What Is a Basis Point?

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DEFINITION

A basis point is considered the smallest measurement of quoting changes to interest rates or yields on bonds. It is a way to describe one-hundredth of a percentage point (0.01%).

Definition and Example of a Basis Point

A basis point represents 0.01%. For example, if someone says the yield on a 10-year Treasury bond fell by 10 basis points, they mean it dropped by 0.1% (0.01 * 10). If someone says a bond yield fell by 100 basis points, it means it decreased by 1% (0.01 * 100). The term is common in discussions about bonds, other fixed-income investments, and loans.

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%.

If someone references basis points, and you can’t remember what that means, you can convert it to a percentage by dividing by 100 or moving the decimal point two places to the left. So, 1,050 basis points are 10.50%, and 236 basis points are 2.36%.

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.

Interest rates are sometimes explained in relation to an index or benchmark rate. One common comparison is to the Secured Overnight Financing Rate (SOFR, which is replacing the London Interbank Offer Rate, LIBOR). A bond with a floating rather than a fixed interest rate may have a rate of 25 basis points above SOFR. If SOFR stands at 2%, then the rate is 2.25%.

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.

Key Takeaways

  • Using basis points prevents confusion when discussing changes in yields or interest rates.
  • Basis points are most commonly used when differences of less than 1% are significant.
  • A basis point refers to one-hundredth of a percentage point. For example, the difference between 1.25% and 1.30% is five basis points.
  • When the Fed benchmark interest rates are changed, they usually go up or down by 25 basis points.
  • Basis points are also commonly used when referring to the costs of owning mutual funds and exchange-traded funds.

Article Sources

  1. Federal Reserve Bank of New York. "Secured Overnight Financing Rate."

  2. Federal Reserve. "Open Market Operations."

  3. Federal Reserve Bank of New York. "Effective Federal Funds Rate."