Alan Cring Productions in association with the Emergent Light Studio presents
the Illinois State Collegiate Compendium, Academic Lectures in Business and Economics.
This is Business Finance, FIL 240 for spring semester 2024.
Today's introduction to bonds. Now the lecture today is fair game for the midterm exam.
We will be reviewing on Monday of next week and then the exam will be on Wednesday.
Now first of all what I do today is the general outline terminology, some concept behind bonds.
The mathematical stuff about bonds I will deal with after the spring break.
And the mathematical information, techniques and skills, they would not be on this midterm exam.
They're like the last half of chapter 7. So this will be the first half of chapter 7
that you will be responsible for for the midterm exam.
And again on Monday I will be spending the day doing the review.
Now the way the review will work is I will come in and I will tell you what I expect you to know for that exam.
Now obviously since I'm writing the exam I probably know a lot about what's going to be on it.
And I will go through step by step. Consider that your study guide.
You should be here and be getting your notes in order for the midterm exam.
And then after I finish telling you what I think you should know, I open it up for you to ask me questions about the midterm exam.
If you say well is this going to be on the exam and it's not, I'll say it's not going to be on the exam.
This helps also shape it. So this isn't just a watch the lecture kind of session on Monday.
Now as far as the exam goes you can start getting your prep done.
You will be allowed a 4x6 note card front and back.
And you might want to start prepping that, getting that together this weekend.
You'll have your formula sheet, the financial ratios formula sheet.
And also of course I do expect you to use Excel for the exam.
And it should be, if I'm not mistaken, only that present values and future values Excel spreadsheet would be what you would need for the test.
But we'll get into that a little more, a lot more on Monday.
So stay tuned for the fun of getting ready for the midterm exam, which is at regular class time.
I had someone ask me about that.
But as I said today I will be doing bonds.
I'm going to clean up a little piece of Chapter 6.
And if I ask you about this I don't think I will push this too hard.
And I'll try to lay off too much of the math and get you down to what you would need to do to accomplish finding a forward rate, as we call it, from a yield curve.
But we'll get to that in a little bit here.
But first we need to go to have a look at these very complicated markets.
As you can see it's technically a bare day, but it is volatile as heck.
If you look at those spark charts for the NASDAQ Dow 30 and Standard Portis 500, they've been down and up and down and up.
It's kind of odd.
There's information flowing both ways.
There's negative information which gets the bears all excited.
And then there is positive information which brings the bulls back.
You can look at the Standard Portis 500, great example there.
Markets started down in the toilet this morning at the opening bell.
And then the bears started, a bull started fighting back, got it almost up to where it had ended last night.
And then the bears came back through and now the bulls are charging again.
Right now the Dow 30 is down 0.11%, which is basically almost nothing.
And similarly the S&P 500 is down just a piece 5 one hundredths of a percent.
And even the NASDAQ it was down rather noticeably more than half a percent at one point.
But now it's been climbing back up too.
What this means, and from my perspective it doesn't, there's nothing that is so major as far as information goes that the market should be so spooked.
But I mean it's like every little thing that comes in today is causing a surge of bulls or bears.
Hard to say what it's all about.
But over here in the crude, now crude actually touched again up there at that 79.
Remember I told you that $72 to $79 is that trading range.
And there you have the crude oil prices.
They touched 79 again just a little bit through it and then they chickened out and they went back down again.
So we're down at $78.64 a barrel.
Now we're up at the upper end of it.
And that's of course somewhat negative news.
We get higher gasoline prices a little bit.
Nothing major.
But there's also a bright side to this too.
From what I have been hearing in the scuttlebutt is that the oil prices are going up a little bit.
It's not because of the conflict in the Middle East or anything like that.
It's because the economy is improving.
And when that happens you have more trucks and cars on the road.
Trucks delivering stuff, cars driving places, and that increases the demand for oil products.
Diesel for the commercial side, gasoline for the personal side.
So there you go.
It might be the case that this crude oil working its way upward, not majorly, but upward a little bit,
is actually a sign of the recovery.
We're in a strong recovery and we may be in the first phases of an actual expansion.
And so this is actually good news for those.
And gold is fortunately just sort of staying in place.
It dropped a lot.
And then when the stock market started getting spooked, it had a little bit of a spike,
but it's pretty much going nowhere right now, as is silver.
Working our way over here, here's the 10-year bond.
Yield is going down on the 10-year bond.
We're down seven basis points, no, I'm sorry, almost three basis points right now.
That yield is going down, so the price is going up.
That means prices are going up.
So putting it in more, starting at the beginning, we have buy.
Demand for bonds is increasing.
The buying causes the price to go up, which causes the yield to go down.
