1
00:00:00,000 --> 00:00:10,000
Alan Cring Productions in association with Emergent Light Studio presents

2
00:00:10,000 --> 00:00:17,000
the Illinois State Collegiate Compendium, academic lectures in business and economics.

3
00:00:17,000 --> 00:00:29,000
This is Business Finance, FIL 190 for spring semester 2024.

4
00:00:29,000 --> 00:00:40,000
Today, introduction to bonds. This will be the last lecture, hang on, this will be the last lecture before the midterm exam on Monday.

5
00:00:40,000 --> 00:00:51,000
Again, we will review for the midterm exam. I will tell you what I think you should know, which is kind of important because I am writing the exam,

6
00:00:51,000 --> 00:01:01,000
but then I will be opening it up for you to ask me questions. I will be very specific. If you say, well, is this going to be on the exam?

7
00:01:01,000 --> 00:01:08,000
And it's not, I will say no, I am not going to ask you that. So it's worth it for you to be very well prepared.

8
00:01:08,000 --> 00:01:22,000
Consider that to be that Monday to be your study guide for the final, for the midterm exam and use it for getting together a good set of notes.

9
00:01:22,000 --> 00:01:33,000
And over the weekend, of course, you may want to start doing your prep and I do permit a four by six note card for front and back.

10
00:01:33,000 --> 00:01:47,000
And of course, you will also be able to use a calculator and Excel. I anticipate that you will use Excel to get some of the problems.

11
00:01:47,000 --> 00:01:59,000
Oh, and the financial analysis formulas sheet that's in your files folder and Canvas. You will be able to use those all on the exam.

12
00:01:59,000 --> 00:02:08,000
That reduces the stress level to some extent. The note card, actually, I find is a great way for you to review the material

13
00:02:08,000 --> 00:02:17,000
and consolidates your knowledge for the exam itself. And I will go into more details of the exam on Monday,

14
00:02:17,000 --> 00:02:28,000
but do be aware that it is very similar to a quiz. It's same structure, layout, multiple choice, fill in the blank, numerical answers, true and false.

15
00:02:28,000 --> 00:02:34,000
So it will have that same layout as an exam, as a quiz would.

16
00:02:34,000 --> 00:02:47,000
I'm trying to think. Well, but yeah, that is all on Monday. And we're going to cover the topic of bonds today, the first round.

17
00:02:47,000 --> 00:02:56,000
Now, I will not be, for the midterm exam, I will not be asking anything that would require mathematical calculations,

18
00:02:56,000 --> 00:03:11,000
yield, price, all of that, that I would not be asking on this midterm. However, the content that I cover today in class is fair game.

19
00:03:11,000 --> 00:03:19,000
Now, this would be about the first half of that chapter seven in the book. So make sure that you have the terminology down,

20
00:03:19,000 --> 00:03:32,000
because those are straight up obvious questions for multiple choice or fill in the blank or true and false on the midterm exam.

21
00:03:32,000 --> 00:03:36,000
Why would we need to use Excel if there is no math on that?

22
00:03:36,000 --> 00:03:45,000
No, no math about bonds. Let me be clear about that. No, no, just the bonds. I mean, the bonds, the math of bonds,

23
00:03:45,000 --> 00:03:55,000
I've got templates for you for that. But to get to the point where you would know what the template is for and what to do with it,

24
00:03:55,000 --> 00:04:02,000
I would go, I have to go into some details. I do that the class when we come back from the spring break.

25
00:04:02,000 --> 00:04:11,000
So, but no, don't you wish I would have math on it. But there'll be plenty of math. But most of it, I'm not saying that everything,

26
00:04:11,000 --> 00:04:22,000
but a great deal of what you have for the questions would be that one Excel spreadsheet, present values and future values.

27
00:04:22,000 --> 00:04:29,000
That would cover a lot of the territory for questions for the exam, for the midterm exam.

28
00:04:29,000 --> 00:04:39,000
So rest easy on that. But while we are on the topic of finance, which is always the topic here,

29
00:04:39,000 --> 00:04:48,000
we want to look at the numbers here. And then I'm going to do one last little piece of something from Chapter 6 slash 7.

30
00:04:48,000 --> 00:04:57,000
Chapter 6 and 7 kind of merge and different textbooks kind of put the topic order in different ways.

31
00:04:57,000 --> 00:05:03,000
But before we get to all of that happiness, let's have a look at the unhappiness that is our market,

32
00:05:03,000 --> 00:05:10,000
how the markets look this morning. And it's a bare day out there.

33
00:05:10,000 --> 00:05:20,000
Huh? Those are red. That's bare. See, look at this. The Dow is, this is what's odd,

34
00:05:20,000 --> 00:05:30,000
is that the Dow and the S&P 500, usually they go in order. But the last couple of markets, days, they haven't.

35
00:05:30,000 --> 00:05:43,000
The Dow is down less than a quarter of a percent. Then the S&P 500 is down less, 0.19%, but then the NASDAQ is down a half a percent.

36
00:05:43,000 --> 00:05:54,000
And the way I would interpret this is that it looks like whatever is making the market grouchy is the kind of information

37
00:05:54,000 --> 00:06:04,000
that impacts smaller cap companies more than it does large cap companies. As you can see, both these Dow and the S&P 500

38
00:06:04,000 --> 00:06:10,000
are having something bothering them. It's making them a little bit negative, a little bearish.

39
00:06:10,000 --> 00:06:19,000
But whatever it is seems to be really annoying the small cap stocks. What it is, kind of hard to say,

40
00:06:19,000 --> 00:06:27,000
I mean, you know, the earnings reports are coming in at all over the place. And the Fed is being very quiet right now.

41
00:06:27,000 --> 00:06:36,000
So whatever is bothering markets, it's not terrible. As you can see, these are not massively bearish numbers.

42
00:06:36,000 --> 00:06:44,000
It's just there's a little bit of a grouchiness about the markets right now. But swinging over here, have a look at crude.

43
00:06:44,000 --> 00:06:53,000
Well, it's trying, it's playing around that upper level of that 72 to 79 band. You can see it bouncing up.

44
00:06:53,000 --> 00:07:04,000
It just bounced back down from it. And now it's just floating around there. Crude is up in price per barrel on all of them.

45
00:07:04,000 --> 00:07:16,000
This is the light sweet Brent. And from what I've picked up, there are a couple of factors going into it.

46
00:07:16,000 --> 00:07:26,000
One is, yeah, there is instability in the Middle East. That's a given right now. But another might not be the worst thing in the world.

47
00:07:26,000 --> 00:07:35,000
There is some perception that the economy is in either late recovery or early expansion.

48
00:07:35,000 --> 00:07:49,000
That would tend to indicate more trucks and cars on the road, delivering goods, if it's commercial, going places if it's private.

49
00:07:49,000 --> 00:07:57,000
And that might be the factor that is pushing these prices of crude up a little bit right now.

50
00:07:57,000 --> 00:08:04,000
That might be, so in other words, price of crude is going up, but it might be for a good reason.

51
00:08:04,000 --> 00:08:15,000
There's some expectation that demand will be going up over the next couple of months for hydrocarbon products, the gasoline and the distillates.

52
00:08:15,000 --> 00:08:22,000
So it's not all bad news. Gold is not really going much place. It's pretty volatile right now.

53
00:08:22,000 --> 00:08:33,000
There's buying and selling, pushing it down and back up. As you can see, it's for the most part today has been a bearish day on gold.

54
00:08:33,000 --> 00:08:43,000
But it's not a huge bearish day. It's only, what, 0.06 percent. It's just pennies right now.

55
00:08:43,000 --> 00:08:49,000
And silver is also down. But coming over here to bonds, and this is a topic today.

56
00:08:49,000 --> 00:08:55,000
Do remember, and this is important for the exam, price and yield are inversely related.

57
00:08:55,000 --> 00:09:01,000
So when I see this chart, this is a yield chart, and it is negative.

58
00:09:01,000 --> 00:09:07,000
The yields are going down. They're down two and a half basis points, about two and a half basis points right now.

59
00:09:07,000 --> 00:09:15,000
That would mean that the prices are going up. That would mean that there is purchasing of bonds.

60
00:09:15,000 --> 00:09:21,000
The balance of orders is on the buy side for bonds.

61
00:09:21,000 --> 00:09:28,000
That might be the result of the bearish equities.

62
00:09:28,000 --> 00:09:36,000
They're getting out of stocks and they're using some of the proceeds to push into bonds, pushing the prices up.

63
00:09:36,000 --> 00:09:41,000
And that would bring the yields down. That would be the order that you would think about it.

64
00:09:41,000 --> 00:09:47,000
Now I want you to make sure that you understand that chain of logic, because I will hit that on the midterm exam,

65
00:09:47,000 --> 00:09:56,000
to make sure you understand that it's supply and demand issues that are underlying price movement,

66
00:09:56,000 --> 00:10:01,000
which is driving yield movement.

