It states in my textbook that as interest rates are lowered it says lenders are the ones who gain from the decrease in interest rates. But isnt this not true? As lower interest rates imply the amount you net from lending decreases as interest decreases?
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2 Answers
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Yes. That's tricky for newcomers to figure out. The concepts to keep in mind are:
a) to buy a bond is essentially to lend to the bond issuer
and
b) bonds are tradable.
So let's say that, in 2010, you bought a 30-year bond at \$10,000 face value that was yielding a 5% rate (known as the coupon rate) and today, in 2020, a 20-year bond is being issued also at \$10,000 par value but only offers a 4% return ($400 annual coupon).
Because bonds are tradable, that means your 30-year bond with 20 years remaining and an annual coupon of \$500 should now have buyers willing to pay a bit more than the $10,000 you paid for it.
Specifically, they can pay up to around $1.135 and still get the equivalent yield to maturity as the newly issued 20-year bond, a 13.5% profit for you.
The reverse also applies. If your 2010 30-year bond had a 4% coupon and the 2020 20-year bond is yielding 5%, you would only be able to sell the 2010 today at a price lower than $10,000.
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When rates decrease, lenders will also pay less to borrow the money that they lend out, so it's plausible that the differential between the rates (equating to the lender's profit) doesn't fluctuate that much when rates go either up or down. However, when rates go down the price to borrow is lower to the consumer. This causes a higher demand for borrowing money, which ultimately leads to a higher volume of loans getting closed overall.
