Alan Cring Productions in association with Emergent Light Studio presents
the Illinois State Collegiate Compendium, academic lectures in business and economics.
This is Business Finance, FIL 190 for spring semester 2024.
Today, introduction to bonds. This will be the last lecture, hang on, this will be the last lecture before the midterm exam on Monday.
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,
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?
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.
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.
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.
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.
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.
That reduces the stress level to some extent. The note card, actually, I find is a great way for you to review the material
and consolidates your knowledge for the exam itself. And I will go into more details of the exam on Monday,
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.
So it will have that same layout as an exam, as a quiz would.
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.
Now, I will not be, for the midterm exam, I will not be asking anything that would require mathematical calculations,
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.
Now, this would be about the first half of that chapter seven in the book. So make sure that you have the terminology down,
because those are straight up obvious questions for multiple choice or fill in the blank or true and false on the midterm exam.
Why would we need to use Excel if there is no math on that?
No, no math about bonds. Let me be clear about that. No, no, just the bonds. I mean, the bonds, the math of bonds,
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,
I would go, I have to go into some details. I do that the class when we come back from the spring break.
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,
but a great deal of what you have for the questions would be that one Excel spreadsheet, present values and future values.
That would cover a lot of the territory for questions for the exam, for the midterm exam.
So rest easy on that. But while we are on the topic of finance, which is always the topic here,
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.
Chapter 6 and 7 kind of merge and different textbooks kind of put the topic order in different ways.
But before we get to all of that happiness, let's have a look at the unhappiness that is our market,
how the markets look this morning. And it's a bare day out there.
Huh? Those are red. That's bare. See, look at this. The Dow is, this is what's odd,
is that the Dow and the S&P 500, usually they go in order. But the last couple of markets, days, they haven't.
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.
And the way I would interpret this is that it looks like whatever is making the market grouchy is the kind of information
that impacts smaller cap companies more than it does large cap companies. As you can see, both these Dow and the S&P 500
are having something bothering them. It's making them a little bit negative, a little bearish.
But whatever it is seems to be really annoying the small cap stocks. What it is, kind of hard to say,
I mean, you know, the earnings reports are coming in at all over the place. And the Fed is being very quiet right now.
So whatever is bothering markets, it's not terrible. As you can see, these are not massively bearish numbers.
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.
Well, it's trying, it's playing around that upper level of that 72 to 79 band. You can see it bouncing up.
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.
This is the light sweet Brent. And from what I've picked up, there are a couple of factors going into it.
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.
There is some perception that the economy is in either late recovery or early expansion.
That would tend to indicate more trucks and cars on the road, delivering goods, if it's commercial, going places if it's private.
And that might be the factor that is pushing these prices of crude up a little bit right now.
That might be, so in other words, price of crude is going up, but it might be for a good reason.
There's some expectation that demand will be going up over the next couple of months for hydrocarbon products, the gasoline and the distillates.
So it's not all bad news. Gold is not really going much place. It's pretty volatile right now.
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.
But it's not a huge bearish day. It's only, what, 0.06 percent. It's just pennies right now.
And silver is also down. But coming over here to bonds, and this is a topic today.
Do remember, and this is important for the exam, price and yield are inversely related.
So when I see this chart, this is a yield chart, and it is negative.
The yields are going down. They're down two and a half basis points, about two and a half basis points right now.
That would mean that the prices are going up. That would mean that there is purchasing of bonds.
The balance of orders is on the buy side for bonds.
That might be the result of the bearish equities.
They're getting out of stocks and they're using some of the proceeds to push into bonds, pushing the prices up.
And that would bring the yields down. That would be the order that you would think about it.
Now I want you to make sure that you understand that chain of logic, because I will hit that on the midterm exam,
to make sure you understand that it's supply and demand issues that are underlying price movement,
which is driving yield movement.
Oh, mother's work is never done. I didn't even look at the overnight markets.
Oh, Nikkei, I mean that's nothing. It just was, it barely moved.
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,
that's no change really. That's trivial.
