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How does a change in the federal fund rate influence the rate of return of corporate...

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yomibolo | Student, Undergraduate | eNotes Newbie

Posted October 14, 2011 at 3:24 AM via web

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How does a change in the federal fund rate influence the rate of return of corporate bonds?

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justaguide | College Teacher | (Level 2) Distinguished Educator

Posted October 14, 2011 at 3:03 PM (Answer #1)

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Banks are required to maintain a specific percentage of the amount that they can lend with themselves in liquid assets. This is done to ensure that if the lenders to the bank want to withdraw their funds an adequate amount of money is available with the banks and they do not default.

To manage the assets available, banks which have reserves in excess of the amount required, lend funds to other banks that may have a deficit. The rate at which this is done is fixed by the federal reserve. If the fed fund rate is high, banks have to pay a higher interest when they borrow funds from other banks. This reduces the amount that they can lend and increases the interest rate at which they do the same. If the rate of interest at which funds are being lent is increased there is a simultaneous increase in the rate of interest that banks have to pay to people that have deposits with them.

Corporate bonds are issued by companies and either pay a fixed interest rate every year and their face value when they are redeemed or no interest in paid but the amount at redemption is much higher that the face value.

If the fed funds rate increases, people can gain more by investing funds as deposits in banks. This decreases the price at which corporate bonds are being traded in the market as there are more sellers than buyers. This decreases the bond yield.

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