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