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.
Later when we get to London, something was upsetting the London exchange.
Through there, almost about through the midday, something was pushing it down and down. There was selling going on.
But then once that information had passed through the system, then it just pretty much floated for the rest of the day.
It's just a physics, Newtonian physics kind of thing. It has to have some force being applied to go somewhere.
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.
And finished off, well, they're still trading right now. It's not quite the end of the day there.
It's off about three quarters of a percent, which is a little bit noticeable.
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.
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.
Everyone's just in a kind of a grouchy mood apparently today.
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.
That comes about on yield curves. Now, you folks are all going to be taking finance courses.
You'll see this one again. It's a hidden feature of a yield curve.
And it has to do with something called forward rates.
Now when I look at these yields, by the way, notice something interesting. I talked about yield curves on Monday.
Notice how this yield curve was dropping from about the six months clear out to the 10 year.
That's 20 and 30. See, I was just dropping all through there and then at the 10 year,
at the 20 year from the 10 to the 20, it finally turned direction and started behaving the way it should.
So you had a yield curve a couple of days ago that was looking like that.
A long inversion, an unusual, almost unprecedentedly long inversion of the yield curve.
That's what that right there would be showing you. See how once it was rising a little bit,
and then it just started falling, falling, falling until it finally got to the out, 20 year.
And never mind, 30 year is always weird. There's something about that that's never normal.
So don't worry about that. Okay, that's good.
However, something special has happened yesterday.
This is the finish line from the last time. See how it's dropping just like it was?
But look. Do you see it? But look right here.
It's actually pulling up hard now. It's trying to do a recovery on the back end of the yield curve.
In other words, it's beginning to show turbulence right in here.
That's a good sign. That probably means that if that turbulence begins to stabilize into a rise,
which we kind of hope it will, see how it brought back up and then it dropped again?
That is an indication that it's beginning to find its ground again.
And this turn upward should begin to infect the shorter rates.
We don't know that yet, but it looks like that's what's happening,
is that it's finally beginning to show signs of wanting to be normal.
And I remember in the past when you had a multi-period inversion,
it was always the back end that began to recover.
And that was like a wave that started to come that way and lift the whole thing up.
This is just from my professional experience.
I've seen it before, not with one this long on an inversion, but that would be a good sign,
that it is de-inverting, for lack of a better term.
And it's happening on the back end, and that wave is going to begin to lift.
As this begins to recover, that will begin to cause the whole yield curve to start to behave like it should,
like we want it to. Don't know yet. We just have to watch it for a while.
But this is an important marker for us as finance professionals.
Yield curves are one of those things that we look at every day.
You go up to the mirror every morning and you look at it and you check yourself out.
Yep. Well, this is one of those things in finance that we do too.
You check your eyes to make sure they're still in your head.
You make sure there are no horns and all that kind of stuff.
These are the things that we check on our person.
And in finance, we look at yield curves. We keep an eye on them.
Just as part of being a professional, what we look at is not what a typical normal person would look at.
But now, let me go on to something else.
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.
And this has to do with what are called forward rates.
You see, we calculate these yields by a classic formula that is actually something that you've seen before.
This rate, let me get back up here and see if I can find...
I wish they would show the numbers 1, 2. 1, 2, 3.
Let me do...let's suppose that this is actually a normal yield curve. 1 year, 2 year, 4.20, 4.3.
Well, let me do 4.26. And a 3 year would be, let's say, 4.34.
Those are the yields. Those are the percentages.
Now, we calculate these yields as simply...they are the price of it.
So this price of, for example, the 1 year would give us a yield mathematically of 4.2%.
So, 1 plus some yield x, and in this case, to the first power, minus 1, would be 1.0420.
Now, that one power is actually 1 over 1 year.
Remember that 1 over the number of years?
The second one would be 1 plus x to the second power, to the 1 over 2, minus 1, would equal 1.0426.
And the third year would be 1 plus 1 over x to the one-third power, minus 1, equals 1.0434.
They'd be straight up geometric averages, for lack of a better term.
