Basis Point - What is a basis point? Begin To Invest Definition Series
What is a basis point?
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A Basis Point is one one-hundredth of a percentage point, or 0.01%.
Basis Points are typically referenced in relation to yields on bonds and interest rates.
You will commonly see basis points used in 2 scenarios:
First, when describing changes in Yield.
For an example, consider the 10 year U.S. Treasury Bond, yielding 2.59% today.
If the interest rate is up 0.02 percentage points, from 2.57% to 2.59%. This increase in 0.02% of yield is more commonly expressed as a “2 basis point rise”.
Or, you also see the term basis point used when describing the spreads between bonds.
For example, a 10 year French bond today yields 2.262%, compare that to the U.S which is 2.588%.
The difference between the interest rates of the French bond and the U.S bond is typically called the “spread” between the U.S. and French 10 year.
2.262 – 2.588 = -32.6
Or a -32.6 basis point spread.
Investors will also see spread reported involving corporate bonds:
For example, a Freeport-McMoran’s bond maturing in February 2022 has a current spread of 293 Basis Points. This means the bond currently yields 2.93% higher than the comparable U.S. Treasury bond. (That is, a U.S. Treasury with similar maturity).
A higher spread means that investors see more risk in the investment, so they are demanding higher yields.
Typically, the U.S. Treasury is considered the “risk-free” investment. The U.S. government has no credit risk, as they can print money if required to pay back the bond. However, corporations do not have the luxury of printing money to pay their bills, so that therefore means that an investment into a corporate bond has certain default or credit risk.
A very strong company may have a very small spread over U.S. Treasuries, while a company barely able to pay its bills may have to pay a large premium over the U.S. Treasury rate. This is the same basis between someone with a bad credit score paying a higher interest rate on a car or home loan than an individual with a high credit score.