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How Bond Interest Rates Are Set
By this point, you're probably wondering how interest rates on bonds are set. It all starts with the Federal Reserve, in particular the Federal Open Market Committee, which sets what is called the "fed funds" rate. This is the rate the Fed charges banks for overnight loans, and is generally the rate that is used for the 3-month T-bill. It is often referred to as the "risk-free" rate because it applies to the lowest-risk Treasury -- though it isn't really completely risk-free!
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Interest rates for longer-term bonds are based on the 3-month T-bill rate. If it goes up, rates for longer-term bonds will probably go up. If it goes down, other rates will likely follow suit. In fact, even a hint that it might go up or down can affect rates. However, under certain economic conditions the relationship might not be this direct, as we'll see in the next section.
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Interest rates on corporate bonds are also based on Treasury market rates, though the credit quality of the company issuing the bond also comes into play. A company with a low credit rating would generally have to offer a higher interest rate to compensate investors for the credit risk (that is, the risk that the company in the future may be unable to fulfill its obligation and pay back the bond).
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If the economy slows, investors often move their money from corporate bonds to Treasuries. This is because the slowing economy usually causes their corporate bonds to drop in value, because corporate earnings also slow. Investors often respond by abruptly moving their money into bonds with less risk. This "flight to quality" can lead to a glut of corporate bonds on the market, further dampening their price. Higher-risk corporate bonds generally fall more in price than higher-quality, lower-risk corporates.
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