What
is the Bond Market?
First watch this video “Intro
To the Bond Market”
https://www.youtube.com/watch?v=O7ww0gQwuhI
…
(transcript of video)
Most individuals who want a
loan borrow money from a bank.
But for a well-known corporation
like Starbucks, borrowing money may be available through another type of
financial intermediary: the bond market.
A bond is essentially an IOU.
It documents who owes and
gets paid how much and when payments must be made.
Like stocks, bonds are traded
on markets.
For an established company
like Starbucks, investors know enough about the company so they're willing to bypass
the bank intermediary and lend directly to the company by buying their bonds.
…
For a large company with a
good reputation this can mean they can borrow money on better terms, at a lower
interest rate, from the bond market than they can borrowing from a bank.
For example Starbucks has
issued over a billion dollars of corporate bonds over the years to fund their
expansion plans.
Unlike a stock, if you buy a
newly issued bond from Starbucks you don’t own part of Starbucks.
You're simply lending
Starbucks money.
In exchange they are
promising to pay you back a specific amount of money at a certain point in time.
…
Some bonds also pay out regular
interest amounts, called coupon payments, on a set schedule.
By issuing bonds, a company
can raise capital and make big investments.
Then the company can repay that
debt over a long time line as those investments provide a profit percent greater
than the interest percent paid to bond-holders.
…
Government also borrows money
in the bond market.
In 2016 the U.S. government
owed the public almost 14 trillion dollars in promised bond payments.
Because the government is so
big, when it borrows money it affects the entire market for saving and
borrowing.
…
Per Figure 1, imagine the
government decides to borrow $100 billion.
This shifts the demand for
loanable funds up and to the right, increasing the equilibrium interest rate
from 7% to 9%.
A higher interest rate means
the quantity of savings supplied will increase, in this case from $200 to $250
billion.
If savings increases by $50
billion that means private consumption is falling by $50 billion.
If we’re saving more that
means we’re consuming less.
...
Per Figure 2, because
borrowing has become more expensive due to the higher interest rate of 9%,
private borrowing and investment will also fall.
At a 9% interest rate, we can
see the private demand for loanable funds is $150 billion.
That’s $50 billion less than
it was at an interest rate of 7%.
We call these effects
“crowding out.”
When the government borrows
$100 billion it crowds out private consumption and private investment.
In this case, it crowds out
$50 billion of private consumption and also $50 million of private investment.
…
Bonds aren’t as risky as
stocks, because the bondholders must be paid before any profits are distributed
to shareholders.
Bonds do have risks, mainly
the risk that when the payment comes due the borrower won’t be able to pay.
That's called the default
risk
When
a company goes bankrupt
-the
shareholder owners lose their entire investment
-the
bondholders get part of their investment back when the assets of the company
such as buildings are sold
…
If investors think a firm
issuing a bond has a significant default risk they’ll demand a higher interest
rate to lend money.
Bonds are rated by agencies
such as the S&P.
Per Figure 3, S&P ratings
go from AAA, which are the safest bonds, all the way down to D.
Everything lower than a
triple B minus are sometimes called junk bonds.
At the time of this posting
Starbucks is rated A minus.
Lending money to Starbucks is
pretty safe, but you never know if people will start making a lot more coffee
at home.
The rating agencies are not
perfect, that became all too obvious during the recent financial crisis.
However, generally the better
rated bonds pay lower interest rates and lower rated riskier bonds pay higher
interest rates.
...
Per
Figure 4, the state of Illinois has the lowest bond rating of any state
government in the United States, an A minus.
It
has to pay significantly more interest to borrow money than does Virginia,
which has the highest rating, a AAA.
...
Another
factor that determines the interest rate on a bond is whether the borrower can
put up collateral, an asset that helps to guarantee the loan.
If
you want to borrow money to buy a house, you’ll typically get a lower interest
rate than if you want to borrow money to buy a vacation.
How
come? It's the same principle, the mortgage loan is less risky for the bank
than the vacation loan, because if you default the bank can repossess your
house.
The
house is collateral.
But
once you’ve been to Maui the bank can't repossess your vacation.
So,
it's cheaper to borrow money to buy a house than to go on vacation.
… …
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