What is a Basis Point?
A basis point (bp) is a unit of measurement commonly used to express changes in interest rates and yields of financial instruments. One basis point is equal to 0.01% or one-hundredth of a percentage point. Therefore, if a rate increases by 25 basis points, it means it has risen by 0.25%.
Why are basis points used? The primary reason for using basis points is the need for precision. They help to represent even minor changes in percentages. This is particularly important when analyzing bonds and other fixed-income financial instruments, where accuracy can significantly influence investment decisions.
Basis Points and Central Banks
Central banks often announce interest rate changes in basis points. For example, if the U.S. Federal Reserve raises its key interest rate by 50 basis points, this represents a 0.5% increase. Investors closely monitor interest rate changes, as they affect the availability of credit and the overall economic situation.
How Basis Points are Applied in Practice
1. Impact on Bond Yields:
Bond yields can be adjusted by just a few basis points, and this can represent a significant change. For instance, if the yield on government bonds increases from 2.00% to 2.05%, this change amounts to 5 basis points.
2. Spreads and the Yield Curve:
Basis points are also used to calculate the yield difference (spread) between debt instruments of varying maturities. For example, if the yield on two-year bonds is 2.70% (270 bps) and that of ten-year bonds is 2.88% (288 bps), the spread equals 18 bps. The spread helps assess how expected short-term asset yields differ from long-term ones and how the market evaluates risks.
What is the Yield Curve?
The yield curve is a graph that displays the yields of bonds with different maturities. Under normal circumstances, the yields of bonds with longer maturities are higher due to additional risks. However, when the yield curve inverts (i.e., short-term bond yields rise above long-term ones), it often signals potential economic risks.
For example, if the yield on two-year government bonds is 2.95% while the yield on ten-year bonds remains at 2.88%, the spread becomes negative (-7 bps), indicating an inverted yield curve.
The Application of Basis Points in Everyday Life
Changes in interest rates for mortgage loans, consumer loans, and credit cards are often expressed in basis points. For instance, a change in a mortgage rate by 0.5% can be represented as a change of 50 bps or 0.5%. This approach helps compare rates across different products and clarify the exact amount by which the interest changes.
Why is Understanding Basis Points Important?
For investors, especially those dealing with bonds and fixed-income instruments, basis points serve as a convenient unit of measurement for evaluating small changes and making decisions. Even slight fluctuations in yields can significantly impact bond prices, particularly with large investments.
Basis points are an essential tool for more accurately assessing changes in interest rates and yields. They play a role not only in investments but also in everyday credit products such as mortgages and consumer loans. Understanding basis points helps investors and borrowers navigate the financial landscape, from interest rates to bonds and spreads, making them more confident in their financial decisions.
Sergey Tereshkin, Founder and CEO of the Oil Products and Raw Materials Marketplace OPEN OIL MARKET
