What Are Interest-Sensitive Assets?
Interest sensitive assets are financial products whose features and characteristics or their secondary market price are vulnerable to changes in interest rates. The adjustable-rate mortgage is an example.
Banks and their customers both are affected by interest-sensitive assets.
- Interest-sensitive assets become more profitable or less profitable as lending rates increase or decrease.
- If interest rates rise, a bank earns more profit from mortgages and other loans.
- If interest rates fall, the consumer keeps more money and spends it elsewhere.
- The trends in overall interest rates drive the economy or slow it down.
Understanding Interest-Sensitive Assets
When lending rates increase, banks can earn more money on adjustable-rate mortgages and credit cards. They also can charge more for new loans such as car loans and fixed-rate mortgages.
The banks can increase their profitability while remaining competitive. Consumers and business borrowers feel the impact. If rates increase, they pay higher interest rates for all of those products. The reverse is true as interest rates fall. The bank makes less profit from their loans. Consumers and businesses pay less interest and therefore have more disposable income.
All interest rates follow the general direction set by the Federal Reserve Open Market Committee (FOMC) when it meets about eight times a year to assess the state of the economy. The governors may act to slow down the economy if they think it's growing too fast or boost it if they think it needs to speed up.
Interest rate sensitivity affects many businesses beyond banking. Homebuilders and realtors are particularly helped or hurt by interest rate changes.
They achieve that by raising or lowering their "targets" for key lending rates, but the only rate they can actually change is the discount rate. But as goes the discount rate, so goes the Fed Funds Rate, as goes the Fed Funds Rate, so go other short term overnight rates such as Money markets, BAs, Commercial Paper, and short-term CDs.
As goes the overnight rates, so goes the Prime Rate (the lending rate that banks charge their most trustworthy customers). Domestically, most other lending rates are derived either from the Prime Rate, the Fed Funds Rate, or from the London Inter-bank Offered Rate (LIBOR),.
Interest-sensitive assets are the financial products that are most affected by changes in borrowing rates.
Other Interest-Sensitive Businesses
Interest-sensitive assets are by definition financial products, but interest rate sensitivity affects many businesses beyond banking.
These are primarily businesses that depend on borrowed money, either directly or indirectly through their customers. Homebuilders and realtors, for example, are in an interest-sensitive sector, real estate. When rates climb, consumers hold back on buying. The retail sector, however, tends to thrive when interest rates are low. Their customers have more disposal income to spend.
Analyzing Interest-Sensitive Assets
Financial professionals analyze interest rate sensitivity in a variety of ways and from many angles. This analysis is typically done for institutional lenders as a way of determining the risk of its lending policies.
Lenders and corporations also analyze the interest rate sensitivity of their investment assets as a part of their balance sheet reporting.
Benchmarks under close watch for interest rate changes include the six-month Treasury bill rate, the London Inter-bank Offered Rate (LIBOR), and the Federal Reserve's prime rate. The indexed rates of these products are the key elements that analysts follow when considering interest sensitivity and that banks use when setting their rates for various financial products.
Coping With Interest-Sensitive Assets in Investment Portfolios
An individual investor's portfolio needs to be scrutinized carefully in times of interest rate volatility, especially if they are heavily invested in bonds.
When interest rates rise, bond prices fall.
Generally, when interest rates are rising, portfolio managers who concentrate on fixed-income investments would hedge against the market risk using derivatives, or potentially swap for variable-rate investments. Conversely, if interest rates are falling, their portfolios can be adjusted to place a greater portion of assets in longer-term fixed-rate investments, thus locking in the higher income.
Floating-rate bonds are one type of product that investors can consider in order to stay on top of interest rate changes without the effort. These bonds pay current market interest rates.