Macro 03/18

Introduction to Bonds

• Bonds: Debt instruments where the issuer (borrower) owes the bondholder (lender) a debt and is obligated to pay that amount plus interest.

• Length of bond maturity affects interest rates and liquidity.

Key Factors Affecting Bond Interest Rates

Term Length

• Longer-term bonds typically offer higher interest rates due to increased risk and reduced liquidity.

• Risk of market changes and personal financial circumstances increases with longer terms.

Credit Risk

• Creditworthiness of borrower determines interest rates.

  • More credible borrowers may secure loans at lower rates.

  • Less credible borrowers are charged higher rates to offset default risk.

Tax Considerations

• Tax implications vary significantly between bond types.

  • Interest from state or municipal bonds is often tax-exempt, leading to lower interest rates compared to taxable bonds.

Inflation Protection

• Bonds indexed to inflation adjust the interest rate to maintain real returns.

• Such bonds typically have lower nominal interest rates as they protect against inflation risk.

Examples of Bonds

Treasury Notes (Long-Term Bonds)

• Issued by the US government, offering fixed interest pay outs.

• Example of a $5,000 Treasury Note issued at 8% interest rate, maturing in 1986:

  • Interest Payment: $200 every six months (4% of $5,000).

Discount Bonds (Short-Term Bonds)

• Sold at a price lower than face value, with no periodic interest payments.

• Example: $100,000 face value bond sold for approximately $95,000 with a maturity date indicating a return of the full face value.

Differentiating Debt and Equity Instruments

Debt Instruments

• Bonds obligate issuers to repay principal plus interest.

Equity Instruments

• Stocks represent ownership in a company rather than a loan.

• Investors earn dividends based on company profits instead of fixed interest payments.

Stock Market Overview

• Stock Exchanges: Where stocks are issued and traded, influenced by supply and demand dynamics.

• Ownership vs. Debt: Purchasing stocks confers ownership, while bonds represent loans to the issuer.

• Market Indices: Reflect the performance of specific stocks (e.g., S&P 500, Dow Jones).

Role of Financial Intermediaries

Banks

• Act as intermediaries by borrowing deposits and lending to those who need funds.

• Banks assess creditworthiness and manage legal aspects of contracts.

Mutual Funds

• Pool small investor money to buy diversified portfolios of stocks or bonds.

• Managed by professionals for those who may lack investment expertise.

National Saving and Investment

Closed Economic Model

• National saving ( S ) equals total national output minus consumption ( C ) and government spending ( G ).

• Investment ( I ) is directly correlated to national saving.

Government Budget

• Budget Surplus: When tax revenue exceeds expenditures.

• Budget Deficit: When expenditures exceed tax revenue, potentially leading to increased borrowing.

• High government debt levels may crowd out private investment by raising interest rates and reducing available loanable funds.

Conclusion

• Understanding interest rates, bond types, risks, and the roles of banks and financial markets is essential for grasping economic dynamics.

• Ongoing discussions about government debt and fiscal policies impact long-term economic growth and investment opportunities.