Now, this one is easy to solve.
They don't have enough board here for me to do this.
I would do this, 1 plus x to the first power would be equal to 0.0420.
Now, when you're saying, why are you doing this?
1 plus x equals...
1 point...sorry.
Whoops, I said minus 1, I apologize for that.
That's not correct, that's just 0.
Okay, 1 plus x...so x equals 0.0420.
That's how we calculate that 1 year.
Now, don't worry if this isn't ringing a bell or anything.
You'll see what I'm after here in a minute.
Now, the second one would be 1 plus x to the one-half equals 1.0426.
So, 1 plus x equals 1.0426 to the second power.
This is just pissing me off the way they've got these boards laid out here.
Dumbasses.
Okay, let me write this again.
Essentially, for a 1 year, x is going to be equal to 0.0420.
For a 2 year, the x is going to be...
and I can't do it exactly.
I know that 1 plus x is going to be 1.0426 to the second power.
So, I could keep going with this.
For the 3 year, 1 plus x is going to be 1.0423...what did I say?
0.0434 to the third power.
Now, taking that aside, making it simple for just a minute.
The 1 year is unquestionably 4.20%.
But the 2 year is actually not...
well, it is if you take just the second power, you get 1 plus x.
But, something else is going on.
Because actually, that 2 year is 1 plus the 1 year...
1 plus the 1 year, 0.0420, times a 1 plus r of a second year.
There are actually 2 interest rates working.
There is the 1 that will be for the year that's preceded.
We know what that 1 is. It's 4.20%.
But the second rate would be the 1 that is going from year 1 to year 2.
It's a composite of 2 effects.
This is called the Fisher effect, kind of loosely.
So this second one right here is called a forward rate.
The 3 year would actually be the 1 year...
times whatever that second year forward rate is, times...
So this one is year 1.
This is the 1 from year 1 to year 2.
This is the year 1 to year 2 to year 3.
You can chain these together to get what's called a forward rate yield curve.
Which looks kind of different.
But we'll see what happens when in practice.
First we have to get this guy solved up.
Because we know that...
playing around going to another board again here...
Let me get this all off here, but not get rid of my rates.
That 1 plus.0420 times 1 plus the 1 to 2 year forward rate...
would be 1.0426 to the second power.
In other words, this second year, the second year rate that you see...
is actually a composite of the year 1 rate and the year 1 to 2 rate.
So ultimately what we can do here is we can say that 1 plus the 1 to 2 year rate...
is 1.0426 to the second power divided by 1.0420.
And that will give us the forward rate for the second year.
Don't worry about all this other stuff.
Just know the mechanics of how I do this over here.
I'm going to chain together and watch what happens.
And this is what's interesting about it.
This is where it gets a little bit interesting anyway.
I'm going to take 1.0426 squared...
divided by 1.0420.
And then I want minus 1.
4.33.
So the 1 to 2 year forward rate is 1....
well, is.0433 or 4.33%.
So in order to get a 2 year composite rate of 4.26%,
you would have to chain a 4.20% for the first year with a 4.33% for the second year.
In other words, the forward rate is a little bit higher than the 1 year rate.
Notice that this forward rate is bigger than the composite,
because the composite was 4.20...
what would happen if you took 4.26 for 2 years.
But if you say, well, we start the first year with a 4.20,
and then the next year it's a 4.33,
yeah, that creates a composite for the 2 years overall of 4.26.
It's almost just an average.
This 4.33 plus 4.20, the average of them is a little less.
This is a geometric, but it's a geometric...
this is a geometric average.
Now, the next thing we can do is we can say this.
Okay, so 1.0420 for the first year times 1.0433 for the second year
times the 2 to 3 year forward rate will be 1.0434.
You see, you built them.
I knew the 1 year right off the bat. It's right there.
I then get the forward 1 to 2,
and then put that together with the forward 2 to 3,
and I can tease out what's going to actually be happening,
or at least what the market thinks will be the rate through year 3,
from year 2 to year 3.
