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Intro to Bond Markets

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

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