People use the terms “basis points” and “percentage points” to avoid confusion when discussing the difference between the two rates. For example, suppose that the yield on a bond rose by 0.5% from 7.5%. The news might report that a bond “is up .5% from yesterday’s close of 7.5%.” You might hear another station report that a bond “is up 50 basis points from yesterday’s close of 7.5%.” Either way, you know the bond’s yield is now 8%.
How Basis Points Work
Basis points are commonly used to express changes in the yields on corporate or government bonds bought and sold by investors. Yields fluctuate, in part because of prevailing interest rates, which are set by the Federal Reserve’s Open Market Committee. If the Fed lowers its fed funds target rate, interest rates on newly issued bonds will decline, and vice versa. Those changes affect the prices that investors are willing to pay for older bonds, which affects the expected return on the bonds. Suppose you have $10,000 to invest and decide to buy a bond with an interest rate—called the “coupon rate”—of 3%. A year later, prevailing rates have dropped by 50 basis points, so new bonds with the same face value now pay 2.5%. Your bond is now worth more to bond investors, because it yields $300 per year rather than $250. Generally, investors want to see yields rising, and you’ll often hear the changes expressed in basis points.
What It Means for Individual Investors
Suppose you’re a mutual fund or exchange-traded fund (ETF) investor. In that case, you may encounter an annual fee called an “expense ratio,” which is the portion of assets deducted each year by your fund manager for fund expenses. If your expense ratio is 145 basis points per $1,000, your fund manager is charging you 1.45%, or $14.50 per $1,000 invested. Basis points are also common in discussions about borrowing as well as investing. The Federal Reserve’s benchmark rate, which influences rates on mortgages, credit cards, and other loans, is usually changed in increments of 25 basis points. The Federal Reserve’s benchmark rate is the Effective Federal Funds Rate, which is the effective rate at which banks borrow funds from each other overnight. This rate is governed by the Federal Fund Rate Target Range set by the Federal Reserve.
