One of the axioms that governs the world of finance is the value of money over time, better known as “Time Value of Money”. A dollar today is worth more than a dollar tomorrow, but how much more? The answer depends mainly on two variables, how far in the future (time) and the “price” of money (rate).
This price of money, or rate, is of great relevance for the valuation of financial assets (bonds, shares, derivatives, real estate, etc.). It also holds a strong impact on consumer behavior and therefore is one of the most powerful tools that guides economic cycles.
When the price of money goes up (restrictive cycle in rates) the savers will receive a bigger prize for their money so they would prioritize saving over spending.
Consumers would slow down and as demand for goods declines, prices of the products yield and inflation decreases. Conversely, in the face of a declining economic activity, central banks often reduce the price of money to encourage consumers to accelerate their purchasing decisions and promote an increase in economic activity.
Now, we have begun to talk about one of the three characteristics of fixed income instruments, the rate. The other two elements are: maturity and principal. A company or organization that issues debt, places an amount (principal) that will pay a certain premium (rate) over a time horizon (maturity).
Intuitively we can realize that it is not the same for an A or B company to issue debt, the rate will depend on many factors such as: liquidity, leverage, industry, profitability, currency, maturity. The rate of fixed income instruments should reflect these factors, considering that the higher the risk, the higher the return will be required.
Speaking of a fixed income instrument, as a government bond, we would understand that the short-term instrument (28 days) should have a lower rate than one issuance with a longer maturity (10 years for example). These differences describe what is known as the “yield curve” which usually has a positive (increasing) slope. When the difference between the short and long rates is reduced, a flattening in the curve is said to exist; and in cases where the difference is negative, it is said to be inverted. In these cases, analysts can interpret the scenarios that the markets are anticipating and act accordingly.
It is along this yield curve where money market management experts will seek returns, and will provide an alpha in fixed income investment instruments or funds, drawing on their experience and knowledge.