In investing and finance, there is a common unit of measure, for interest rates and other percentages, called a basis point. But just what are “basis points?” Here is everything one needs to know about them and their association with interest rates and investments.
Known as a “bip” or bps, a basis point is a unit of measure that is used to describe the percentage change in the rate or value of a financial instrument. The word “basis” in the standard measure derives from the base move between two percentages, or the spread between interest rates.
The basis point is often employed to calculate changes in interest rates, fixed-income security yields, and equity indices. Loans and bonds are commonly quoted in basis points.
A basis point is equal to 0.01% (1/100th of a percent) or, in decimal form, 0.0001 (0.01/100). For example, a 1% change equals a change of 100 basis points, and 0.01% change is the same as one basis point.
Remember, to convert a basis point into percentages, start with a decimal point and multiply by 100. If beginning with a percentage and want the decimal form, divide it by 100.
Basis points can reveal to investors the performance of stocks, bonds, mortgage loans, mutual funds, and other financial instruments.
For example, it might be said that a bond whose yield rises from 5% to 5.5% has increased by 50 basis points.
For some institutional and accredited investors, just a couple of basis points of performance could mean a great deal of money.
The Federal Reserve Board uses basis points to determine the federal funds rate which, in turn, affects the prime rate and, thus, other interest rates.
If the Fed heightens by 25 basis points the target interest rate, that means that rates have increased by 0.25 percentage points. If rates were 2.50% and were raised by the board by 25 basis points, that would put the new rate at 2.75%.
For example, it could be said that one’s bank has an interest rate that is 60 bps over the Secured Overnight Financing Rate (SOFR). The SOFR is used to establish rates for some consumer and business loans. Meanwhile, the prime rate plays a major role in setting rates for personal loans, credit cards, home equity loans, and more.
The Federal Deposit Insurance Corporation (FDIC) presents annual rates in basis points, which are cents per $100 of assessment base.
On invoices, the annual rate is changed to a quarterly multiplier by dividing the yearly rate by 10,000, dividing by four, and lastly rounding to seven decimal places.
Investors can use basis points to potentially determine the best times to invest as well as how their investments are performing relative to interest rate changes.
When comparing funds, investors can use basis points to garner a better understanding of cost differences. For example, it may be stated that a fund that has 0.35% in expenses is 10 basis points under another fund that has a yearly expense of 0.45%.
Basis points are also used in reference to the cost of exchange-traded funds and mutual funds. A mutual fund’s annual management expense ratio of 0.15%, for example, will be quoted as 15 bps. Basis points also affect annuities, corporate and treasury bonds, and fund-style vehicles.
Note that because interest rates do not apply to stocks, basis points are not as commonly used in that market. Rather, stock prices are quoted using dollars and cents.
The price value of a basis point is a gauge of the change in the absolute value of a bond’s price for a one basis point yield change. Rather than employing a 100-basis point change, a basis point’s price value merely utilizes a single basis point change.
It is an additional way to assess interest rate risk and can be likened to duration, which establishes the permit change in a bond’s price given a 1% rate change.
Basis points are used to filter leveraged loans that are used in collateralized loan obligations (CLOs).
CLOs comprise a $910 billion asset class of mostly leveraged loans that are managed and securitized as a fund. Every CLO is a series of what are called “tranches,” groups of bonds that pay interest in addition to some equity.
CLOs usually provide higher yields than other fixed-income investments such as investment-grade corporate bonds or government bonds, in addition to a credit risk structure that provides extra protection to senior-tranche investors against losses due to defaults in the underlying loans.
Further, collateralized loan obligations are generally more liquid than their underlying loans since they may be purchased and sold in the secondary market. This can render it easier for investors to manage their holdings and pivot when necessary.
Also, because there is a collateral manager who handles the loan pool that backs CLO securities, investors have access to professionals with credit-markets expertise.
Note that every investment carries risk, including CLOs, which are exposed to credit risk related to the underlying loans. Such risk is limited, however, owing to the credit risk structure mentioned above.
Collateralized loan obligations are among the broad selection of vetted and curated opportunities offered by Yieldstreet, a leading platform for alternative investments — basically asset classes other than stocks or bonds.
Such assets include real estate, art, transportation, and more, and are increasingly popular for their potential for steady secondary returns and low correlation to public markets, which can reduce portfolio volatility.
Investors in Yieldstreet CLOs receive quarterly income as in excess of 100 underlying loans make interest payments. This year alone, net annualized returns have totaled 11.3%. Compare that to 3.7% for investment-grade bonds and 7.3% for high-yield bonds
Since Yieldstreet’s CLOs access diversified funds, they serve another crucial purpose, and that is portfolio diversification. Holdings of varying assets can help reduce risk and even provide better returns. In fact, diversification is central to long-term investment success.
Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.
In some cases, this risk can be greater than that of traditional investments.
This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.
However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.
Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.
Investors can use their knowledge about basis points, which can tell investors quite a bit about investments and help them decide where to take positions, to invest in collateralized loan obligations for potentially high returns and portfolio diversification.
Yieldstreet provides access to alternative investments previously reserved only for institutions and the ultra-wealthy. Our mission is to help millions of people generate $3 billion of income outside the traditional public markets by 2025. We are committed to making financial products more inclusive by creating a modern investment portfolio.