ArtsAutosBooksBusinessEducationEntertainmentFamilyFashionFoodGamesGenderHealthHolidaysHomeHubPagesPersonal FinancePetsPoliticsReligionSportsTechnologyTravel

Understand the different component factors in the interest rate paid by your investments

Updated on March 3, 2015
Cruncher profile image

Cruncher is the pseudonym of an actuary working in London with experience in insurance, pensions and investments.

We all know that we invest our money to get a return. Whether than return comes as income or capital gains, the overall return is what matters.

But what drives the different returns you get on different assets? In this article I'll show the five main components of the return on an asset. This particular breakdown applies especially to fixed interest investments like bonds, but the principles apply to any kind of investment.


1. The risk free real rate of return

The risk free rate of return is the return any investor could get without taking any risks with their money. When we say "real" return we mean return net of the effect of inflation. This is important because inflation erodes the spending power of your money, so over time you can buy less stuff with the same amount of money.

In most developed countries the risk free rate of return (for long terms at least) are considered to be near enough equal to the yield on government bonds (such as gilts in the UK). This only works if there is very little risk of the government defaulting.

In reality there is no guarantee that an investor can get the risk free real rate of return.

The reason that (most of the time) the risk free rate of return is more than zero is because most of the time we prefer to have money now over money later so borrowers have to pay a positive return to persuade to invest our money instead of just spending it now. Although at the moment in many countries the risk free rate of return is zero or even negative at the moment, which makes investing an even greater challenge.


2. Expected inflation

The real risk free rate is net of inflation, but in the real world we invest in nominal terms, ie in cash terms. So the rate of return needs to include an allowance for inflation.

Unfortunately we don't know exactly what inflation will be, so all we can do is make the best estimate we can. Overall then, the rate of return on an asset (based on it's market price) contains the "market's expectation" of future inflation. This is something an "average" of all the investors in the markets ideas about future inflation.

Risk Premiums

If you take a risk on your investments you would expect to get a higher return for taking that risk. Otherwise you could just invest in an equivalent less risky asset. It can be helpful to think of these extra returns as a "risk premium" for the risk taken on.

3. Default-risk premium

When you invest your money there is always a risk that you won't get money back because whoever you invested with defaults. This might be losing everything, or might just be not getting back everything you were promised.

When investing you should expect to get a premium for this default risk. The greater the chance of default the bigger the premium.

Some investments come with credit ratings which give an idea of the default risk. These are given by credit rating agencies. However it is important to note that these ratings don't guarantee anything, they are just an informed opinion on the investment.


4. Liquidity risk premium

Liquidity is a measure of how easy it is to turn an investment into cash. This might be by selling it, or because the investment itself generates a lot of cash.

Investors generally prefer liquid investments as it is easier to manage your portfolio if the value of the investment can be realised quickly. Therefore investors would expect to get a premium for investing in illiquid assets.

The main reason an asset is illiquid is if there is not a very well developed market for the asset.

5. Maturity risk premium

The longer your money is tied up for the higher the return you might expect. Investing over a longer period increases the risks to your money - there is more time for things to go wrong. Longer maturity assets are also more affected by other changes such as changes in bank interest rates.


Component of interest rates
Risk free real rate of return
The rate of return that investors can achieve with no risk, net of the effect of inflation
Expected inflation
The market expectation of future inflation
Default-risk premium
Compensation for the risk that the investor might not get their money back
Liquidity premium
Compensation if an investment is hard to sell
Maturity premium
Compensation for locking your money away for a long time


    0 of 8192 characters used
    Post Comment

    No comments yet.


    This website uses cookies

    As a user in the EEA, your approval is needed on a few things. To provide a better website experience, uses cookies (and other similar technologies) and may collect, process, and share personal data. Please choose which areas of our service you consent to our doing so.

    For more information on managing or withdrawing consents and how we handle data, visit our Privacy Policy at:

    Show Details
    HubPages Device IDThis is used to identify particular browsers or devices when the access the service, and is used for security reasons.
    LoginThis is necessary to sign in to the HubPages Service.
    Google RecaptchaThis is used to prevent bots and spam. (Privacy Policy)
    AkismetThis is used to detect comment spam. (Privacy Policy)
    HubPages Google AnalyticsThis is used to provide data on traffic to our website, all personally identifyable data is anonymized. (Privacy Policy)
    HubPages Traffic PixelThis is used to collect data on traffic to articles and other pages on our site. Unless you are signed in to a HubPages account, all personally identifiable information is anonymized.
    Amazon Web ServicesThis is a cloud services platform that we used to host our service. (Privacy Policy)
    CloudflareThis is a cloud CDN service that we use to efficiently deliver files required for our service to operate such as javascript, cascading style sheets, images, and videos. (Privacy Policy)
    Google Hosted LibrariesJavascript software libraries such as jQuery are loaded at endpoints on the or domains, for performance and efficiency reasons. (Privacy Policy)
    Google Custom SearchThis is feature allows you to search the site. (Privacy Policy)
    Google MapsSome articles have Google Maps embedded in them. (Privacy Policy)
    Google ChartsThis is used to display charts and graphs on articles and the author center. (Privacy Policy)
    Google AdSense Host APIThis service allows you to sign up for or associate a Google AdSense account with HubPages, so that you can earn money from ads on your articles. No data is shared unless you engage with this feature. (Privacy Policy)
    Google YouTubeSome articles have YouTube videos embedded in them. (Privacy Policy)
    VimeoSome articles have Vimeo videos embedded in them. (Privacy Policy)
    PaypalThis is used for a registered author who enrolls in the HubPages Earnings program and requests to be paid via PayPal. No data is shared with Paypal unless you engage with this feature. (Privacy Policy)
    Facebook LoginYou can use this to streamline signing up for, or signing in to your Hubpages account. No data is shared with Facebook unless you engage with this feature. (Privacy Policy)
    MavenThis supports the Maven widget and search functionality. (Privacy Policy)
    Google AdSenseThis is an ad network. (Privacy Policy)
    Google DoubleClickGoogle provides ad serving technology and runs an ad network. (Privacy Policy)
    Index ExchangeThis is an ad network. (Privacy Policy)
    SovrnThis is an ad network. (Privacy Policy)
    Facebook AdsThis is an ad network. (Privacy Policy)
    Amazon Unified Ad MarketplaceThis is an ad network. (Privacy Policy)
    AppNexusThis is an ad network. (Privacy Policy)
    OpenxThis is an ad network. (Privacy Policy)
    Rubicon ProjectThis is an ad network. (Privacy Policy)
    TripleLiftThis is an ad network. (Privacy Policy)
    Say MediaWe partner with Say Media to deliver ad campaigns on our sites. (Privacy Policy)
    Remarketing PixelsWe may use remarketing pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to advertise the HubPages Service to people that have visited our sites.
    Conversion Tracking PixelsWe may use conversion tracking pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to identify when an advertisement has successfully resulted in the desired action, such as signing up for the HubPages Service or publishing an article on the HubPages Service.
    Author Google AnalyticsThis is used to provide traffic data and reports to the authors of articles on the HubPages Service. (Privacy Policy)
    ComscoreComScore is a media measurement and analytics company providing marketing data and analytics to enterprises, media and advertising agencies, and publishers. Non-consent will result in ComScore only processing obfuscated personal data. (Privacy Policy)
    Amazon Tracking PixelSome articles display amazon products as part of the Amazon Affiliate program, this pixel provides traffic statistics for those products (Privacy Policy)