ECON 110 1st Edition Lecture 12 SECTION 8.1:THE BOND MARKETBONDLegal contract specifying the terms of a loan between a borrower and a lenderA bond is a certificate of debt issued by a government or corporationguaranteeing repayment of an initial loan plus interest.Example: Suppose Pitt needs to borrow $100 million to build some newdormitories. Pitt would issue (sell) bonds for $100 million. Pitt would “promise”to pay the lenders a specified amount of interest on specified dates and would“promise” to repay the principal on a specified date (the “date of maturity”).Thus, the bond is an IOU issued by Pitt indicating that Pitt borrowed money fromvarious lenders and owes the lenders their money back in the future withinterest.A bond contract specifies 1. Amount that a borrower will repay to the lender on the date of maturity:(Par Value or Principal)2. When the Principal will be repaid (time to maturity or date of maturity)3. Interest rate (or amount of interest, or coupon rate) that will be paid onthe Par Value 4. Date when each interest payment will be madeBOND EXAMPLE: Ford issues a bond with Par Value of $1 million for 30 years at 4% annual interest.1. Principal = $1 million2. Time to maturity = 30 years3. Interest rate = 4% per year4. Annual interest = $40,000 per year5. Interest of $40,000 will be paid at the end of each year6. A payment of the $1 million par value will be made at the end of 30 yearsSOME FACTORS WHICH INFLUENCE THE PRICE OF A BOND1The price of a bond is the amount a lender will give the borrower today in return for theborrower’s “promise” to make specified repayments in the future.The price a lender will pay for a bond depends partly on 1. The market interest rate2. The amount of interest offered on the bond3. The riskiness (probability of default) of the bond4. Future expectations of market interest ratesTHE PRICE PAID FOR A BOND DEPENDS IN PART ON THE MARKET INTEREST RATE1. The market interest rateExample: Suppose your bond offers 5% annual interest and other places are offering 8%interest. Other things being equal, if interest rates in the economy are HIGH, then I canearn lots of interest elsewhere so your bond will not be so attractive to me and I will notoffer as much for your bond.THE PRICE PAID FOR A BOND DEPENDS IN PART ON THE BOND’S COUPON RATE2. The amount of interest offered on the bondExample: Other things being equal, if you offer to pay me 8% annual interest (or $80 ona $1,000 bond), your bond will be more attractive to me than if you offer only 5% annualinterest (or $50 on a $1,000 bond). Thus, I will pay you more for the bond which pays8% interest.THE PRICE PAID FOR A BOND DEPENDS IN PART ON THE BOND’S RISKINESSTHE PRICE OF A BOND DEPENDS ON DEFAULT RISK3. The riskiness (probability of default) of the bondDEFAULT RISKRisk that a borrower will not repay a loanHigh risk leads to higher interest rate that must be offered to entice a lender tolend.Alternatively, high risk means that a lender will offer a lower price to purchasethe bond.RISKY BORROWERS:Cities & states with falling populations2Cities & states with declining tax basesCities & states with rising expendituresNew corporations, small corporationsUnprofitable or failing corporationsCorporations in declining industries or with intense competitionTHE PRICE PAID FOR A BOND DEPENDS IN PART ON FUTURE EXPECTATIONSBONDS ARE NEGOTIABLESuppose I purchased a bond issued by your company. This means that I loaned youmoney, and you are obligated to repay the loan with interest. I can resell the bond toanother investor, so that you will then owe the interest and principal to the new ownerinstead of to me.When I try to resell the bond, I might make a profit or I might make a loss. Roughlyspeaking, I make a profit, if I resell the bond for more than I lent to you. I make a loss, ifI resell the bond for less than I lent to you.SOME FACTORS THAT INFLUENCE THE RESALE PRICE OF A BOND?IF MARKET INTEREST RATES RISE, THE PRICE OF A BOND DECLINESExample: Suppose that when I lent you money, interest rates in the economy were 4%.The amount I paid you for your bond was based on the assumption that the best I coulddo elsewhere would be to earn 4% interest on my investment. Now suppose thatinterest rates have risen to, say, 6%. Now I have better opportunities elsewhere, so I willnot offer you as much to purchase your bond.SOME TYPES OF BONDSUS GOVERNMENT SECURITIESCORPORATE BONDSMUNICIPAL BONDSJUNK BONDSUS GOVERNMENT SECURITIESTreasury Department writes checks to cover Federal Government SPENDING.3Treasury gets its REVENUE from TAXES.If government SPENDING exceeds TAX REVENUE, the government has a BUDGET DEFICITThen, the Treasury Department must borrow to pay its billsThus, new Treasury securities are issuedUS GOVERNMENT SECURITIESTREASURY BILLS: maturity up to 1 yearTREASURY NOTES: more than 1 year to less than 10 yearsTREASURY BONDS: 10 years or moreInterest is taxableLeast risky of all bonds: NO DANGER OF DEFAULTCORPORATE BONDS:Rated by Standard & Poors or MoodysAAA, AA, A, BAA, BA, B, etc.Interest is taxableC = JUNK BONDS (highest risk of default)MUNICIPAL BONDS:Issued by cities and countiesInterest is not taxableBig advantage for municipalitiesIt lowers the interest rate that municipalities must payRisk varies from city to cityOTHER FACTORS THAT INFLUENCE BOND PRICES4THE INFLATION RATELenders want to earn a profit after adjusting for inflationHigher expected inflation causes lenders to demand a higher interest rate or theywill offer a lower priceTERM TO MATURITYLonger term to maturity causes lenders to demand a higher interest rate or theywill offer a lower priceTAXABILITY OF INTERESTTaxable interest causes lenders to demand a higher interest rate or they will offera lower priceLenders want to make a profit after adjusting for inflation.Example: Suppose I have $1,000 in cash. I can buy something (call it GOOD A) todayworth $1,000. Alternatively, I can lend the $1,000 to you for one year. Hopefully, whenyou repay me the $1,000 plus interest, I will have enough to purchase GOOD A and stillhave a little left over to represent my profit.Suppose you offer me 5% interest and the inflation rate is 3%. At the end of the year,you would repay me $1,000 plus 5% interest (or $50), so I would have $1,050. If theprice of GOOD A increased 3%, then it would cost $1,030 at the end of the