The Mathematics of Money

266 Chapter 6 Investments

It may not be entirely clear how to interpret the entries in this table. What we are doing

is imagining that the $1,105.73 is a debt being paid off by the coupon and redemption

payments made by the issuer. If the interest rate is correct, we know that the ending bal-

ance should work out to be $0.00, refl ecting the fact that with the correct interest rate the

issuer’s payments should “pay off” the $1,105.73 present value. Using guess and check, we

eventually fi nd that the closest we can get this value to zero occurs when the rate is 6.70%

(even though the rates quoted in the table went to three decimal places, we will continue our

practice of only carrying interest rate calculations out to two.)

Rows Omitted

26 24 $1,040.00 $33.69 $1,006.31 -$0.71

25 23 $40.00 $33.89 $6.11 $1,005.60

1 Rate: 6.70% Initial Balance: $1,105.73

2

3

A B C D

Half Year Payment From Principal Ending Balance

1 $40.00 $2.96 $1,102.77

From Interest

$37.04

4 2 $40.00 $36.94 $3.06 $1,099.71

5 3$316$40 00 $36 84 $1 096 55

E

The Bond Market

We’ve repeatedly noted that bonds can be bought and sold, and in fact the amount of

money that changes hands in the bond market is enormous. Governments, banks, corpora-

tions, insurance companies, pension funds, investment companies, individual investors,

and others regularly buy and sell bonds on the open market. As with stocks, some bonds

are more liquid than others. The bonds of large, well-known corporations naturally tend to

be more liquid than those of smaller companies, and likewise the bonds issued by the U.S.

federal government are naturally more liquid than those issued by a small-town water and

sewer district. Overall, though, the bond market represents an enormous financial market,

by most estimates far larger in size than the stock market, even though the stock market

gets paid greater attention.

Just like stocks, bond prices fluctuate from moment to moment according to market

conditions. However, bond prices tend to be less volatile than stock prices. This is partially

because bond prices are heavily dependent on prevailing interest rates expected in the mar-

ket, and interest rates usually change at a fairly slow pace over time. Also, if a company’s

prospects dim, its bondholders have the consolation that, if the company does end up in

bankruptcy, the bondholders’ claims against the company’s remaining assets generally

come ahead of stockholders’ claims. The bondholders of a bankrupt company usually end

up receiving some compensation from the company’s remaining assets, while the stockhold-

ers often end up with worthless stock and little else. In addition, stocks tend to move more

significantly with changes in a business’s outlook, since the owners’ (i.e., stockholders)

future investment return is more closely tied to the business’s profits or losses, while its

creditors (i.e., bondholders) receive the same coupon and redemption payments regardless

of profits or losses (unless of course things go very badly and the company actually ends up

in bankruptcy).

Even though bonds generally carry less risk and volatility than stocks, they are by no

means risk- and volatility-free. Every bond carries with it some credit risk, the risk that the

issuer will not be able to make the required payments of the bond. There are several rating

agencies, companies whose business it is to evaluate how great this risk is with any given

bond issuer. Each agency has its own methods, rating systems, and standards, but even

though there may be differences from one rating agency to another, the different agencies

usually agree reasonably closely in their assessments of different issuers’ creditworthiness.