67
00:10:01,000 --> 00:10:06,000
Oh, mother's work is never done. I didn't even look at the overnight markets.

68
00:10:06,000 --> 00:10:13,000
Oh, Nikkei, I mean that's nothing. It just was, it barely moved.

69
00:10:13,000 --> 00:10:22,000
Overall you could just say there was no change. When you got a 0.08% change from the beginning to the end of the trading day over in Tokyo,

70
00:10:22,000 --> 00:10:26,000
that's no change really. That's trivial.

71
00:10:26,000 --> 00:10:37,000
However, we do have, you notice this kind of an interesting thing. You can say, oh, something was bothered when we get to London later.

72
00:10:37,000 --> 00:10:46,000
Later when we get to London, something was upsetting the London exchange.

73
00:10:46,000 --> 00:10:55,000
Through there, almost about through the midday, something was pushing it down and down. There was selling going on.

74
00:10:55,000 --> 00:11:04,000
But then once that information had passed through the system, then it just pretty much floated for the rest of the day.

75
00:11:04,000 --> 00:11:12,000
It's just a physics, Newtonian physics kind of thing. It has to have some force being applied to go somewhere.

76
00:11:12,000 --> 00:11:21,000
There was a negative force, and then when that force had finished doing its stuff, then it just floated for the rest of the day.

77
00:11:21,000 --> 00:11:28,000
And finished off, well, they're still trading right now. It's not quite the end of the day there.

78
00:11:28,000 --> 00:11:33,000
It's off about three quarters of a percent, which is a little bit noticeable.

79
00:11:33,000 --> 00:11:43,000
Now what's the cause of that? Well, Britain is Britain and all of Great Britain, they have their own political things and economic things going on there.

80
00:11:43,000 --> 00:11:54,000
What I can't say, we're having a bad day here, a negative day here, but I can't say that it's a bleed over from the rest of the world.

81
00:11:54,000 --> 00:12:00,000
Everyone's just in a kind of a grouchy mood apparently today.

82
00:12:00,000 --> 00:12:12,000
Must be the weather outside. But all of that being set aside, I want to show you one last thing that comes from, I didn't mean to do that.

83
00:12:12,000 --> 00:12:21,000
That comes about on yield curves. Now, you folks are all going to be taking finance courses.

84
00:12:21,000 --> 00:12:28,000
You'll see this one again. It's a hidden feature of a yield curve.

85
00:12:28,000 --> 00:12:35,000
And it has to do with something called forward rates.

86
00:12:35,000 --> 00:12:44,000
Now when I look at these yields, by the way, notice something interesting. I talked about yield curves on Monday.

87
00:12:44,000 --> 00:12:55,000
Notice how this yield curve was dropping from about the six months clear out to the 10 year.

88
00:12:55,000 --> 00:13:01,000
That's 20 and 30. See, I was just dropping all through there and then at the 10 year,

89
00:13:01,000 --> 00:13:10,000
at the 20 year from the 10 to the 20, it finally turned direction and started behaving the way it should.

90
00:13:10,000 --> 00:13:22,000
So you had a yield curve a couple of days ago that was looking like that.

91
00:13:22,000 --> 00:13:32,000
A long inversion, an unusual, almost unprecedentedly long inversion of the yield curve.

92
00:13:32,000 --> 00:13:40,000
That's what that right there would be showing you. See how once it was rising a little bit,

93
00:13:40,000 --> 00:13:48,000
and then it just started falling, falling, falling until it finally got to the out, 20 year.

94
00:13:48,000 --> 00:13:53,000
And never mind, 30 year is always weird. There's something about that that's never normal.

95
00:13:53,000 --> 00:13:57,000
So don't worry about that. Okay, that's good.

96
00:13:57,000 --> 00:14:04,000
However, something special has happened yesterday.

97
00:14:04,000 --> 00:14:11,000
This is the finish line from the last time. See how it's dropping just like it was?

98
00:14:11,000 --> 00:14:22,000
But look. Do you see it? But look right here.

99
00:14:22,000 --> 00:14:32,000
It's actually pulling up hard now. It's trying to do a recovery on the back end of the yield curve.

100
00:14:32,000 --> 00:14:39,000
In other words, it's beginning to show turbulence right in here.

101
00:14:39,000 --> 00:14:46,000
That's a good sign. That probably means that if that turbulence begins to stabilize into a rise,

102
00:14:46,000 --> 00:14:52,000
which we kind of hope it will, see how it brought back up and then it dropped again?

103
00:14:52,000 --> 00:14:56,000
That is an indication that it's beginning to find its ground again.

104
00:14:56,000 --> 00:15:05,000
And this turn upward should begin to infect the shorter rates.

105
00:15:05,000 --> 00:15:09,000
We don't know that yet, but it looks like that's what's happening,

106
00:15:09,000 --> 00:15:15,000
is that it's finally beginning to show signs of wanting to be normal.

107
00:15:15,000 --> 00:15:23,000
And I remember in the past when you had a multi-period inversion,

108
00:15:23,000 --> 00:15:27,000
it was always the back end that began to recover.

109
00:15:27,000 --> 00:15:32,000
And that was like a wave that started to come that way and lift the whole thing up.

110
00:15:32,000 --> 00:15:35,000
This is just from my professional experience.

111
00:15:35,000 --> 00:15:42,000
I've seen it before, not with one this long on an inversion, but that would be a good sign,

112
00:15:42,000 --> 00:15:46,000
that it is de-inverting, for lack of a better term.

113
00:15:46,000 --> 00:15:52,000
And it's happening on the back end, and that wave is going to begin to lift.

114
00:15:52,000 --> 00:15:59,000
As this begins to recover, that will begin to cause the whole yield curve to start to behave like it should,

115
00:15:59,000 --> 00:16:04,000
like we want it to. Don't know yet. We just have to watch it for a while.

116
00:16:04,000 --> 00:16:09,000
But this is an important marker for us as finance professionals.

117
00:16:09,000 --> 00:16:18,000
Yield curves are one of those things that we look at every day.

118
00:16:18,000 --> 00:16:23,000
You go up to the mirror every morning and you look at it and you check yourself out.

119
00:16:23,000 --> 00:16:28,000
Yep. Well, this is one of those things in finance that we do too.

120
00:16:28,000 --> 00:16:31,000
You check your eyes to make sure they're still in your head.

121
00:16:31,000 --> 00:16:34,000
You make sure there are no horns and all that kind of stuff.

122
00:16:34,000 --> 00:16:38,000
These are the things that we check on our person.

123
00:16:38,000 --> 00:16:42,000
And in finance, we look at yield curves. We keep an eye on them.

124
00:16:42,000 --> 00:16:51,000
Just as part of being a professional, what we look at is not what a typical normal person would look at.

125
00:16:51,000 --> 00:16:54,000
But now, let me go on to something else.

126
00:16:54,000 --> 00:17:04,000
I will use this yield curve here again, but I would prefer to use one that's a little bit more normal to show this subject.

127
00:17:04,000 --> 00:17:08,000
And this has to do with what are called forward rates.

128
00:17:08,000 --> 00:17:20,000
You see, we calculate these yields by a classic formula that is actually something that you've seen before.

129
00:17:20,000 --> 00:17:25,000
This rate, let me get back up here and see if I can find...

130
00:17:25,000 --> 00:17:35,000
I wish they would show the numbers 1, 2. 1, 2, 3.

131
00:17:35,000 --> 00:17:53,000
Let me do...let's suppose that this is actually a normal yield curve. 1 year, 2 year, 4.20, 4.3.

132
00:17:53,000 --> 00:18:11,000
Well, let me do 4.26. And a 3 year would be, let's say, 4.34.

133
00:18:11,000 --> 00:18:15,000
Those are the yields. Those are the percentages.

134
00:18:15,000 --> 00:18:27,000
Now, we calculate these yields as simply...they are the price of it.

135
00:18:27,000 --> 00:18:42,000
So this price of, for example, the 1 year would give us a yield mathematically of 4.2%.

136
00:18:42,000 --> 00:19:03,000
So, 1 plus some yield x, and in this case, to the first power, minus 1, would be 1.0420.

137
00:19:03,000 --> 00:19:10,000
Now, that one power is actually 1 over 1 year.

138
00:19:10,000 --> 00:19:17,000
Remember that 1 over the number of years?

139
00:19:17,000 --> 00:19:45,000
The second one would be 1 plus x to the second power, to the 1 over 2, minus 1, would equal 1.0426.

140
00:19:45,000 --> 00:20:00,000
And the third year would be 1 plus 1 over x to the one-third power, minus 1, equals 1.0434.

141
00:20:00,000 --> 00:20:12,000
They'd be straight up geometric averages, for lack of a better term.

142
00:20:12,000 --> 00:20:24,000
Now, this one is easy to solve.

143
00:20:24,000 --> 00:20:27,000
They don't have enough board here for me to do this.

144
00:20:27,000 --> 00:20:41,000
I would do this, 1 plus x to the first power would be equal to 0.0420.