And that would... I'm sorry, that would be to the third power.
And walking it through that...
1.0434 to the third power...
Now, watch me screw this up.
Divided by open parenthesis...
1... wait, that's a comma.
Divided by open... that's right, you can't do it.
I have to use the calculator.
Open parenthesis...
1.0420 times 1.0433.
Close the parenthesis, and then minus 1...
4.49%, if I did that calculation right.
So R3, the 2 to 3 year forward rate, is 4.49%.
The yield curve that you see is 4.2, 4.26, 4.34.
The forward yield curve is 4.20, 4.33, 4.49.
Because these are each year's projected,
as far as the market is concerned.
These are what the market is seeing each year's forward rate, interest rate as.
And the yield curve, if the yield curve is upward sloping,
the one you see is upward sloping,
then the forward yield curve will be steeper.
That's ideally the one we want to look at, but we don't.
Because if it's upward sloping, when we look at the normal one,
we know that the forward yield curve will be upward sloping too,
just at a more accelerated rate.
However, notice that it's a little more than that though.
The forward yield curve is obviously rising at a maturity premium and all that.
But if I look at that one that I did there, that's a little more disturbing.
That one is actually, they're in year two to year three.
That thing is kicked up.
The markets are anticipating, they're whispering,
that they expect that in year three, during year three,
interest rates will have made it up to 4.5%.
It's not too terrible, but it does show that there is an expectation
of a higher interest rate than we might have expected
just looking at the yield curve itself.
Now, let me do this one right here.
I want to show you what a downward sloping yield curve looks like,
what it does to forward rates.
5.03, 4.70, 4.50.
And I'll do this quickly enough so that I won't fatigue you with it.
I've got other things to do.
But I do want to show you what an inverted yield curve says.
Okay, we've got, what are the numbers?
They were 5.03, 4.70, 4.50.
5.03, 4.70, and 4.50.
So, the one year is right there.
That's where we stand right now.
So, the next one would be, we would say, 1.053,
yeah, 0503 times 1 plus the one to two year forward rate
should be 1 plus 0.0470 to the second power.
Here too.
So, if I tease that out and beat it up a little bit,
I would have, calling up, let me clear this so that I've got a clean field.
I would say 1.0470 squared divided by 1.0503 minus 1, 4.37.
And then the year three should be 1.0503 times 1.0437
times 1 plus the forward rate for year three.
That should be 1.0450 to the third power.
So, the third year forward rate would be 1.0450 to the third power over 1.040530, 0503, times 1.0437.
So, let's see what the third year forward rate is.
So, we're going to do 1.0450 cubed to the third power divided by 1.0533.
0530, 0503 I should say, 03 times 1.0437.
Close the parenthesis, minus 1, 4.10.
What does this mean?
This is actually why an inverted yield curve is a warning sign of a recession.
It's because business activity is drying up year by year.
And in year two, there will not be as much demand for the capital
because businesses aren't trying to reinvest or not trying to grow their companies.
So, you're losing, the demand for capital is going down.
And in year three, the demand for capital is going down even further as the recession continues.
And as long as the yield curve is dropping, that would say that demand for capital in that year,
year three, year four, year five, as long as the inversion continues,
you're seeing the demand for capital falling backward.
And that is just simply why, what a recession does.
Business activity goes down, consumer purchasing goes down, and so the demand for capital goes down.
And so, interest rates go down because the demand for money is going down.
That's why when it turns back up, that's when the forward rates begin to recover.
If the yield curve itself starts turning back up, you'll see the forward rate starts to turn back up as well.
And that is the indication of the demand for capital beginning to surge again.
Now, in this case, that's what's really creepy about this long, long inversion we see now.
This is whispering that the markets seemed to be thinking that this demand for capital was going to fall
in years one, two, three, five, seven, and ten.
In other words, almost like a depression that would be.
As a matter of fact, the last time we saw a long inversion of a yield curve was the Great Depression.
