Bonds

How to Borrow?  Two traditional ways of borrowing: –Borrow from a bank (e.g., get a loan) –Interest rate is set when the contract is signed  Or, Sell “bonds”

Bonds  Bond = promise to pay back a certain amount at a certain time  New bonds are sold at an auction (By companies or the Treasury Department)  Bonds can be resold on the bond market (where they can be bought and sold by the Fed, too)  Bond prices fluctuate moment to moment, just like stocks  Bond prices determine the interest rate that their owners will receive: when bond prices change, their effective interest rate also changes

Government Bonds  Governments that run deficits (mot governments) sell bonds –Borrow money from whoever buys the bonds –Create new bonds constantly –Use bonds to fund new debt –Use bonds to pay off existing debt  Bonds can have different “maturity” dates –US Treasury 10-year bonds are considered the fundamental bonds for world comparison  US Treasury creates NEW bonds when the government needs money

Bond Example  A company needs money, so it sells a bond. In a year, the company will pay the owner of the bond $10,000.  Today, the company holds an auction to sell the bond. An investor pays $9,500 for it.  Its interest rate then, is…?  A month from now, economists announce that inflation has risen to 7%. Our investor needs to sell the bond to buy a car. Is his bond more valuable today than when he bought it?  He sells it for $9,100. He loses $400 on the deal. Its interest rate now is…?

Critical Observation  Bond prices move in the opposite direction as bond interest rates.  When bond prices fall, interest rates rise. When bond prices rise, interest rates fall.