145
00:20:41,000 --> 00:20:43,000
Now, when you're saying, why are you doing this?

146
00:20:43,000 --> 00:20:49,000
1 plus x equals...

147
00:20:49,000 --> 00:20:55,000
1 point...sorry.

148
00:20:55,000 --> 00:20:58,000
Whoops, I said minus 1, I apologize for that.

149
00:20:58,000 --> 00:21:01,000
That's not correct, that's just 0.

150
00:21:01,000 --> 00:21:09,000
Okay, 1 plus x...so x equals 0.0420.

151
00:21:09,000 --> 00:21:14,000
That's how we calculate that 1 year.

152
00:21:14,000 --> 00:21:18,000
Now, don't worry if this isn't ringing a bell or anything.

153
00:21:18,000 --> 00:21:21,000
You'll see what I'm after here in a minute.

154
00:21:21,000 --> 00:21:38,000
Now, the second one would be 1 plus x to the one-half equals 1.0426.

155
00:21:38,000 --> 00:21:49,000
So, 1 plus x equals 1.0426 to the second power.

156
00:21:49,000 --> 00:21:55,000
This is just pissing me off the way they've got these boards laid out here.

157
00:21:55,000 --> 00:22:01,000
Dumbasses.

158
00:22:01,000 --> 00:22:07,000
Okay, let me write this again.

159
00:22:07,000 --> 00:22:27,000
Essentially, for a 1 year, x is going to be equal to 0.0420.

160
00:22:27,000 --> 00:22:40,000
For a 2 year, the x is going to be...

161
00:22:40,000 --> 00:22:42,000
and I can't do it exactly.

162
00:22:42,000 --> 00:22:59,000
I know that 1 plus x is going to be 1.0426 to the second power.

163
00:22:59,000 --> 00:23:02,000
So, I could keep going with this.

164
00:23:02,000 --> 00:23:15,000
For the 3 year, 1 plus x is going to be 1.0423...what did I say?

165
00:23:15,000 --> 00:23:27,000
0.0434 to the third power.

166
00:23:27,000 --> 00:23:33,000
Now, taking that aside, making it simple for just a minute.

167
00:23:33,000 --> 00:23:40,000
The 1 year is unquestionably 4.20%.

168
00:23:40,000 --> 00:23:47,000
But the 2 year is actually not...

169
00:23:47,000 --> 00:23:52,000
well, it is if you take just the second power, you get 1 plus x.

170
00:23:52,000 --> 00:23:57,000
But, something else is going on.

171
00:23:57,000 --> 00:24:05,000
Because actually, that 2 year is 1 plus the 1 year...

172
00:24:05,000 --> 00:24:20,000
1 plus the 1 year, 0.0420, times a 1 plus r of a second year.

173
00:24:20,000 --> 00:24:23,000
There are actually 2 interest rates working.

174
00:24:23,000 --> 00:24:27,000
There is the 1 that will be for the year that's preceded.

175
00:24:27,000 --> 00:24:30,000
We know what that 1 is. It's 4.20%.

176
00:24:30,000 --> 00:24:36,000
But the second rate would be the 1 that is going from year 1 to year 2.

177
00:24:36,000 --> 00:24:40,000
It's a composite of 2 effects.

178
00:24:40,000 --> 00:24:46,000
This is called the Fisher effect, kind of loosely.

179
00:24:46,000 --> 00:24:59,000
So this second one right here is called a forward rate.

180
00:24:59,000 --> 00:25:08,000
The 3 year would actually be the 1 year...

181
00:25:08,000 --> 00:25:17,000
times whatever that second year forward rate is, times...

182
00:25:17,000 --> 00:25:20,000
So this one is year 1.

183
00:25:20,000 --> 00:25:23,000
This is the 1 from year 1 to year 2.

184
00:25:23,000 --> 00:25:28,000
This is the year 1 to year 2 to year 3.

185
00:25:28,000 --> 00:25:34,000
You can chain these together to get what's called a forward rate yield curve.

186
00:25:34,000 --> 00:25:36,000
Which looks kind of different.

187
00:25:36,000 --> 00:25:39,000
But we'll see what happens when in practice.

188
00:25:39,000 --> 00:25:43,000
First we have to get this guy solved up.

189
00:25:43,000 --> 00:25:48,000
Because we know that...

190
00:25:48,000 --> 00:25:53,000
playing around going to another board again here...

191
00:25:53,000 --> 00:25:59,000
Let me get this all off here, but not get rid of my rates.

192
00:25:59,000 --> 00:26:11,000
That 1 plus.0420 times 1 plus the 1 to 2 year forward rate...

193
00:26:11,000 --> 00:26:18,000
would be 1.0426 to the second power.

194
00:26:18,000 --> 00:26:23,000
In other words, this second year, the second year rate that you see...

195
00:26:23,000 --> 00:26:30,000
is actually a composite of the year 1 rate and the year 1 to 2 rate.

196
00:26:30,000 --> 00:26:37,000
So ultimately what we can do here is we can say that 1 plus the 1 to 2 year rate...

197
00:26:37,000 --> 00:26:52,000
is 1.0426 to the second power divided by 1.0420.

198
00:26:52,000 --> 00:26:56,000
And that will give us the forward rate for the second year.

199
00:26:56,000 --> 00:26:58,000
Don't worry about all this other stuff.

200
00:26:58,000 --> 00:27:02,000
Just know the mechanics of how I do this over here.

201
00:27:02,000 --> 00:27:06,000
I'm going to chain together and watch what happens.

202
00:27:06,000 --> 00:27:08,000
And this is what's interesting about it.

203
00:27:08,000 --> 00:27:14,000
This is where it gets a little bit interesting anyway.

204
00:27:14,000 --> 00:27:25,000
I'm going to take 1.0426 squared...

205
00:27:25,000 --> 00:27:36,000
divided by 1.0420.

206
00:27:36,000 --> 00:27:41,000
And then I want minus 1.

207
00:27:41,000 --> 00:27:45,000
4.33.

208
00:27:45,000 --> 00:27:51,000
So the 1 to 2 year forward rate is 1....

209
00:27:51,000 --> 00:28:03,000
well, is.0433 or 4.33%.

210
00:28:03,000 --> 00:28:09,000
So in order to get a 2 year composite rate of 4.26%,

211
00:28:09,000 --> 00:28:20,000
you would have to chain a 4.20% for the first year with a 4.33% for the second year.

212
00:28:20,000 --> 00:28:30,000
In other words, the forward rate is a little bit higher than the 1 year rate.

213
00:28:30,000 --> 00:28:34,000
Notice that this forward rate is bigger than the composite,

214
00:28:34,000 --> 00:28:40,000
because the composite was 4.20...

215
00:28:40,000 --> 00:28:48,000
what would happen if you took 4.26 for 2 years.

216
00:28:48,000 --> 00:28:54,000
But if you say, well, we start the first year with a 4.20,

217
00:28:54,000 --> 00:28:58,000
and then the next year it's a 4.33,

218
00:28:58,000 --> 00:29:05,000
yeah, that creates a composite for the 2 years overall of 4.26.

219
00:29:05,000 --> 00:29:08,000
It's almost just an average.

220
00:29:08,000 --> 00:29:16,000
This 4.33 plus 4.20, the average of them is a little less.

221
00:29:16,000 --> 00:29:19,000
This is a geometric, but it's a geometric...

222
00:29:19,000 --> 00:29:23,000
this is a geometric average.

223
00:29:23,000 --> 00:29:29,000
Now, the next thing we can do is we can say this.

224
00:29:29,000 --> 00:29:45,000
Okay, so 1.0420 for the first year times 1.0433 for the second year

225
00:29:45,000 --> 00:29:58,000
times the 2 to 3 year forward rate will be 1.0434.

226
00:29:58,000 --> 00:30:00,000
You see, you built them.

227
00:30:00,000 --> 00:30:04,000
I knew the 1 year right off the bat. It's right there.

228
00:30:04,000 --> 00:30:08,000
I then get the forward 1 to 2,

229
00:30:08,000 --> 00:30:13,000
and then put that together with the forward 2 to 3,

230
00:30:13,000 --> 00:30:17,000
and I can tease out what's going to actually be happening,

231
00:30:17,000 --> 00:30:21,000
or at least what the market thinks will be the rate through year 3,

232
00:30:21,000 --> 00:30:24,000
from year 2 to year 3.

233
00:30:24,000 --> 00:30:31,000
And that would... I'm sorry, that would be to the third power.

234
00:30:31,000 --> 00:30:39,000
And walking it through that...

235
00:30:39,000 --> 00:30:54,000
1.0434 to the third power...

236
00:30:54,000 --> 00:30:56,000
Now, watch me screw this up.

237
00:30:56,000 --> 00:31:02,000
Divided by open parenthesis...

238
00:31:02,000 --> 00:31:09,000
1... wait, that's a comma.

239
00:31:09,000 --> 00:31:12,000
Divided by open... that's right, you can't do it.

