, before the Senate Committee on Banking, Housing, and Urban Affairs, July 18, 1996 (available at http://www.federalreserve.gov/BOARDDOCS/hh/1996/july/testimony.htm).

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