And therefore, this forward rate, I mean, that's scary when you see that because the markets were thinking,
and still are to some extent, that there is going to be a long-term back down fall in the demand for capital.
For what it's worth.
Now, I'm not going to ask you this on a quiz or an exam to calculate forward rates.
You've got a couple of pretty much easy questions.
All you ever have to do to remember is you calculate the year two forward rate,
and then you chain those together and you make that equal to the yield curves rate to the second power for the second year.
And then once you've got that one, you can chain together the two that you've got to get the third one,
one plus R3, by setting it equal to what the yield curve is saying and raise that to the third power.
One thing about this though is that notice that treasuries aren't every year.
One, there's one year treasuries, two year treasuries, three year, but then it jumps to five, seven, ten, twenty, and thirty.
So you can't really do this.
I mean, you can do something, but it's a pain in the ass to do it.
So this is really only a very useful exercise for the forward rates for years two and three.
After that, there are gaps.
So you could get a forward rate that would be for the two years from year four to year,
for year three to year four to year five.
But you can't get exact annual forward rates by this method.
So it's useful really realistically only for the first forward rates.
So the one year is the annualized rate and it is the forward rate.
The two year is an annualized rate from which you can get the forward rate.
The third year is an annualized rate from which you can get the year three.
Now in a way, it would be better to show this subject later in the course after bonds.
You're going to see why in a while.
But the reality of it is that this is not how markets work.
Markets work on prices.
They don't directly calculate yields.
Yields are the consequence of the prices, buying and selling of stocks, buying and selling of bonds.
You don't see a quote that says the capital gain for this stock for today is,
or the yield on this bond, well for some of them.
You see prices.
You buy and sell on prices.
But the prices behind the scene drive holding period returns, capital gains, dividend yields and all of that.
It's behind the scenes that that happens.
So now let me get all this nonsense off the board and get to something that's a lot more tangible.
The subject of bonds.
Now bonds are hugely important in finance.
In fact, I probably have mentioned this before, but I could ask you about it.
The bond market is ten times the size of the stock market.
It's ten times the size.
And yet all of the talking heads on TV shows and blogs and all the newsletters,
all they talk about are stocks.
Yeah?
Is it because other countries also buy bonds so it's more international?
No.
It's because bonds are not interesting.
They are boring.
If you watch, you're standing on an overpass of a highway.
You see the cars.
But cars, wouldn't you pay attention more if you saw a major accident?
Smash, tinkle.
Bonds are boring.
Their prices do not fluctuate anywhere near the way stock prices do.
There's a reason for that.
But the reason the talking heads pay so much attention to bonds is that they are boring.
And you cannot make a fortune overnight.
You will not have a day trader, boy, I really put it into bonds today, my God, and I made a fortune off.
It'll never happen.
Well, once in a, was it a blue boob, maybe.
But for the most part, they don't go very far from one day to the next.
And there are two reasons for that.
One is that bonds are lower risk, therefore lower volatility.
Why are they lower risk?
Yeah?
You said that the same risk, because if a corporation was to fail, the only thing that they had was the order of liquidation.
Well, if we're talking about a bankruptcy, we're just talking about a normal company.
Bonds have the prior claim.
The company must pay its bonds, what is due to the bondholders, always before the stockholders can get a penny,
either through dividends or through reinvestment in the company.
Whatever is left over is what the stockholders get, and that is volatile.
In fact, that is the reason that corporations, for their own funds, have rules against investing in stocks a lot of times.
You can't do that.
Because stockholders can lose their shirts.
The stock price might not go up.
They might cut off the dividend.
The company may go bankrupt.
In any of those cases, the stock loses.
The bondholders, the worst that can happen to a bond is that they will have to force the company into liquidation
and get whatever they can out of the ashes.
But in a normal course of business, the bondholders must be paid their coupon payments, their interest.
They must also be paid a balance, the payoff of the bond, before stockholders can do anything.
So if I have my debts in my own company, I am the shareholder.
I can't have dinner tonight off the company's revenue until I have paid the bills for the month.
The liabilities have to come first.