240
00:31:12,000 --> 00:31:14,000
I have to use the calculator.

241
00:31:14,000 --> 00:31:17,000
Open parenthesis...

242
00:31:17,000 --> 00:31:31,000
1.0420 times 1.0433.

243
00:31:31,000 --> 00:31:39,000
Close the parenthesis, and then minus 1...

244
00:31:39,000 --> 00:31:45,000
4.49%, if I did that calculation right.

245
00:31:45,000 --> 00:32:00,000
So R3, the 2 to 3 year forward rate, is 4.49%.

246
00:32:00,000 --> 00:32:07,000
The yield curve that you see is 4.2, 4.26, 4.34.

247
00:32:07,000 --> 00:32:17,000
The forward yield curve is 4.20, 4.33, 4.49.

248
00:32:17,000 --> 00:32:21,000
Because these are each year's projected,

249
00:32:21,000 --> 00:32:24,000
as far as the market is concerned.

250
00:32:24,000 --> 00:32:32,000
These are what the market is seeing each year's forward rate, interest rate as.

251
00:32:32,000 --> 00:32:35,000
And the yield curve, if the yield curve is upward sloping,

252
00:32:35,000 --> 00:32:38,000
the one you see is upward sloping,

253
00:32:38,000 --> 00:32:44,000
then the forward yield curve will be steeper.

254
00:32:44,000 --> 00:32:48,000
That's ideally the one we want to look at, but we don't.

255
00:32:48,000 --> 00:32:52,000
Because if it's upward sloping, when we look at the normal one,

256
00:32:52,000 --> 00:32:57,000
we know that the forward yield curve will be upward sloping too,

257
00:32:57,000 --> 00:33:01,000
just at a more accelerated rate.

258
00:33:01,000 --> 00:33:06,000
However, notice that it's a little more than that though.

259
00:33:06,000 --> 00:33:14,000
The forward yield curve is obviously rising at a maturity premium and all that.

260
00:33:14,000 --> 00:33:20,000
But if I look at that one that I did there, that's a little more disturbing.

261
00:33:20,000 --> 00:33:24,000
That one is actually, they're in year two to year three.

262
00:33:24,000 --> 00:33:26,000
That thing is kicked up.

263
00:33:26,000 --> 00:33:30,000
The markets are anticipating, they're whispering,

264
00:33:30,000 --> 00:33:35,000
that they expect that in year three, during year three,

265
00:33:35,000 --> 00:33:40,000
interest rates will have made it up to 4.5%.

266
00:33:40,000 --> 00:33:45,000
It's not too terrible, but it does show that there is an expectation

267
00:33:45,000 --> 00:33:50,000
of a higher interest rate than we might have expected

268
00:33:50,000 --> 00:33:53,000
just looking at the yield curve itself.

269
00:33:53,000 --> 00:33:57,000
Now, let me do this one right here.

270
00:33:57,000 --> 00:34:03,000
I want to show you what a downward sloping yield curve looks like,

271
00:34:03,000 --> 00:34:05,000
what it does to forward rates.

272
00:34:05,000 --> 00:34:11,000
5.03, 4.70, 4.50.

273
00:34:11,000 --> 00:34:16,000
And I'll do this quickly enough so that I won't fatigue you with it.

274
00:34:16,000 --> 00:34:17,000
I've got other things to do.

275
00:34:17,000 --> 00:34:23,000
But I do want to show you what an inverted yield curve says.

276
00:34:23,000 --> 00:34:27,000
Okay, we've got, what are the numbers?

277
00:34:27,000 --> 00:34:36,000
They were 5.03, 4.70, 4.50.

278
00:34:36,000 --> 00:34:54,000
5.03, 4.70, and 4.50.

279
00:34:54,000 --> 00:34:58,000
So, the one year is right there.

280
00:34:58,000 --> 00:35:00,000
That's where we stand right now.

281
00:35:00,000 --> 00:35:09,000
So, the next one would be, we would say, 1.053,

282
00:35:09,000 --> 00:35:19,000
yeah, 0503 times 1 plus the one to two year forward rate

283
00:35:19,000 --> 00:35:34,000
should be 1 plus 0.0470 to the second power.

284
00:35:34,000 --> 00:35:36,000
Here too.

285
00:35:36,000 --> 00:35:40,000
So, if I tease that out and beat it up a little bit,

286
00:35:40,000 --> 00:35:46,000
I would have, calling up, let me clear this so that I've got a clean field.

287
00:35:46,000 --> 00:36:11,000
I would say 1.0470 squared divided by 1.0503 minus 1, 4.37.

288
00:36:16,000 --> 00:36:39,000
And then the year three should be 1.0503 times 1.0437

289
00:36:39,000 --> 00:36:45,000
times 1 plus the forward rate for year three.

290
00:36:45,000 --> 00:36:59,000
That should be 1.0450 to the third power.

291
00:36:59,000 --> 00:37:28,000
So, the third year forward rate would be 1.0450 to the third power over 1.040530, 0503, times 1.0437.

292
00:37:28,000 --> 00:37:31,000
So, let's see what the third year forward rate is.

293
00:37:31,000 --> 00:38:00,000
So, we're going to do 1.0450 cubed to the third power divided by 1.0533.

294
00:38:00,000 --> 00:38:20,000
0530, 0503 I should say, 03 times 1.0437.

295
00:38:20,000 --> 00:38:42,000
Close the parenthesis, minus 1, 4.10.

296
00:38:42,000 --> 00:38:45,000
What does this mean?

297
00:38:45,000 --> 00:38:58,000
This is actually why an inverted yield curve is a warning sign of a recession.

298
00:38:58,000 --> 00:39:04,000
It's because business activity is drying up year by year.

299
00:39:04,000 --> 00:39:10,000
And in year two, there will not be as much demand for the capital

300
00:39:10,000 --> 00:39:16,000
because businesses aren't trying to reinvest or not trying to grow their companies.

301
00:39:16,000 --> 00:39:22,000
So, you're losing, the demand for capital is going down.

302
00:39:22,000 --> 00:39:30,000
And in year three, the demand for capital is going down even further as the recession continues.

303
00:39:30,000 --> 00:39:38,000
And as long as the yield curve is dropping, that would say that demand for capital in that year,

304
00:39:38,000 --> 00:39:43,000
year three, year four, year five, as long as the inversion continues,

305
00:39:43,000 --> 00:39:47,000
you're seeing the demand for capital falling backward.

306
00:39:47,000 --> 00:39:53,000
And that is just simply why, what a recession does.

307
00:39:53,000 --> 00:40:01,000
Business activity goes down, consumer purchasing goes down, and so the demand for capital goes down.

308
00:40:01,000 --> 00:40:07,000
And so, interest rates go down because the demand for money is going down.

309
00:40:07,000 --> 00:40:12,000
That's why when it turns back up, that's when the forward rates begin to recover.

310
00:40:12,000 --> 00:40:18,000
If the yield curve itself starts turning back up, you'll see the forward rate starts to turn back up as well.

311
00:40:18,000 --> 00:40:26,000
And that is the indication of the demand for capital beginning to surge again.

312
00:40:26,000 --> 00:40:33,000
Now, in this case, that's what's really creepy about this long, long inversion we see now.

313
00:40:33,000 --> 00:40:42,000
This is whispering that the markets seemed to be thinking that this demand for capital was going to fall

314
00:40:42,000 --> 00:40:49,000
in years one, two, three, five, seven, and ten.

315
00:40:49,000 --> 00:40:53,000
In other words, almost like a depression that would be.

316
00:40:53,000 --> 00:41:03,000
As a matter of fact, the last time we saw a long inversion of a yield curve was the Great Depression.

317
00:41:03,000 --> 00:41:11,000
And therefore, this forward rate, I mean, that's scary when you see that because the markets were thinking,

318
00:41:11,000 --> 00:41:21,000
and still are to some extent, that there is going to be a long-term back down fall in the demand for capital.

319
00:41:21,000 --> 00:41:26,000
For what it's worth.

320
00:41:26,000 --> 00:41:32,000
Now, I'm not going to ask you this on a quiz or an exam to calculate forward rates.

321
00:41:32,000 --> 00:41:35,000
You've got a couple of pretty much easy questions.

322
00:41:35,000 --> 00:41:41,000
All you ever have to do to remember is you calculate the year two forward rate,

323
00:41:41,000 --> 00:41:51,000
and then you chain those together and you make that equal to the yield curves rate to the second power for the second year.

324
00:41:51,000 --> 00:41:58,000
And then once you've got that one, you can chain together the two that you've got to get the third one,

325
00:41:58,000 --> 00:42:05,000
one plus R3, by setting it equal to what the yield curve is saying and raise that to the third power.

326
00:42:05,000 --> 00:42:12,000
One thing about this though is that notice that treasuries aren't every year.

327
00:42:12,000 --> 00:42:20,000
One, there's one year treasuries, two year treasuries, three year, but then it jumps to five, seven, ten, twenty, and thirty.

