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 bond 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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