On October 5, 1998, William McDonough, president of the Federal Reserve Bank of New York, declared "I believe that we are in the most serious financial crisis since World War II."¹ Since August 17, when the Russian government had defaulted on some of its bonds, deteriorating investor confidence had increased volatility in the financial markets. Bond markets were the hardest hit; as lenders re-evaluated the relative risk of holding different bonds, some prices plummeted while others soared. This simultaneous increase in some interest rates and decline in others—a rise in what are called interestrate spreads—was a clear sign to McDonough that the substantial stress the financial markets were experiencing could easily spread to the wider economy, affecting everyone.

Changes in bond prices can have a pronounced effect on the welfare of individual corporations. The case of General Electric, one of the largest companies in the world, provides an instructive example. GE borrows to maintain and expand its business by issuing bonds that take as long as 30 years to mature. The company also sells commercial paper, which is short-term debt that must be repaid in less than a year. In March 2002, information slowly emerged that GE might need to increase its borrowing significantly, adding to its existing $250 billion in long- and short-term debt. This prospect led investors to question GE's financial condition and its ability to repay what it owed. Despite the fact that GE is a very large corporation, its borrowing pattern meant it would have to raise substantial funds quickly to meet obligations to creditors. The result was an increase in the perceived risk of GE's bonds and a corresponding decline in their price.

These examples highlight the need to understand the differences among the many types of bonds that are sold and traded in financial markets. What was it about the movement in the prices of different bonds that Mr. McDonough found so informative? How did information about the issuance of one sort of debt affect investors' willingness to lend to GE? To answer these questions, we will study the differences among the multitude of bonds in the world. We will see that these bonds differ in two crucial respects: the identity of the issuer and the time to maturity. This chapter will examine how each of these affects the price of a bond and then use our knowledge to interpret fluctuations in a broad variety of bond prices.

¹Mr. McDonough's job was to monitor financial market developments for the Federal Reserve System, to devise government reaction to such financial crises, and to formulate policies that prevented crises. As we will see in our discussion of the structure of the Federal Reserve System in Chapter 16, the Federal Reserve Bank of New York is the largest of the 12 regional banks in the Federal Reserve System. The president of that bank plays a special role as the eyes and ears of the government in world financial markets.