17.2 How households supply financial capital  (Page 3/43)

The bottom line on bank accounts looks like this: low risk means low rate of return but high liquidity.

Bonds

An investor who buys a bond expects to receive a rate of return. However, bonds vary in the rates of return that they offer, according to the riskiness of the borrower. An interest rate can always be divided up into three components (as explained in Choice in a World of Scarcity ): compensation for delaying consumption, an adjustment for an inflationary rise in the overall level of prices, and a risk premium that takes the borrower’s riskiness into account.

The U.S. government is considered to be an extremely safe borrower, so when the U.S. government issues Treasury bonds, it can pay a relatively low rate of interest. Firms that appear to be safe borrowers, perhaps because of their sheer size or because they have consistently earned profits over time, will still pay a higher interest rate than the U.S. government. Firms that appear to be riskier borrowers, perhaps because they are still growing or their businesses appear shaky, will pay the highest interest rates when they issue bonds. Bonds that offer high interest rates to compensate for their relatively high chance of default are called high yield bonds or junk bonds    . A number of today’s well-known firms issued junk bonds in the 1980s when they were starting to grow, including Turner Broadcasting and Microsoft.

A bond issued by the U.S. government or a large corporation may seem to be relatively low risk: after all, the issuer of the bond has promised to make certain payments over time, and except for rare cases of bankruptcy, these payments will be made. If the issuer of a corporate bond fails to make the payments that it owes to its bondholders, the bondholders can require that the company declare bankruptcy, sell off its assets, and pay them as much as it can. Even in the case of junk bonds, a wise investor can reduce the risk by purchasing bonds from a wide range of different companies since, even if a few firms go broke and do not pay, they are not all likely to go bankrupt.

As we noted before, bonds carry an interest rate risk. For example, imagine you decide to buy a 10-year bond that would pay an annual interest rate of 8%. Soon after you buy the bond, interest rates on bonds rise, so that now similar companies are paying an annual rate of 12%. Anyone who buys a bond now can receive annual payments of $120 per year, but since your bond was issued at an interest rate of 8%, you have tied up $1,000 and receive payments of only $80 per year. In the meaningful sense of opportunity cost, you are missing out on the higher payments that you could have received. Furthermore, the amount you should be willing to pay now for future payments can be calculated. To place a present discounted value on a future payment, decide what you would need in the present to equal a certain amount in the future. This calculation will require an interest rate. For example, if the interest rate is 25%, then a payment of $125 a year from now will have a present discounted value of $100—that is, you could take $100 in the present and have $125 in the future. (This is discussed further in the appendix on Present Discounted Value .)