Now, I can play a few games with putting off accounts payable and all that.
That's just cash management.
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.
It's over.
The company is gone.
They go right to court and they turn my company into liquid assets that they divvy up among themselves.
That's the problem with bonds is that they're great.
It's other people's money.
As long as you recognize that they get their candy before anyone else gets its candy.
That's just the way it works.
The bondholders have the prior claim to the cash flows of the corporation.
But there's another reason that bonds are less volatile than stocks, that they are safer than stocks.
Bonds have an anchor.
Somewhere down the line, you pay off a bond.
There is a dollar amount.
There is no somewhere down the line where your stock ends up.
It could end up at zero or it could end up at a billion dollars.
There is no predictability in a certain way, in a very real sense.
I don't know what a stock is going to do.
I know damn well what a bond is going to do.
It's going to pay me a thousand dollars at the time of maturity.
Can't you just do a buy back and buy it all back?
We'll talk about those.
That's fine.
But the reality, just the basic theoretical framework, is that there's an anchor.
No matter what else happens to a company, me as a bondholder, I get paid off.
As long as the company isn't dead, I get paid off at the end.
And what you're talking about, that's only with convertibles or with another kind of bond.
You can put them back to where they want to sell them.
You can do that, but you cannot do it if the bond covenants don't allow you to.
That's the important thing.
I'll get to that in just a minute here.
But the first thing first is that there are many different kinds of bonds.
And although they have characteristics in common, they can be all over the place.
The first thing first though is that when I use the word bond, I'm using generically.
Remember, a bill is a debt that is due in less than a year.
A note is a debt that is due in one, two, seven, ten, fifteen years.
Who knows?
And then a bond is due in a longer period of time.
Now that note thing is subject to some disagreement among professionals right now.
Netflix issued 15-year, and I would have called those notes, but the financial media were calling them...
No, I would have called those bonds, but the financial media was referring to them as notes.
But then I saw another that was 15 years, and the financial media was referring to those as bonds.
So when I use the term bond, I'm being very generic.
Any debt instrument is a bond.
Now there are all kinds of ways you can divide up bonds.
But generally speaking, it's important to know the difference between a private debt instrument and a corporate or a government debt instrument.
When you take out...you decided that you were going to buy a car.
Payments, we did the calculation of the payments.
Now here's the problem with that.
Well, for you, your payment...you calculate a payment.
That payment includes an interest that you'll pay on what you still owe and some that will pay down the balance you owe.
It services the debt, the interest, and it amortizes the principal.
So they do both.
Corporate and government debt does not work that way.
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.
There is no amortization of the principal for most of these instruments.
All they do is pay interest.
In other words, the payment services the bond.
And then at the end, what you borrowed is all paid back.
And I'll get into that. It's a little more detailed than that.
But there...so in other words, if a company, a corporation borrows $50 million at 8%...
Well, let's make it easy.
...Borrow $10 million at 8% and let's say it's 20 years.
It gets the $10 million right now.
For 20 years, it must pay...
$800,000. Years 1 through 20...
No, it will be $800,000.
I can do percentages in my head.
And then at the end, it makes one last payment of $800,000 and then it pays off the $10 million.
At the end, it just pays.
So there's one last check at year 20 for $800,000 and at year 20, the company pays back the $10 million.
Now in reality, the bondholders are not going to rely on it.
Oh, I hope they have that $10 million.
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.
That's called a sinking fund.
There are variations on it.
One variation that's rather normal, well, not that normal, but it's there, is when you...
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.
That's one way.
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.
The other way is...
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.
That's another way.
And there are a couple of other odd tricks that I've seen lately.
But let's go back here.
Now, government bonds work the same way.
And there is a twist.
Normally, this is for only very short-term debt instruments.
However, it can be for longer term, too.
It's where the bond you actually buy, sell the bond, a company says, we need money.
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.
That's called a deep discount bond.
This is the way short-term works almost always.
There isn't really an interest.
It's just a discount.
Commercial paperwork works that way.
A company says, we want to borrow money for 30 days.