328
00:42:20,000 --> 00:42:23,000
So you can't really do this.

329
00:42:23,000 --> 00:42:28,000
I mean, you can do something, but it's a pain in the ass to do it.

330
00:42:28,000 --> 00:42:39,000
So this is really only a very useful exercise for the forward rates for years two and three.

331
00:42:39,000 --> 00:42:41,000
After that, there are gaps.

332
00:42:41,000 --> 00:42:48,000
So you could get a forward rate that would be for the two years from year four to year,

333
00:42:48,000 --> 00:42:53,000
for year three to year four to year five.

334
00:42:53,000 --> 00:42:59,000
But you can't get exact annual forward rates by this method.

335
00:42:59,000 --> 00:43:06,000
So it's useful really realistically only for the first forward rates.

336
00:43:06,000 --> 00:43:13,000
So the one year is the annualized rate and it is the forward rate.

337
00:43:13,000 --> 00:43:19,000
The two year is an annualized rate from which you can get the forward rate.

338
00:43:19,000 --> 00:43:25,000
The third year is an annualized rate from which you can get the year three.

339
00:43:25,000 --> 00:43:33,000
Now in a way, it would be better to show this subject later in the course after bonds.

340
00:43:33,000 --> 00:43:35,000
You're going to see why in a while.

341
00:43:35,000 --> 00:43:41,000
But the reality of it is that this is not how markets work.

342
00:43:41,000 --> 00:43:44,000
Markets work on prices.

343
00:43:44,000 --> 00:43:47,000
They don't directly calculate yields.

344
00:43:47,000 --> 00:43:56,000
Yields are the consequence of the prices, buying and selling of stocks, buying and selling of bonds.

345
00:43:56,000 --> 00:44:02,000
You don't see a quote that says the capital gain for this stock for today is,

346
00:44:02,000 --> 00:44:07,000
or the yield on this bond, well for some of them.

347
00:44:07,000 --> 00:44:08,000
You see prices.

348
00:44:08,000 --> 00:44:11,000
You buy and sell on prices.

349
00:44:11,000 --> 00:44:21,000
But the prices behind the scene drive holding period returns, capital gains, dividend yields and all of that.

350
00:44:21,000 --> 00:44:24,000
It's behind the scenes that that happens.

351
00:44:24,000 --> 00:44:34,000
So now let me get all this nonsense off the board and get to something that's a lot more tangible.

352
00:44:34,000 --> 00:44:47,000
The subject of bonds.

353
00:44:47,000 --> 00:44:57,000
Now bonds are hugely important in finance.

354
00:44:57,000 --> 00:45:04,000
In fact, I probably have mentioned this before, but I could ask you about it.

355
00:45:04,000 --> 00:45:09,000
The bond market is ten times the size of the stock market.

356
00:45:09,000 --> 00:45:14,000
It's ten times the size.

357
00:45:14,000 --> 00:45:22,000
And yet all of the talking heads on TV shows and blogs and all the newsletters,

358
00:45:22,000 --> 00:45:27,000
all they talk about are stocks.

359
00:45:27,000 --> 00:45:28,000
Yeah?

360
00:45:28,000 --> 00:45:31,000
Is it because other countries also buy bonds so it's more international?

361
00:45:31,000 --> 00:45:32,000
No.

362
00:45:32,000 --> 00:45:37,000
It's because bonds are not interesting.

363
00:45:37,000 --> 00:45:41,000
They are boring.

364
00:45:41,000 --> 00:45:47,000
If you watch, you're standing on an overpass of a highway.

365
00:45:47,000 --> 00:45:52,000
You see the cars.

366
00:45:52,000 --> 00:45:57,000
But cars, wouldn't you pay attention more if you saw a major accident?

367
00:45:57,000 --> 00:46:03,000
Smash, tinkle.

368
00:46:03,000 --> 00:46:05,000
Bonds are boring.

369
00:46:05,000 --> 00:46:12,000
Their prices do not fluctuate anywhere near the way stock prices do.

370
00:46:12,000 --> 00:46:16,000
There's a reason for that.

371
00:46:16,000 --> 00:46:27,000
But the reason the talking heads pay so much attention to bonds is that they are boring.

372
00:46:27,000 --> 00:46:32,000
And you cannot make a fortune overnight.

373
00:46:32,000 --> 00:46:39,000
You will not have a day trader, boy, I really put it into bonds today, my God, and I made a fortune off.

374
00:46:39,000 --> 00:46:41,000
It'll never happen.

375
00:46:41,000 --> 00:46:45,000
Well, once in a, was it a blue boob, maybe.

376
00:46:45,000 --> 00:46:51,000
But for the most part, they don't go very far from one day to the next.

377
00:46:51,000 --> 00:46:55,000
And there are two reasons for that.

378
00:46:55,000 --> 00:47:02,000
One is that bonds are lower risk, therefore lower volatility.

379
00:47:02,000 --> 00:47:05,000
Why are they lower risk?

380
00:47:05,000 --> 00:47:06,000
Yeah?

381
00:47:06,000 --> 00:47:15,000
You said that the same risk, because if a corporation was to fail, the only thing that they had was the order of liquidation.

382
00:47:15,000 --> 00:47:20,000
Well, if we're talking about a bankruptcy, we're just talking about a normal company.

383
00:47:20,000 --> 00:47:23,000
Bonds have the prior claim.

384
00:47:23,000 --> 00:47:32,000
The company must pay its bonds, what is due to the bondholders, always before the stockholders can get a penny,

385
00:47:32,000 --> 00:47:36,000
either through dividends or through reinvestment in the company.

386
00:47:36,000 --> 00:47:42,000
Whatever is left over is what the stockholders get, and that is volatile.

387
00:47:42,000 --> 00:47:57,000
In fact, that is the reason that corporations, for their own funds, have rules against investing in stocks a lot of times.

388
00:47:57,000 --> 00:47:59,000
You can't do that.

389
00:47:59,000 --> 00:48:03,000
Because stockholders can lose their shirts.

390
00:48:03,000 --> 00:48:06,000
The stock price might not go up.

391
00:48:06,000 --> 00:48:08,000
They might cut off the dividend.

392
00:48:08,000 --> 00:48:10,000
The company may go bankrupt.

393
00:48:10,000 --> 00:48:14,000
In any of those cases, the stock loses.

394
00:48:14,000 --> 00:48:22,000
The bondholders, the worst that can happen to a bond is that they will have to force the company into liquidation

395
00:48:22,000 --> 00:48:26,000
and get whatever they can out of the ashes.

396
00:48:26,000 --> 00:48:34,000
But in a normal course of business, the bondholders must be paid their coupon payments, their interest.

397
00:48:34,000 --> 00:48:44,000
They must also be paid a balance, the payoff of the bond, before stockholders can do anything.

398
00:48:44,000 --> 00:48:52,000
So if I have my debts in my own company, I am the shareholder.

399
00:48:52,000 --> 00:49:01,000
I can't have dinner tonight off the company's revenue until I have paid the bills for the month.

400
00:49:01,000 --> 00:49:04,000
The liabilities have to come first.

401
00:49:04,000 --> 00:49:09,000
Now, I can play a few games with putting off accounts payable and all that.

402
00:49:09,000 --> 00:49:11,000
That's just cash management.

403
00:49:11,000 --> 00:49:23,000
If I've got a long-term debt agreement with, let's say, what my company does with a credit union, I don't pay that.

404
00:49:23,000 --> 00:49:24,000
It's over.

405
00:49:24,000 --> 00:49:26,000
The company is gone.

406
00:49:26,000 --> 00:49:34,000
They go right to court and they turn my company into liquid assets that they divvy up among themselves.

407
00:49:34,000 --> 00:49:38,000
That's the problem with bonds is that they're great.

408
00:49:38,000 --> 00:49:40,000
It's other people's money.

409
00:49:40,000 --> 00:49:46,000
As long as you recognize that they get their candy before anyone else gets its candy.

410
00:49:46,000 --> 00:49:48,000
That's just the way it works.

411
00:49:48,000 --> 00:49:54,000
The bondholders have the prior claim to the cash flows of the corporation.

412
00:49:54,000 --> 00:50:08,000
But there's another reason that bonds are less volatile than stocks, that they are safer than stocks.

413
00:50:08,000 --> 00:50:11,000
Bonds have an anchor.

414
00:50:11,000 --> 00:50:16,000
Somewhere down the line, you pay off a bond.

415
00:50:16,000 --> 00:50:19,000
There is a dollar amount.

416
00:50:19,000 --> 00:50:24,000
There is no somewhere down the line where your stock ends up.

417
00:50:24,000 --> 00:50:29,000
It could end up at zero or it could end up at a billion dollars.

418
00:50:29,000 --> 00:50:36,000
There is no predictability in a certain way, in a very real sense.

419
00:50:36,000 --> 00:50:39,000
I don't know what a stock is going to do.

