[MUSIC] In the documentary, The Ascent of Money. Harvard Historian Niall Ferguson explains the origin of the bond market. In 1436, the government of Florence came up with what was then a revolutionary way to raise more public money. Instead of requiring it's citizens to pay more in taxes, they were persuaded by the government to invest in bonds. They were in fact, obliged to lend money to their own city. And this helped to pay for expeditions to plunder other states, to invest in social projects that provided guaranteed returns in uncertain times of floods, plagues and other disasters. Remember, this was the Florence of the Medici's of Michelangelo and Machiavelli. And the city's money lenders used this amazing financial invention for generations, raising sums that increased from 5,000 to 5 million florins. This program was called the Monte Commune, which literally means a mountain of debt. An idea that is now associated with the sort of financial excesses, they eventually found themselves in. Not surprisingly, over alliance on debt ultimately led to very high interest rates and high rates decreased the value of the bonds and eroded both the economic and political power of the Monte Commune. In the centuries since, the story of the bond markets has played out in different parts of the world. Raising questions about the important lessons that should have been learned. The fact is that almost all governments run deficits, which means spending more money than the revenues that are raised. Eventually, these deficits are financed through bond issues, which can pile up into staggering amounts of debt. The money raised is spent on key government functions, such as infrastructure spending, social programs or wars. Corporations also issue lots of debt and have created numerous types of bonds. These include debentures, mortgages, zero-coupon, variable rate, convertible, callable, income junk and other types of bonds with different features that appeal to various investors. Estimates of the size of bond markets vary. But nationally, they exceed the monies raised and traded in stock markets and globally maybe around the $100 trillion mark. One common sense lesson from the rise and fall of bond markets is to think of them as a double edged instrument. On the one hand, they are a vital long term source of money for sustaining societal needs. And on the other, they are time bombs. Once debt capacity is used up, which is when there isn't enough cash flow to meet the outstanding obligations. This can result in a collapse that leads to bankruptcy. For developed countries, this possibility implicates a lot more people than ever before, because of aging populations who are completely dependent on pension income, on funds and other investments that hold bonds in their portfolio. Wealthy countries like the US and the UK, which continue to run persistent deficits are showing signs of using up their debt capacity. With large portions of their budget that are used to pay for interest on their national debts, alongside major social and Medicare programs that are in some cases, already close to being insolvent. Global bond markets are also implicated by interest rates that are close to 0%, which have encouraged dramatic increases in the size of the bond markets. In addition, most of us are not aware that a quarter of the world's safest or least risky government bonds now offer the bizarre phenomena of negative interest rates. When negative interest rates factor into general loans, this means for borrowers that instead of paying 2% interest say, $2 on borrowing $100, you receive $2 from the lender. In other words, the lender pays you to borrow and the opposite holds if you're deposing money. Here, you must pay extra to invest since lending at a negative rate means that you will not get all of your money back. If you find this twisted, it absolutely is. These circumstances can provide a perverse incentive to borrowers. Lenders seem to be okay with this, perhaps because they're worried about a sharp economic slowdown that leads to default. So they're willing accept a negative rate from the least, risky investment, the government and they'll be satisfied with the return of their money. Meaning, the lender will not get their money back rather than a return on their money. Meaning, the lender would get their money back plus extra or interest, but it's a lot more complicated than that. We have seen some countries using negative interest rates through central banks, to strategically protect their currency and boost their exports. Others, especially in Europe have used negative rates to discourage banks from hoarding money by keeping it with the central bank and instead lend more to businesses to help stimulate economic growth. So in theory, negative rates appear to be a disparate measure to invigorate the economy or to prevent it from sliding into deflation, which is when prices fall reducing national income and causing an economic contraction. Whatever the reason, this much is clear. Negative interest rates are an ongoing experiment and we do not know the overall impact yet. What we can say with some confidence is that negative rates are unconventional. And as we have learned earlier in the course, central bankers have little experience with them. They speak to desperate measures, which is likely to cause significant volatility in the bond markets. So, the least we can do is understand how bonds are price and how those prices can change. To summarize, countries with sophisticated bond markets are able to borrow for long time periods to tackle big economic and social challenges. But whether an individual, a company or a government has gone too far in borrowing too much, this is what we will cover exclusively in course four, which is on debt. For now, let's look at some of the basics of how bond prices are determined. Let's also understand some key terminology including the role of bond yields that determine the interplay of values in various bond markets around the world.
