Intro to Bond Markets
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0:00 - 0:03♪ [music] ♪
-
0:14 - 0:18- [Alex] As we've seen, most
individuals who want a loan, they borrow -
0:18 - 0:23money from a bank. But for a well-known
corporation like Starbucks, borrowing -
0:23 - 0:28money may be available through another
type of financial intermediary, the bond -
0:28 - 0:35market. A bond is essentially an IOU. It
documents who owes how much and when -
0:35 - 0:42payment must be made. Like stocks, bonds
are traded on markets. For an established -
0:42 - 0:47company like Starbucks, investors - they
already know enough about the company that -
0:47 - 0:52they're willing to bypass the bank as an
intermediary and lend to the company -
0:52 - 0:57directly. So for a large company with a
good reputation, this could mean they can -
0:57 - 1:02borrow money on better terms from the bond
market than they can through traditional -
1:02 - 1:08bank lending. Starbucks, for example, has
issued over a billion dollars of corporate -
1:08 - 1:15bonds over the years, in order to fund
their expansion plans. Now unlike a stock, -
1:15 - 1:20if you buy a newly issued bond from
Starbucks, you don't own part of -
1:20 - 1:26Starbucks. You're simply lending Starbucks
money, and in exchange, they're promising -
1:26 - 1:32to pay you back a specific sum at a
particular point in time. In addition, -
1:32 - 1:36some bonds also pay out regular
installments, called coupon payments, -
1:36 - 1:42according to a preordained schedule. By
issuing bonds, a company can raise capital -
1:42 - 1:49and make big investments. And then they
can repay that debt over a long timeline, -
1:49 - 1:55as those investments provide a return.
Corporations aren't the only institutions -
1:55 - 2:00that borrow money in the bond market.
Governments do so as well. In 2016, the -
2:00 - 2:07U.S. government owed the public almost $14
trillion in promised bond payments. And -
2:07 - 2:11because the government is so big, when it
borrows money, it affects the entire -
2:11 - 2:16market for saving and borrowing. Let's go
back to the supply and demand for loanable -
2:16 - 2:21funds. We'll use some numbers here for
illustration. Here's the demand curve -
2:21 - 2:25showing the demand for borrowing. Now,
imagine that the government decides to -
2:25 - 2:30borrow $100 billion. This shifts the
demand for loanable funds up and to the -
2:30 - 2:38right, increasing the equilibrium interest
rate from 7% to 9%. A higher interest -
2:38 - 2:43rate - that means that the quantity of
savings supplied will increase, in this -
2:43 - 2:50case, from $200 to $250 billion. Now
remember, that if savings increases by $50 -
2:50 - 2:54billion, that means that private
consumption is falling by $50 billion. -
2:54 - 3:00If we're saving more, that means we're
consuming less. And because borrowing has -
3:00 - 3:05become more expensive due to the higher
interest rate, private investment will -
3:05 - 3:11also fall. At a 9% interest rate, we can
see that the private demand for loanable -
3:11 - 3:20funds is $150 billion, $50 billion less
than it was at an interest rate of 7%. We -
3:20 - 3:25call these two effects “Crowding Out”. When
the government borrows $100 billion, it -
3:25 - 3:32crowds out private consumption and private
investment. In this case, it crowds out -
3:32 - 3:37$50 billion of private consumption and
also $50 billion of private investment. -
3:37 - 3:43Bonds aren't as risky as stocks because
the bondholders must be paid before any -
3:43 - 3:49profits are distributed to shareholders.
But bonds do have risk, namely the risk -
3:49 - 3:53that when the payments come due, the
borrower won't be able to pay. That's -
3:53 - 3:57called the default risk.
If investors think that a firm issuing a -
3:57 - 4:02bond has a significant default risk,
they'll demand a higher interest rate to -
4:02 - 4:08lend money. Bonds are rated by agencies,
such as the S&P. The S&P ratings go from -
4:08 - 4:14AAA, which are the safest bonds, all the
way down to D, and anything lower than a -
4:14 - 4:20BBB-, those are sometimes called “junk
Bonds”. If you're curious, Starbucks gets -
4:20 - 4:25an A-. Lending money to Starbucks, it's
pretty safe, but you never know what might -
4:25 - 4:31happen if all those pod people start
making a lot more coffee at home. Now, the -
4:31 - 4:35rating agencies aren't perfect. That
became all too obvious during the recent -
4:35 - 4:41financial crisis. However, generally
speaking, you'll find that better rated -
4:41 - 4:47bonds, they pay lower interest rates. And
lower rated, riskier bonds, they pay -
4:47 - 4:53higher interest rates. The state of
Illinois has the lowest bond rating of any -
4:53 - 4:59state government in the United States, an
A-. And it has to pay significantly more -
4:59 - 5:04to borrow money than does Virginia, which
has the highest rating, a AAA. Another -
5:04 - 5:08factor that determines the interest rate
on a bond is whether the bond borrower can -
5:08 - 5:13put up collateral, an asset that helps to
guarantee the loan. If you want to borrow -
5:13 - 5:18money to buy a house, you'll typically get
a lower interest rate than if you want to -
5:18 - 5:25borrow money to buy a vacation. How come?
It's the same principle. The mortgage loan -
5:25 - 5:31is less risky for the bank than the
vacation loan because if you default, the -
5:31 - 5:37bank can repossess your house. The house
is collateral. But once you've been to -
5:37 - 5:41Maui, the bank can't repossess your
vacation. So it's cheaper to borrow money -
5:41 - 5:46to buy a house than to go on vacation.
Okay, we've covered banks, we've covered -
5:46 - 5:50Stocks, we've covered bonds… But actually,
there's many other financial -
5:50 - 5:55intermediaries that we could talk about,
including hedge funds, venture capital, -
5:55 - 6:00mortgages, and a lot more. What are you
curious about? Let us know. -
6:01 - 6:05- [Narrator] If you want to test yourself,
click "Practice Questions." Or if you're -
6:05 - 6:08ready to move on, you can click
"Go to the Next Video." -
6:11 - 6:17You can also visit MRUniversity.com to see
our entire library of videos and resources. -
6:17 - 6:19♪ [music] ♪
- Title:
- Intro to Bond Markets
- Description:
-
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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- Video Language:
- English
- Team:
Marginal Revolution University
- Project:
- Macro
- Duration:
- 06:24
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kbebell edited English subtitles for Intro to Bond Markets |