The concept of a Basis Point
The basis point (bps) is commonly used when analyzing fixed income instruments to estimate returns and interest rates. One basis point is 1/100 of a percentage point, or 0.01%. It is also used by stock market investors who focus on investment returns as a function of dividends.
In addition, central bank monetary policy decisions often include interest rate adjustments, whose changes are expressed in basis points. For example, a 25 basis point increase in the federal funds rate represents an increase of 0.25%, or a quarter of a percentage point. Basis points are often used to quantify the difference between the returns of two instruments because it can be more accurate than using regular percentage points (eg 102 bps = 1.02%).
Basis points and yield curves
The curve that reflects the change in the yield of an instrument depending on the maturity of various issues is called the yield curve. Spreads between issues are calculated by subtracting the yield on issues with a shorter maturity from the yield on longer-term bonds. Depending on the obtained difference, the curve may have a steep slope or be flat. In a normal situation, the profitability of long-term issues is higher due to the greater number of possible risks.
In some cases, there is an inversion of the yield curve (when short-term securities offer higher yields than long-term issues). This suggests that, for some reason, the short-term risks far outweigh the long-term ones.
For example, if the yield on 2-year government bonds is currently 2.70% or 270 bps, and the yield on 10-year government bonds is 2.88% or 288 bp, then the spread between them is 18 bps. If the previous week it was 25 bps, then the spread flattened by 7 bps. If the yield on 2-year bonds increases to 2.95%, while the yield on 10-year bonds remains unchanged, then the spread will be -7 bps, and the curve will reverse.
Basis points for consumers
Basis points are also used when comparing consumer lending rates. The change in these rates is often expressed in terms of basis points, as it is usually less than a percentage point (for example, 0.5% = 50 b.p.), or includes odd fractions of a percentage point (for example, 1⅜% = 137.5 b.p.).
In addition, these rates are often defined as a function of risk relative to a base rate, such as the federal funds rate or the 10-year government bond yield. The difference between the 10-year mortgage rate and the 10-year Treasury yield is usually expressed in basis points for clarity of comparison.
The US government bond yields page offers a chart of yields for various countries, ranging from 1-month bills to 50-year bonds. The resulting table contains a column of intraday changes, where 0.01% = 1 basis point.