BondsBonds

How to Borrow?How to Borrow? Two traditional Two traditional

ways of ways of borrowing:borrowing:

– Borrow from a Borrow from a bank (e.g., get bank (e.g., get a loan)a loan)

– Interest rate is Interest rate is set when the set when the contract is contract is signedsigned

Or, Sell “bonds”Or, Sell “bonds”

BondsBonds Bond = promise to pay back Bond = promise to pay back

a certain amount at a a certain amount at a certain timecertain time

New bonds are sold at an New bonds are sold at an auction (By companies or auction (By companies or the Treasury Department)the Treasury Department)

Bonds can be resold on the Bonds can be resold on the bond market (where they bond market (where they can be bought and sold by can be bought and sold by the Fed, too)the Fed, too)

Bond prices fluctuate Bond prices fluctuate moment to moment, just like moment to moment, just like stocksstocks

Bond prices determine the Bond prices determine the interest rate that their interest rate that their owners will receive: when owners will receive: when bond prices change, their bond prices change, their effective interest rate also effective interest rate also changeschanges

Government BondsGovernment Bonds Governments that run Governments that run

deficits (mot deficits (mot governments) sell bondsgovernments) sell bonds

– Borrow money from whoever Borrow money from whoever buys the bondsbuys the bonds

– Create new bonds constantlyCreate new bonds constantly– Use bonds to fund new debtUse bonds to fund new debt– Use bonds to pay off existing Use bonds to pay off existing

debtdebt Bonds can have different Bonds can have different

“maturity” dates“maturity” dates– US Treasury 10-year bonds US Treasury 10-year bonds

are considered the are considered the fundamental bonds for world fundamental bonds for world comparisoncomparison

US Treasury creates NEW US Treasury creates NEW bonds when the bonds when the government needs moneygovernment needs money

Bond ExampleBond Example A company needs money, so A company needs money, so

it sells a bond. In a year, it sells a bond. In a year, the company will pay the the company will pay the owner of the bond $10,000. owner of the bond $10,000.

Today, the company holds Today, the company holds an auction to sell the bond. an auction to sell the bond. An investor pays $9,500 for An investor pays $9,500 for it. it.

Its interest rate then, is…? Its interest rate then, is…? A month from now, A month from now,

economists announce that economists announce that inflation has risen to 7%. inflation has risen to 7%. Our investor needs to sell Our investor needs to sell the bond to buy a car. Is his the bond to buy a car. Is his bond more valuable today bond more valuable today than when he bought it?than when he bought it?

He sells it for $9,100. He He sells it for $9,100. He loses $400 on the deal.loses $400 on the deal.Its interest rate now is…?Its interest rate now is…?

%26.5%100500,9

500,9000,10

x

%9.9%100100,9

100,9000,10

x

Critical ObservationCritical Observation

Bond prices move in the Bond prices move in the opposite direction as bond opposite direction as bond interest rates. interest rates.

When bond prices fall, When bond prices fall, interest rates rise. When interest rates rise. When bond prices rise, interest bond prices rise, interest rates fall. rates fall.