420
00:50:39,000 --> 00:50:41,000
I know damn well what a bond is going to do.

421
00:50:41,000 --> 00:50:47,000
It's going to pay me a thousand dollars at the time of maturity.

422
00:50:47,000 --> 00:50:49,000
Can't you just do a buy back and buy it all back?

423
00:50:49,000 --> 00:50:51,000
We'll talk about those.

424
00:50:51,000 --> 00:50:52,000
That's fine.

425
00:50:52,000 --> 00:50:57,000
But the reality, just the basic theoretical framework, is that there's an anchor.

426
00:50:57,000 --> 00:51:04,000
No matter what else happens to a company, me as a bondholder, I get paid off.

427
00:51:04,000 --> 00:51:09,000
As long as the company isn't dead, I get paid off at the end.

428
00:51:09,000 --> 00:51:16,000
And what you're talking about, that's only with convertibles or with another kind of bond.

429
00:51:16,000 --> 00:51:21,000
You can put them back to where they want to sell them.

430
00:51:21,000 --> 00:51:25,000
You can do that, but you cannot do it if the bond covenants don't allow you to.

431
00:51:25,000 --> 00:51:27,000
That's the important thing.

432
00:51:27,000 --> 00:51:29,000
I'll get to that in just a minute here.

433
00:51:29,000 --> 00:51:35,000
But the first thing first is that there are many different kinds of bonds.

434
00:51:35,000 --> 00:51:41,000
And although they have characteristics in common, they can be all over the place.

435
00:51:41,000 --> 00:51:47,000
The first thing first though is that when I use the word bond, I'm using generically.

436
00:51:47,000 --> 00:51:51,000
Remember, a bill is a debt that is due in less than a year.

437
00:51:51,000 --> 00:51:57,000
A note is a debt that is due in one, two, seven, ten, fifteen years.

438
00:51:57,000 --> 00:51:59,000
Who knows?

439
00:51:59,000 --> 00:52:02,000
And then a bond is due in a longer period of time.

440
00:52:02,000 --> 00:52:10,000
Now that note thing is subject to some disagreement among professionals right now.

441
00:52:10,000 --> 00:52:21,000
Netflix issued 15-year, and I would have called those notes, but the financial media were calling them...

442
00:52:21,000 --> 00:52:27,000
No, I would have called those bonds, but the financial media was referring to them as notes.

443
00:52:27,000 --> 00:52:34,000
But then I saw another that was 15 years, and the financial media was referring to those as bonds.

444
00:52:34,000 --> 00:52:38,000
So when I use the term bond, I'm being very generic.

445
00:52:38,000 --> 00:52:41,000
Any debt instrument is a bond.

446
00:52:41,000 --> 00:52:45,000
Now there are all kinds of ways you can divide up bonds.

447
00:52:45,000 --> 00:52:58,000
But generally speaking, it's important to know the difference between a private debt instrument and a corporate or a government debt instrument.

448
00:52:58,000 --> 00:53:04,000
When you take out...you decided that you were going to buy a car.

449
00:53:04,000 --> 00:53:07,000
Payments, we did the calculation of the payments.

450
00:53:07,000 --> 00:53:09,000
Now here's the problem with that.

451
00:53:09,000 --> 00:53:13,000
Well, for you, your payment...you calculate a payment.

452
00:53:13,000 --> 00:53:24,000
That payment includes an interest that you'll pay on what you still owe and some that will pay down the balance you owe.

453
00:53:24,000 --> 00:53:30,000
It services the debt, the interest, and it amortizes the principal.

454
00:53:30,000 --> 00:53:33,000
So they do both.

455
00:53:33,000 --> 00:53:37,000
Corporate and government debt does not work that way.

456
00:53:37,000 --> 00:53:53,000
Through the life of a corporate bond, through the life of a government bond, all in most cases, or in almost all cases, all that is paid along the way is the interest.

457
00:53:53,000 --> 00:53:58,000
There is no amortization of the principal for most of these instruments.

458
00:53:58,000 --> 00:54:02,000
All they do is pay interest.

459
00:54:02,000 --> 00:54:07,000
In other words, the payment services the bond.

460
00:54:07,000 --> 00:54:12,000
And then at the end, what you borrowed is all paid back.

461
00:54:12,000 --> 00:54:15,000
And I'll get into that. It's a little more detailed than that.

462
00:54:15,000 --> 00:54:23,000
But there...so in other words, if a company, a corporation borrows $50 million at 8%...

463
00:54:23,000 --> 00:54:26,000
Well, let's make it easy.

464
00:54:26,000 --> 00:54:37,000
...Borrow $10 million at 8% and let's say it's 20 years.

465
00:54:37,000 --> 00:54:40,000
It gets the $10 million right now.

466
00:54:40,000 --> 00:54:46,000
For 20 years, it must pay...

467
00:54:46,000 --> 00:54:57,000
$800,000. Years 1 through 20...

468
00:54:57,000 --> 00:55:04,000
No, it will be $800,000.

469
00:55:04,000 --> 00:55:07,000
I can do percentages in my head.

470
00:55:07,000 --> 00:55:17,000
And then at the end, it makes one last payment of $800,000 and then it pays off the $10 million.

471
00:55:17,000 --> 00:55:19,000
At the end, it just pays.

472
00:55:19,000 --> 00:55:31,000
So there's one last check at year 20 for $800,000 and at year 20, the company pays back the $10 million.

473
00:55:31,000 --> 00:55:38,000
Now in reality, the bondholders are not going to rely on it.

474
00:55:38,000 --> 00:55:40,000
Oh, I hope they have that $10 million.

475
00:55:40,000 --> 00:55:53,000
They're going to have some kind of an arrangement so that the company is putting away some of that money every year so that they have the $10 million.

476
00:55:53,000 --> 00:55:55,000
That's called a sinking fund.

477
00:55:55,000 --> 00:55:57,000
There are variations on it.

478
00:55:57,000 --> 00:56:08,000
One variation that's rather normal, well, not that normal, but it's there, is when you...

479
00:56:08,000 --> 00:56:22,000
The company will make the agreement, look, we will buy back a certain percentage of your bonds from you every year so that by year 20, they're all off the books, all gone.

480
00:56:22,000 --> 00:56:24,000
That's one way.

481
00:56:24,000 --> 00:56:37,000
One way is just to put money away in a sinking fund every year so that well before the 20 years, the $10 million is in there for the bondholders so that that's taken care of.

482
00:56:37,000 --> 00:56:38,000
The other way is...

483
00:56:38,000 --> 00:56:55,000
Another way is for the company to buy back bonds every year through the life of the bond until there is no $10 million by the time year 20, there's just a little bit of the bond still out there in the market to buy.

484
00:56:55,000 --> 00:56:57,000
That's another way.

485
00:56:57,000 --> 00:57:01,000
And there are a couple of other odd tricks that I've seen lately.

486
00:57:01,000 --> 00:57:04,000
But let's go back here.

487
00:57:04,000 --> 00:57:08,000
Now, government bonds work the same way.

488
00:57:08,000 --> 00:57:12,000
And there is a twist.

489
00:57:12,000 --> 00:57:18,000
Normally, this is for only very short-term debt instruments.

490
00:57:18,000 --> 00:57:21,000
However, it can be for longer term, too.

491
00:57:21,000 --> 00:57:30,000
It's where the bond you actually buy, sell the bond, a company says, we need money.

492
00:57:30,000 --> 00:57:47,000
What we'd like to do is we'll borrow $8 million and in let's say in seven years, we'll pay back $10 million.

493
00:57:47,000 --> 00:57:51,000
That's called a deep discount bond.

494
00:57:51,000 --> 00:57:54,000
This is the way short-term works almost always.

495
00:57:54,000 --> 00:57:56,000
There isn't really an interest.

496
00:57:56,000 --> 00:57:58,000
It's just a discount.

497
00:57:58,000 --> 00:58:00,000
Commercial paperwork works that way.

498
00:58:00,000 --> 00:58:06,000
A company says, we want to borrow money for 30 days.

499
00:58:06,000 --> 00:58:17,000
We'll pay back $1 million and then the price will be like $998,000 or something like that.

500
00:58:17,000 --> 00:58:27,000
So in other words, the interest is the difference between what is lent to the company and what the company pays back 30 days, 60, 90 days later.

501
00:58:27,000 --> 00:58:29,000
Those are called discount bonds.

502
00:58:29,000 --> 00:58:34,000
There was a wild and it's still out there once in a great while.

503
00:58:34,000 --> 00:58:37,000
There was a wild version on this.

504
00:58:37,000 --> 00:58:50,000
They're called zero coupon bonds, ZCBs, where these companies that knew they wouldn't have any revenue for a few years, this was back during the late 1990s.

505
00:58:50,000 --> 00:58:56,000
They did an arrangement just like I described, what's the seven years out or 10 years out.

506
00:58:56,000 --> 00:59:01,000
It was a disaster and it was because of Federal Reserve.

