What Is a Basis Point?
How The Measurement Relates to Interest Rates and Your Investments
If you follow financial media or speak to experienced investors, you may hear the term “basis point” in conversations around interest rates. The term is common in discussions about bonds and other fixed-income investments as well as loans.
A basis point is considered the smallest measurement of quoting changes to interest rates or yields on bonds. It is simply a way to describe one-hundredth of a percentage point: (0.01%). So, if someone says: “The yield on 10-year Treasuries fell 10 basis points to 1.9%,” that means the yield was 2% previously.
In Fixed Income
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 investors are willing to pay for older bonds, and that in turn affects the yields—the expected return on the bonds.
Let’s use an oversimplified example just to illustrate. Let’s say you have $10,000 to invest, and decide to buy a bond with an interest rate—usually called a coupon rate—of 3%. A year later, prevailing rates have dropped 50 basis points, so new bonds with the same face value are now paying 2.5%. Your bond is now worth more because it pays out $300 a year rather than $250. Generally, investors want to see yields rising, and you’ll often hear the changes expressed in basis points (abbreviated bps.)
Interest rates are sometimes explained in relation to an index or benchmark rate. One common comparison is to the London Interbank Offer Rate (LIBOR), another benchmark. A bond with a floating rather than a fixed interest rate may have a rate of “25 basis points above LIBOR”. If LIBOR stands at 2%, then the rate is 2.25%.
Basis points are common in discussions about borrowing as well as investing. The Fed’s benchmark rate, which influences rates on mortgages, credit cards, and other loans, is usually changed 25 basis points (one-quarter of a percentage point) at a time. The Fed last changed the benchmark in December 2018, raising it from 2.25% to 2.50%.
In Expense Ratios
If you’re an investor in mutual funds or exchange-traded funds, you may encounter an annual fee called an expense ratio—the portion of assets deducted each year by your fund manager for fund expenses. If your expense ratio is 145 basis points, that means your fund manager is charging you 1.45% of your total assets in the fund.
For Clarity’s Sake
Why do people use the terms basis points and percentage points rather than percentages? To avoid confusion when discussing the difference between two rates. Let’s say, for example, that a news report said the yield on a bond rose .5% from 7.5%. It might be difficult to discern what the new yield is. It could be 8% (7.5%+.5%) or it could be 7.5375% (7.5% + .0375, which is 5% of 7.5). If, however, the news reported a .5 percentage point increase—or a 50-basis point increase—you would know the new yield is 8%.
Basis points are often used instead of percentage points when differences of less than 1% are meaningful. If rates increase by a half a percentage point, that’s 50 basis points. A full percentage point is 100 basis points.
Converting Basis Points
If someone references basis points and you can’t remember what that means in terms of percentage, there’s some simple math you can do. To turn basis points into a percentage, multiply the basis points by .01. So, 765 basis points is 7.65%. Another very easy way to convert to a percentage is to place the decimal point before the final two numbers. So 1,050 basis points is 10.50%, and 236 basis points is 2.36%.
- Using basis points can avoid confusion when discussing changes in yields or interest rates.
- Basis points are most commonly used when differences of less than 1% are meaningful.
- A basis point refers to one-hundredth of a percentage point. For example, the difference between 1.25% and 1.30% is 5 basis points.
- When benchmark interest rates are changed, they usually go up or down by 25 basis points.