Intro to the Bond Market

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.