Bonds and interest rates meet in the bond market where bonds are bought and sold. Sometimes you even find new loans coming out of this market. Where it gets confusing is how pricing is conducted.

I'll not try to explain pricing today. I am not the expert to undertake such an effort. My mission today is to propose a simpler way to understand market basics. I will propose that we follow the sometimes expressed preference of Modern Monetary Theory (MMT) advocates who want to have universal interest rates set at zero.

I propose accomplishing the zero interest rate goal by passing a national law stipulating that all forthcoming loan documents be limited to a zero percent annual interest rate. Nothing would be said about discounts or cost of fees.

Going forward, borrowers would have the advantage of loans that had a zero per cent face rate. All they would need to worry about would be their monthly payment, which would presumably be fixed until payoff or sale of the loan obligation with supporting assets.

Here's the 'catch' in this proposal: The initial loan would have a stated rate of zero but what would the apparent rate be? The lender would charge initialization fees and may also propose a 'discount'. The discount could include any justification what-so-ever, including the shape of the

The reader may pause here; How can there be a yield curve if all loan contracts (including bonds) have a legally set interest rate of Zero? The yield curve should be flat!

Well, how should we consider the bond

Presumably a spectrum of bonds (all bearing a zero rate stipulation) with differing remaining times to payoff would be on-offer. Potential buyers of these bonds would be willing to offer different discounts for each different time duration. A time based chart of these discounts, translated into interest rates, would generate a yield curve.

Golly! It seems that zero based interest rates may not be zero interest at all. At least not if the lender wants to calculate the

Going forward, borrowers would have the advantage of loans that had a zero per cent face rate. All they would need to worry about would be their monthly payment, which would presumably be fixed until payoff or sale of the loan obligation with supporting assets.

Here's the 'catch' in this proposal: The initial loan would have a stated rate of zero but what would the apparent rate be? The lender would charge initialization fees and may also propose a 'discount'. The discount could include any justification what-so-ever, including the shape of the

*yield curve*.The reader may pause here; How can there be a yield curve if all loan contracts (including bonds) have a legally set interest rate of Zero? The yield curve should be flat!

Well, how should we consider the bond

**market? After all, many people want to sell bonds (that they own) long before the bond approaches payoff date. Lenders have the option of either buying resale bonds or buying a brand new bond. How do they value bonds with a zero percent interest rate on the resale market?***resale*Presumably a spectrum of bonds (all bearing a zero rate stipulation) with differing remaining times to payoff would be on-offer. Potential buyers of these bonds would be willing to offer different discounts for each different time duration. A time based chart of these discounts, translated into interest rates, would generate a yield curve.

Golly! It seems that zero based interest rates may not be zero interest at all. At least not if the lender wants to calculate the

*true*return, expressed as a rate of interest, over the remaining life of the loan.**Return to Reality**

My proposal for legally set zero interest rate contracts is made with 'tongue-in-cheek'. The concept helped me understand the bond market by taking the variability of contract interest rates out of the valuation schedule. That leaves fees, discounts, and time as variables in an apparent interest rate calculation. I thought I would share the idea with my readers; what you just read was my method of sharing.

I think I have the key to Brian's post now. Apparent interest rates are set in the bond resale market (which makes new loans as well). Central Banks enter this market to influence interest rates (and the yield curve) by buying or selling bonds. Perhaps most important: a formula is used to calculate apparent interest rates for yield curve construction. Only accidentally does the actual interest rate displayed on any particular issue correspond with the yield curve rate.

**Conclusion**I think I have the key to Brian's post now. Apparent interest rates are set in the bond resale market (which makes new loans as well). Central Banks enter this market to influence interest rates (and the yield curve) by buying or selling bonds. Perhaps most important: a formula is used to calculate apparent interest rates for yield curve construction. Only accidentally does the actual interest rate displayed on any particular issue correspond with the yield curve rate.

Again a disclaimer: I am making a proposal with 'tongue-in-cheek', not offering investment advice.

[1] tantalus: "2 not capitalized : a locked cellarette with contents visible but not obtainable without a key" (Thanks to Google Search. Click "What does it mean to call someone a Tantalus.")

(c) Roger Sparks 2020

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