507
00:59:01,000 --> 00:59:09,000
At the time, the chairman had an extraordinary spite for how awesome the market was behaving, but I'll get into that later.

508
00:59:09,000 --> 00:59:11,000
Let me get into some of the things.

509
00:59:11,000 --> 00:59:13,000
First things first.

510
00:59:13,000 --> 00:59:22,000
Every bond sets up and let's say that it's an investment banker.

511
00:59:22,000 --> 00:59:30,000
Now, I go to the investment bank and I say, I should like to borrow $100 million.

512
00:59:30,000 --> 00:59:44,000
Now, the investment banker is going to go to his resources, those who have that kind of money, and to his own treasury, his or her own treasury.

513
00:59:44,000 --> 00:59:55,000
They're going to say, okay, we will buy this issue and then we'll break it up and sell it to our investors and all that.

514
00:59:55,000 --> 01:00:01,000
But there will be a negotiation that goes on.

515
01:00:01,000 --> 01:00:17,000
It ultimately resolves in what's called the bond indenture agreement.

516
01:00:17,000 --> 01:00:25,000
I had been teaching this for years, decades before I actually ever saw the real deal.

517
01:00:25,000 --> 01:00:33,000
I was going to New York to visit a friend of mine who had been in the business for just a long, long time.

518
01:00:33,000 --> 01:00:35,000
He was working with an investment.

519
01:00:35,000 --> 01:00:37,000
He worked for an investment banking firm.

520
01:00:37,000 --> 01:00:38,000
He wasn't a principal.

521
01:00:38,000 --> 01:00:43,000
But I said, Marty, I've got a favor.

522
01:00:43,000 --> 01:00:48,000
Can you show me an actual bond indenture agreement?

523
01:00:48,000 --> 01:00:50,000
He said, yeah, I'll show you one.

524
01:00:50,000 --> 01:00:55,000
When I got there, he had a thick binder.

525
01:00:55,000 --> 01:00:58,000
And I thought, well, he handed it to me.

526
01:00:58,000 --> 01:01:00,000
He said, you wanted a bond indenture agreement?

527
01:01:00,000 --> 01:01:01,000
Here it is.

528
01:01:01,000 --> 01:01:06,000
It's a contract between the lenders and the borrower.

529
01:01:06,000 --> 01:01:09,000
And I won't tell you the name of the company, but you might even recognize it.

530
01:01:09,000 --> 01:01:15,000
It was just, geez, it was a giant contract.

531
01:01:15,000 --> 01:01:19,000
Now, the contract has all kinds of paragraphs.

532
01:01:19,000 --> 01:01:27,000
We call these the covenants of the indenture agreement.

533
01:01:27,000 --> 01:01:31,000
The who, who, where, for, why, what if, who farted.

534
01:01:31,000 --> 01:01:33,000
Everything is in there.

535
01:01:33,000 --> 01:01:37,000
The amount, the coupon, that's the interest rate.

536
01:01:37,000 --> 01:01:46,000
And that's oftentimes settled very shortly before the issue happens, because they've got to get the coupon as close to the

537
01:01:46,000 --> 01:01:50,000
prevailing risk-adjusted interest rate as possible.

538
01:01:50,000 --> 01:01:59,000
But there were, you know, what day everything happens on the bond payments, how many times a year the coupon is paid.

539
01:01:59,000 --> 01:02:02,000
Normally, they're paid twice a year.

540
01:02:02,000 --> 01:02:09,000
So that $80,000 they did over there, that would actually be two $40,000 payments each year on it.

541
01:02:09,000 --> 01:02:10,000
Yeah?

542
01:02:10,000 --> 01:02:14,000
Are they the same with stocks where IDs buy them and then sell them?

543
01:02:14,000 --> 01:02:16,000
Well, that's exactly the same thing.

544
01:02:16,000 --> 01:02:24,000
Except with bonds, they are easier to place, because you've got all these ginormous corporations,

545
01:02:24,000 --> 01:02:28,000
especially like life insurance companies and trust funds.

546
01:02:28,000 --> 01:02:30,000
They love bonds.

547
01:02:30,000 --> 01:02:32,000
They're easy to dump.

548
01:02:32,000 --> 01:02:35,000
So it would be like a whole other kind of investment company?

549
01:02:35,000 --> 01:02:38,000
Well, yeah, but not necessarily.

550
01:02:38,000 --> 01:02:40,000
I mean, they're done by all kinds.

551
01:02:40,000 --> 01:02:49,000
I mean, there are even places I can't exactly describe that participate in these syndications.

552
01:02:49,000 --> 01:02:52,000
These are syndicated like stocks are.

553
01:02:52,000 --> 01:02:59,000
But the bonds, the covenants, now a couple of covenants that are important.

554
01:02:59,000 --> 01:03:03,000
One is the bond trustee.

555
01:03:03,000 --> 01:03:17,000
This is a company or maybe an individual that oversees the bondholders' interests over the company.

556
01:03:17,000 --> 01:03:20,000
So, for example, you might run a company.

557
01:03:20,000 --> 01:03:23,000
You've borrowed $100 million.

558
01:03:23,000 --> 01:03:28,000
And you've got this brilliant idea, well, we're going to take on this really risky new project,

559
01:03:28,000 --> 01:03:31,000
new technology and all of that.

560
01:03:31,000 --> 01:03:33,000
And I'm the bond trustee.

561
01:03:33,000 --> 01:03:35,000
I'm going to say, no, you're not.

562
01:03:35,000 --> 01:03:37,000
Well, why not?

563
01:03:37,000 --> 01:03:39,000
Because you're not.

564
01:03:39,000 --> 01:03:40,000
I have the say so.

565
01:03:40,000 --> 01:03:42,000
Why don't I want that?

566
01:03:42,000 --> 01:03:50,000
Because you see, that would be great for your stockholders, because your stock could, could go way up in price.

567
01:03:50,000 --> 01:03:59,000
But if it turns out to be a dog, you won't have enough money to pay the interest payments I represent for the people I represent.

568
01:03:59,000 --> 01:04:06,000
They, I'm not going to let you do things that would take your EBIT below your interest expense.

569
01:04:06,000 --> 01:04:08,000
I'm not going to let you do that.

570
01:04:08,000 --> 01:04:10,000
But I want to.

571
01:04:10,000 --> 01:04:12,000
So, tough darts.

572
01:04:12,000 --> 01:04:13,000
You're not.

573
01:04:13,000 --> 01:04:27,000
I'm going to make sure that you behave in a way that protects EBIT so that it can't dip too low to pay my interest payments, to get those interest payments to me.

574
01:04:27,000 --> 01:04:30,000
Remember EBIT over, at times, intersterned and all that.

575
01:04:30,000 --> 01:04:34,000
I want to make sure that has plenty of distance above one.

576
01:04:34,000 --> 01:04:42,000
And if you start playing with your revenue, boing, boing, boing, boing, boing, boing, well, yeah, maybe they'll go boing, or maybe they'll go pfft, like that.

577
01:04:42,000 --> 01:04:46,000
I don't want that, because all I want is my damn fixed payment from you.

578
01:04:46,000 --> 01:04:48,000
You understand that?

579
01:04:48,000 --> 01:04:53,000
And I'm also going to, that bond trustee is also going to talk dividends.

580
01:04:53,000 --> 01:04:58,000
Well, yeah, you want to do a special dividend this year to make your shareholder happy.

581
01:04:58,000 --> 01:05:09,000
No, I don't want you to do that, you see, because I want that in retained earnings, because next year might not be a great year, and I want to make sure you have enough pad in your retained earnings to pay me what I want.

582
01:05:09,000 --> 01:05:11,000
To pay me what I am owed.

583
01:05:11,000 --> 01:05:14,000
So they will have a say.

584
01:05:14,000 --> 01:05:18,000
It depends on how powerful the agreement is.

585
01:05:18,000 --> 01:05:26,000
But behind the scenes, when you see companies doing things, a lot of times, there's a bond trustee in there.

586
01:05:26,000 --> 01:05:35,000
That's one of the reasons that some companies don't want to have debt, is because they don't want the shackles that that would put on them.

587
01:05:35,000 --> 01:05:41,000
Because they might be high tech, everything we do is risky, and we've got to get in front of the curve.

588
01:05:41,000 --> 01:05:47,000
That might be something they do, and the bond trustee is going to say, it might be right for somebody, for you.

589
01:05:47,000 --> 01:05:51,000
Because you've got us all behind you, and we're going to smack your ass if you do that.

590
01:05:51,000 --> 01:05:56,000
You see, that's one of the things that kind of is a driving background force in companies.

591
01:05:56,000 --> 01:06:01,000
Well, why don't these companies do more?

592
01:06:01,000 --> 01:06:09,000
Well, it might be that their bond trustee is an old three-piece suit guy who's a bitch.

593
01:06:09,000 --> 01:06:12,000
He doesn't want you to do that.

