Thursday

 Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.

PART 9 The Real Economy in the Long Run

Chapter 26 of 36 Saving, Investment, and the Financial System

Section 4 of 25

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Bonds differ according to three significant characteristics, the bond’s

1· term

2· credit risk

3· tax treatment

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1· Term is the length of time from the date a bond is issued until the date it matures and must be paid back.

Some bonds have short terms of a few months, while others have terms as long as 30 years.

Long-term bonds are riskier than short-term bonds because holders must wait longer for repayment of principal.

If a holder of a long-term bond needs money before the distant maturity date, the bond may have to be sold at a reduced price.

In addition, long-term bonds are more affected by inflation: over time, rising prices reduce the purchasing power of the fixed interest payments and the principal that will be repaid in the future.

To compensate for these two —price risk, and inflation— long-term bonds usually pay higher interest rates than short-term bonds.

2· Credit risk is the probability the bond issuing borrower will fail to pay some or all of the interest or principal.

Such a payment failure is called a default.

Borrowers sometimes default on their bonds by declaring bankruptcy.

When bond buyers perceive the probability of default is high they demand a higher interest rate to compensate for this risk.

The U.S. government is considered a safe credit risk so federal government bonds pay low interest rates.

Corporations with a high chance of failure and bankruptcy raise money by issuing so-called junk bonds which pay high interest rates.

3· Tax treatment is how tax laws treat the interest earned on the bond.

The interest on most bonds is taxable income and the bond owner must pay income tax on the interest.

But when state and local governments issue bonds, called municipal bonds,

the bond holders do not pay federal income tax on the interest.

Because of this advantage municipal bonds pay a lower interest rate than bonds issued by corporations or the federal government.

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If a company sells a $10,000 one-year (to maturity and principal payback) bond that pays a 5% interest rate, typically what would be the interest rate for a same company same $10,000 amount ten-year bond?

ChatGPT:

If a company issues:

1-year bond with 5% interest rate

Then a 10-year bond interest rate from the same company might typically be around 5.5% to 7%

Short-term (1-year) reflects current conditions

Long-term (10-year) reflects expected future inflation + price risk premium

In this case a 30-year bond interest rate would typically be 6% to 8%

… …

municipal bonds have a tax advantage

chihōsai wa zeikin yūi o motteru

地方債は税金優位を持ってる