We'll pay back $1 million and then the price will be like $998,000 or something like that.
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.
Those are called discount bonds.
There was a wild and it's still out there once in a great while.
There was a wild version on this.
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.
They did an arrangement just like I described, what's the seven years out or 10 years out.
It was a disaster and it was because of Federal Reserve.
At the time, the chairman had an extraordinary spite for how awesome the market was behaving, but I'll get into that later.
Let me get into some of the things.
First things first.
Every bond sets up and let's say that it's an investment banker.
Now, I go to the investment bank and I say, I should like to borrow $100 million.
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.
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.
But there will be a negotiation that goes on.
It ultimately resolves in what's called the bond indenture agreement.
I had been teaching this for years, decades before I actually ever saw the real deal.
I was going to New York to visit a friend of mine who had been in the business for just a long, long time.
He was working with an investment.
He worked for an investment banking firm.
He wasn't a principal.
But I said, Marty, I've got a favor.
Can you show me an actual bond indenture agreement?
He said, yeah, I'll show you one.
When I got there, he had a thick binder.
And I thought, well, he handed it to me.
He said, you wanted a bond indenture agreement?
Here it is.
It's a contract between the lenders and the borrower.
And I won't tell you the name of the company, but you might even recognize it.
It was just, geez, it was a giant contract.
Now, the contract has all kinds of paragraphs.
We call these the covenants of the indenture agreement.
The who, who, where, for, why, what if, who farted.
Everything is in there.
The amount, the coupon, that's the interest rate.
And that's oftentimes settled very shortly before the issue happens, because they've got to get the coupon as close to the
prevailing risk-adjusted interest rate as possible.
But there were, you know, what day everything happens on the bond payments, how many times a year the coupon is paid.
Normally, they're paid twice a year.
So that $80,000 they did over there, that would actually be two $40,000 payments each year on it.
Yeah?
Are they the same with stocks where IDs buy them and then sell them?
Well, that's exactly the same thing.
Except with bonds, they are easier to place, because you've got all these ginormous corporations,
especially like life insurance companies and trust funds.
They love bonds.
They're easy to dump.
So it would be like a whole other kind of investment company?
Well, yeah, but not necessarily.
I mean, they're done by all kinds.
I mean, there are even places I can't exactly describe that participate in these syndications.
These are syndicated like stocks are.
But the bonds, the covenants, now a couple of covenants that are important.
One is the bond trustee.
This is a company or maybe an individual that oversees the bondholders' interests over the company.
So, for example, you might run a company.
You've borrowed $100 million.
And you've got this brilliant idea, well, we're going to take on this really risky new project,
new technology and all of that.
And I'm the bond trustee.
I'm going to say, no, you're not.
Well, why not?
Because you're not.
I have the say so.
Why don't I want that?
Because you see, that would be great for your stockholders, because your stock could, could go way up in price.
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.
They, I'm not going to let you do things that would take your EBIT below your interest expense.
I'm not going to let you do that.
But I want to.
So, tough darts.
You're not.
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.
Remember EBIT over, at times, intersterned and all that.
I want to make sure that has plenty of distance above one.
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.
I don't want that, because all I want is my damn fixed payment from you.
You understand that?
And I'm also going to, that bond trustee is also going to talk dividends.
Well, yeah, you want to do a special dividend this year to make your shareholder happy.
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.
To pay me what I am owed.
So they will have a say.
It depends on how powerful the agreement is.
But behind the scenes, when you see companies doing things, a lot of times, there's a bond trustee in there.
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.
Because they might be high tech, everything we do is risky, and we've got to get in front of the curve.
That might be something they do, and the bond trustee is going to say, it might be right for somebody, for you.
Because you've got us all behind you, and we're going to smack your ass if you do that.
You see, that's one of the things that kind of is a driving background force in companies.
Well, why don't these companies do more?
Well, it might be that their bond trustee is an old three-piece suit guy who's a bitch.
He doesn't want you to do that.