594
01:06:12,000 --> 01:06:20,000
So that's an important thing to think about in the background of corporate governance and decision making,

595
01:06:20,000 --> 01:06:29,000
is that it might not be in the interest of the bond trustee, the bond holders, and their trustee won't let a company do things.

596
01:06:29,000 --> 01:06:33,000
Or why doesn't this company use more debt in its capital structure?

597
01:06:33,000 --> 01:06:41,000
Well, it might be because they don't want that chain around their neck on what they are going to do.

598
01:06:41,000 --> 01:06:43,000
That's the bond indenture agreement.

599
01:06:43,000 --> 01:06:48,000
But I mean, the thing is big. It's a contract. It's a contract, and it's got a lot to it.

600
01:06:48,000 --> 01:06:51,000
And it's a negotiation.

601
01:06:51,000 --> 01:06:53,000
Okay, you want to borrow this much, okay?

602
01:06:53,000 --> 01:06:56,000
We're going to have...we'll work on this.

603
01:06:56,000 --> 01:07:00,000
There will be fees involved, a flotation cost, as it were.

604
01:07:00,000 --> 01:07:08,000
There will be a negotiation about that interest rate, that coupon, that will be on the bond.

605
01:07:08,000 --> 01:07:11,000
Now, we get down to the meat of it.

606
01:07:11,000 --> 01:07:14,000
And this is just a basic outline.

607
01:07:14,000 --> 01:07:18,000
Some terminology.

608
01:07:18,000 --> 01:07:21,000
The face value.

609
01:07:21,000 --> 01:07:31,000
Now, for our purposes, we will use $1,000 as the face.

610
01:07:31,000 --> 01:07:39,000
Well, $10 million, well, that would just mean that you issue $10 million in $1,000 increments.

611
01:07:39,000 --> 01:07:46,000
It scales it down so that we don't have to use giant numbers on our calculators, as it were.

612
01:07:46,000 --> 01:07:54,000
However, interestingly enough, the price of the bond will float above and below.

613
01:07:54,000 --> 01:08:00,000
That's based upon the difference between the coupon rate and what the prevailing market conditions are.

614
01:08:00,000 --> 01:08:10,000
If investors...if interest rates start going up, and the coupon is going to be pretty much fixed for a lot of bonds,

615
01:08:10,000 --> 01:08:23,000
then the price might fall to, let's say, $990.

616
01:08:23,000 --> 01:08:30,000
Because the coupon isn't paying enough under the current economic conditions.

617
01:08:30,000 --> 01:08:36,000
In that case, we would say that the bond is selling at a discount to par.

618
01:08:36,000 --> 01:08:39,000
Par is the thousand.

619
01:08:39,000 --> 01:08:41,000
I've got to say something about that here in a minute.

620
01:08:41,000 --> 01:08:49,000
But suppose that the coupon's 8% and prevailing interest rates for risk-adjusted instruments like that goes to 7%.

621
01:08:49,000 --> 01:08:53,000
Well, everyone's going to want that bond because it's paying more than it should.

622
01:08:53,000 --> 01:09:01,000
In a case like that, the bond might go up to, let's say, $1,008.

623
01:09:01,000 --> 01:09:05,000
Because it's paying more than it needs to, but it can't change that.

624
01:09:05,000 --> 01:09:11,000
So in that case, we would say that the bond is selling at a premium to par.

625
01:09:11,000 --> 01:09:15,000
If it sells above face, it's a premium.

626
01:09:15,000 --> 01:09:17,000
Below face, it's a discount.

627
01:09:17,000 --> 01:09:20,000
And you'll see the machinery behind that.

628
01:09:20,000 --> 01:09:23,000
Not this time, but just know that much about it.

629
01:09:23,000 --> 01:09:26,000
One more thing.

630
01:09:26,000 --> 01:09:30,000
You will not see $990.

631
01:09:30,000 --> 01:09:34,000
You will not see $1,008.

632
01:09:34,000 --> 01:09:38,000
Because bonds are quoted on the hundred.

633
01:09:38,000 --> 01:09:45,000
So this one would actually, if you looked at a financial news, a ticker,

634
01:09:45,000 --> 01:09:51,000
or you called your broker, that broker would say,

635
01:09:51,000 --> 01:09:55,000
it's quoting at $108.

636
01:09:55,000 --> 01:09:58,000
Or it's quoting at $99.

637
01:09:58,000 --> 01:10:02,000
The quote is one-tenth of the price.

638
01:10:02,000 --> 01:10:09,000
Historically, long, long ago,

639
01:10:09,000 --> 01:10:16,000
the reason behind it was that the broad sheets that were printed every morning

640
01:10:16,000 --> 01:10:22,000
before the markets opened in the 19th century, early 20th century,

641
01:10:22,000 --> 01:10:26,000
they had to put all of this information in these thin little columns.

642
01:10:26,000 --> 01:10:28,000
Stock prices, bond prices.

643
01:10:28,000 --> 01:10:33,000
So it was just that they quoted, they put them on the hundred.

644
01:10:33,000 --> 01:10:36,000
Because it saved a little column space.

645
01:10:36,000 --> 01:10:41,000
Treasury bonds. Those are sold, they are sold by the government.

646
01:10:41,000 --> 01:10:47,000
When I say you sell a bond, a primary, that means you borrowed the money.

647
01:10:47,000 --> 01:10:49,000
So the treasury comes off.

648
01:10:49,000 --> 01:10:56,000
It sells a billion dollars worth of 30-year bonds.

649
01:10:56,000 --> 01:11:03,000
That means that it was borrowing a billion dollars.

650
01:11:03,000 --> 01:11:05,000
It was borrowing.

651
01:11:05,000 --> 01:11:06,000
That's the treasury.

652
01:11:06,000 --> 01:11:11,000
It borrows money hand over fist, especially any more.

653
01:11:11,000 --> 01:11:13,000
It borrows money.

654
01:11:13,000 --> 01:11:15,000
It borrows money for operations,

655
01:11:15,000 --> 01:11:20,000
and it borrows money to pay back previous borrowings.

656
01:11:20,000 --> 01:11:21,000
Okay?

657
01:11:21,000 --> 01:11:23,000
So that's treasury.

658
01:11:23,000 --> 01:11:26,000
Now, the treasury direct, they have bills, notes, bonds.

659
01:11:26,000 --> 01:11:27,000
I showed you that.

660
01:11:27,000 --> 01:11:29,000
That's what those were, bills, notes, bonds.

661
01:11:29,000 --> 01:11:36,000
But it also, agencies of the government have their own debt.

662
01:11:36,000 --> 01:11:39,000
There are agencies, like the Tennessee Valley Authority is one.

663
01:11:39,000 --> 01:11:49,000
There are many agencies that issue their own quasi-treasuries.

664
01:11:49,000 --> 01:11:56,000
And then there are municipals, munis, cities, states,

665
01:11:56,000 --> 01:12:01,000
and other sovereign entities will borrow money too.

666
01:12:01,000 --> 01:12:08,000
Like, for example, a school district might borrow $3 million

667
01:12:08,000 --> 01:12:12,000
to build a nice new high school.

668
01:12:12,000 --> 01:12:19,000
Now, in that case, I'll tell you a story later after the spring break

669
01:12:19,000 --> 01:12:22,000
about the Fed messing that market up terribly.

670
01:12:22,000 --> 01:12:26,000
But oftentimes those are like a revenue bond.

671
01:12:26,000 --> 01:12:28,000
Revenue bonds.

672
01:12:28,000 --> 01:12:33,000
Essentially, the authority says, look, we're going to raise taxes,

673
01:12:33,000 --> 01:12:37,000
and that extra tax that we raise from property taxes,

674
01:12:37,000 --> 01:12:39,000
that will pay the bonds.

675
01:12:39,000 --> 01:12:42,000
That will pay off that.

676
01:12:42,000 --> 01:12:46,000
Then there are corporate bonds, obviously, we'll talk a lot about.

677
01:12:46,000 --> 01:12:49,000
And then there are foreign bonds.

678
01:12:49,000 --> 01:12:53,000
Foreign bonds are denominated in another currency.

679
01:12:53,000 --> 01:12:57,000
Like, a company in the United States could borrow money in Europe,

680
01:12:57,000 --> 01:13:01,000
and it promises to pay the coupons in the face in Euros.

681
01:13:01,000 --> 01:13:05,000
Companies overseas issue foreign bonds here.

682
01:13:05,000 --> 01:13:11,000
They promise to pay it back in American dollars.

683
01:13:11,000 --> 01:13:15,000
There are even commodity bonds.

684
01:13:15,000 --> 01:13:19,000
There are famous stories about World War II, gold bonds.

685
01:13:19,000 --> 01:13:22,000
We issued bonds to fund the war,

686
01:13:22,000 --> 01:13:29,000
and we promised to pay back gold from Fort Knox.

687
01:13:29,000 --> 01:13:31,000
Enough.

688
01:13:31,000 --> 01:13:33,000
That's all I have for you today.

689
01:13:33,000 --> 01:13:45,000
Thank you.