Intro to Bond Markets

This week: Learn about another financial intermediary -- the bond market!

Next week: Dive into a practice problem about bonds with our next Office Hours video.

Most borrowers borrow through banks. But established and reputable institutions can also borrow from a different intermediary: the bond market. That’s the topic of this video. We’ll discuss what a bond is, what it does, how it’s rated, and what those ratings ultimately mean.

First, though: what’s a bond? It’s essentially an IOU. A bond details who owes what, and when debt repayment will be made. Unlike stocks, bond ownership doesn’t mean owning part of a firm. It simply means being owed a specific sum, which will be paid back at a promised time. Some bonds also entitle holders to “coupon payments,” which are regular installments paid out on a schedule.

Now—what does a bond do? Like stocks, bonds help raise money. Companies and governments issue bonds to finance new ventures. The ROI from these ventures, can then be used to repay bond holders. Speaking of repayments, borrowing through the bond market may mean better terms than borrowing from banks. This is especially the case for highly-rated bonds.

But what determines a bond’s rating?

Bond ratings are issued by agencies like Standard and Poor’s. A rating reflects the default risk of the institution issuing a bond. “Default risk” is the risk that a bond issuer may be unable to make payments when they come due. The higher the issuer’s default risk, the lower the rating of a bond. A lower rating means lenders will demand higher interest before providing money. For lenders, higher ratings mean a safer investment. And for borrowers (the bond issuers), a higher rating means paying a lower interest on debt.

That said, there are other nuances to the bond market—things like the “crowding out” effect, as well as the effect of collateral on a bond’s interest rate. These are things we’ll leave you to discover in the video. Happy learning!

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[Alex] As we've seen,
most individuals who want a loan --

they 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 how much

and when payment must be made.

Like stocks,
bonds are traded on markets.

For an established company,
like Starbucks, investors --

they already know
enough about the company

that they're willing to bypass
the bank as an intermediary

and lend to the company directly.

So for a large company
with a good reputation,

this could mean
they can borrow money

on better terms
from the bond market

than they can
through traditional bank lending.

Starbucks, for example,

has issued over a billion dollars
of corporate bonds over the years,

in order to fund
their expansion plans.

Now 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,

and in exchange, they're promising
to pay you back a specific sum

at a particular point in time.

In addition, some bonds
also pay out regular installments,

called coupon payments,
according to a preordained schedule.

By issuing bonds,
a company can raise capital

and make big investments.

And then they can repay that debt
over a long timeline

as those investments
provide a return.

Corporations aren't
the only institutions

that borrow money
in the bond market.

Governments do so as well.

In 2016, the U.S. government
owed the public

almost $14 trillion
in promised bond payments.

And because
the government is so big,

when it borrows money,
it affects the entire market

for saving and borrowing.

Let's go back
to the supply and demand

for loanable funds.

We'll use some numbers here
for illustration.

Here's the demand curve
showing the demand for borrowing.

Now, imagine that 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 --

that means that the quantity
of savings supplied will increase,

in this case,
from $200 to $250 billion.

Now remember that
if savings increases by $50 billion,

that means that private consumption
is falling by $50 billion.

If we're saving more,
that means we're consuming less.

And because borrowing
has become more expensive

due to the higher interest rate,
private investment will also fall.

At a 9% interest rate,

we can see that the private demand
for loanable funds is $150 billion,

$50 billion less than it was
at an interest rate of 7%.

We call these two 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 billion
of private investment.

Bonds aren't as risky as stocks

because the bondholders
must be paid

before any profits
are distributed to shareholders.

But bonds do have risk,

namely the risk
that when the payments come due,

the borrower won't be able to pay.

That's called the default risk.

If investors think that 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.

The S&P ratings go from AAA,
which are the safest bonds,

all the way down to D,
and anything lower than a BBB-,

those are sometimes called
“junk bonds.”

If you're curious,
Starbucks gets an A-.

Lending money to Starbucks --
it's pretty safe.

But you never know
what might happen

if all those pod people start making
a lot more coffee at home.

Now, the rating agencies
aren't perfect.

That became all too obvious
during the recent financial crisis.

However, generally speaking,

you'll find that
better-rated bonds --

they pay lower interest rates.

And lower-rated, riskier bonds --
they pay higher interest rates.

The state of Illinois has
the lowest bond rating

of any state government
in the United States, an A-.

And it has to pay
significantly more 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.

Okay, we've covered banks,
we've covered stocks,

we've covered bonds…

But actually, there's
many other financial intermediaries

that we could talk about,
including hedge funds,

venture capital, mortgages,
and a lot more.

What are you curious about?
Let us know.

[Narrator] If you want
to test yourself,

click "Practice Questions."

Or if you're ready to move on,

you can click
"Go to the Next Video."

You can also visit MRUniversity.com

to see our entire library
of videos and resources.

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