So that's an important thing to think about in the background of corporate governance and decision making,
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.
Or why doesn't this company use more debt in its capital structure?
Well, it might be because they don't want that chain around their neck on what they are going to do.
That's the bond indenture agreement.
But I mean, the thing is big. It's a contract. It's a contract, and it's got a lot to it.
And it's a negotiation.
Okay, you want to borrow this much, okay?
We're going to have...we'll work on this.
There will be fees involved, a flotation cost, as it were.
There will be a negotiation about that interest rate, that coupon, that will be on the bond.
Now, we get down to the meat of it.
And this is just a basic outline.
Some terminology.
The face value.
Now, for our purposes, we will use $1,000 as the face.
Well, $10 million, well, that would just mean that you issue $10 million in $1,000 increments.
It scales it down so that we don't have to use giant numbers on our calculators, as it were.
However, interestingly enough, the price of the bond will float above and below.
That's based upon the difference between the coupon rate and what the prevailing market conditions are.
If investors...if interest rates start going up, and the coupon is going to be pretty much fixed for a lot of bonds,
then the price might fall to, let's say, $990.
Because the coupon isn't paying enough under the current economic conditions.
In that case, we would say that the bond is selling at a discount to par.
Par is the thousand.
I've got to say something about that here in a minute.
But suppose that the coupon's 8% and prevailing interest rates for risk-adjusted instruments like that goes to 7%.
Well, everyone's going to want that bond because it's paying more than it should.
In a case like that, the bond might go up to, let's say, $1,008.
Because it's paying more than it needs to, but it can't change that.
So in that case, we would say that the bond is selling at a premium to par.
If it sells above face, it's a premium.
Below face, it's a discount.
And you'll see the machinery behind that.
Not this time, but just know that much about it.
One more thing.
You will not see $990.
You will not see $1,008.
Because bonds are quoted on the hundred.
So this one would actually, if you looked at a financial news, a ticker,
or you called your broker, that broker would say,
it's quoting at $108.
Or it's quoting at $99.
The quote is one-tenth of the price.
Historically, long, long ago,
the reason behind it was that the broad sheets that were printed every morning
before the markets opened in the 19th century, early 20th century,
they had to put all of this information in these thin little columns.
Stock prices, bond prices.
So it was just that they quoted, they put them on the hundred.
Because it saved a little column space.
Treasury bonds. Those are sold, they are sold by the government.
When I say you sell a bond, a primary, that means you borrowed the money.
So the treasury comes off.
It sells a billion dollars worth of 30-year bonds.
That means that it was borrowing a billion dollars.
It was borrowing.
That's the treasury.
It borrows money hand over fist, especially any more.
It borrows money.
It borrows money for operations,
and it borrows money to pay back previous borrowings.
Okay?
So that's treasury.
Now, the treasury direct, they have bills, notes, bonds.
I showed you that.
That's what those were, bills, notes, bonds.
But it also, agencies of the government have their own debt.
There are agencies, like the Tennessee Valley Authority is one.
There are many agencies that issue their own quasi-treasuries.
And then there are municipals, munis, cities, states,
and other sovereign entities will borrow money too.
Like, for example, a school district might borrow $3 million
to build a nice new high school.
Now, in that case, I'll tell you a story later after the spring break
about the Fed messing that market up terribly.
But oftentimes those are like a revenue bond.
Revenue bonds.
Essentially, the authority says, look, we're going to raise taxes,
and that extra tax that we raise from property taxes,
that will pay the bonds.
That will pay off that.
Then there are corporate bonds, obviously, we'll talk a lot about.
And then there are foreign bonds.
Foreign bonds are denominated in another currency.
Like, a company in the United States could borrow money in Europe,
and it promises to pay the coupons in the face in Euros.
Companies overseas issue foreign bonds here.
They promise to pay it back in American dollars.
There are even commodity bonds.
There are famous stories about World War II, gold bonds.
We issued bonds to fund the war,
and we promised to pay back gold from Fort Knox.
Enough.
That's all I have for you today.
Thank you.