Now, you need to understand and make sure you've got that in your notes,
how the mechanism for what we are seeing, how it works.
Because I could ask you something about that on the midterm exam.
So make sure that you know that chain of events from the demand or demand side action,
what it does to the price, and what the inverse consequence is on the yield.
Make sure you have that down.
It's pretty much straightforward, and I usually do it as a multiple choice kind of question.
But anyway, moving over here to the other side of the world, Tokyo last night,
it finished almost right where it started.
There was no definitive place that it went because of some good or bad news.
London, on the other hand, you see how there was that drop until about the midday?
That would have been negative information coming in,
pushing down on the prices of the securities on the FTSE 100.
But you notice once that was gone, no more information.
You had to think pretty much just drift, just Newton's Law, one of Newton's Laws of Motion.
You had to have some force to make it do something.
If there is no force in markets, that's information,
then it would just sit there looking stupid and float along.
Looks like there was a little bit of a sell-off there at the very end.
But we came over here to the U.S.
and you can see that whatever was making the markets upset over in London
really was hard on the opening bell here in the United States.
See how it would just, right off the bat, it was down.
So there was negative news, but apparently it didn't really spook the markets completely
because they started to recover, and then it's just been a seesaw back and forth ever since then.
So there's the stuff about the markets right now.
And what I want to do, I want to cover one last piece.
Oops, I didn't mean to do that. I wanted to get to the...
I can't hold bookmarks here, so...
I wanted to show you the yield curve.
This lecture is about bonds.
And yield curves are nothing but maps of the governments, the treasuries, debt securities.
Bonds are debt securities.
And I put this up here, but I won't use the example of this yield curve
because as I said on Monday, the yield curves right now are really, really weird.
I think historically there might have been one situation where we had such a long-term decline
in version of a yield curve, and that would have been around the Great Depression.
So I won't use this one first for the little lesson I want to show you now.
But...
Now for God's sake, don't think too much about what I'm going to do.
Just follow the steps of the math of it, and I'll explain it as I go along.
But I'll show you with this.
Now if you look up here at the headers, and I wish they would let the headers come down with it.
We usually start talking about this with the one year.
These are very short-term debt instruments, cash management debt securities of the government.
They'll borrow money for a month to cover some bills.
They'll borrow money for two months, three months, four months, six months.
So that's kind of its own market, what we call a money market.
We begin this with the one year.
We'll talk about this.
Now here if you see right at the yields at the close yesterday.
For the one year, the yield, the return on a one year bond was 5.03%.
Now that's just that math calculation, ending price over beginning price divided by minus one to the first power.
So remember this little thing that I had given you.
End price over beginning price to the one over the number of years minus one.
That is a yield. That's a yield.
Now these are showing in percentages, yields.
Now notice that underneath the yield are prices, but we don't see those in yield curves.
We don't even, well we do a little bit talk about them with bonds in general.
So that 5.03 is simply saying the terminal price divided by what you paid to start it out to the one over one power, that equals 5.03.
This two year, so a one year would be end price over the beginning price to the one over one year minus one.
The two year would be the end price of a two year treasury security over its beginning price to the one over two years minus one.
And the three year would be the end price over the beginning price to the one over three minus one and on and on for the five year, seven year, ten year.
See there's kind of a little bit of a hidden story behind these though.
Let me see what...
What we're saying is that ultimately for the one year is in this case one plus point...
Well let me do this, let me do this, I don't want to use those yet. Let me say we have a normal yield curve.
One year, two year and three year.
Now the one year, let's say that the one year is 4.24%.
The two year is 4.28% and the three year is 4.34%.
Let me do that.
A normal yield curve, that's why I can't use those because they're declining.
I'll show you what that means in a minute here.
But let's take a normal yield curve because it'll look a little more sensible.
So we would have that the one year...
I just wrote that over there.
Now...
So how should I do this? I'm going to do this the fastest way so that you don't see all the complexities inside that would drive you crazy.
So one plus point 0.420 to the one over one minus one.
And that would give me the one year yield.
Now the thing though is that the two year would say that one plus point 0...
Did I do that? No, I said 2.4, I'm sorry.
4.24.
One plus 0.428 to the one over two years minus one.
Well that one equals 0.04.
You're saying, well duh.
But there's something going on here. Would be 0.0428.
Well there's kind of something going on underneath the surface there.
If I write it a little bit differently,
one plus 0.0428 to the one half equals one plus 0.0428.
Put another way, one plus 0.0428 is actually one plus 0.0428 squared.
Hidden in here, oops I didn't mean to do that.
Let me...actual rates.
The two year is actually one plus 0.0424 times one plus,
this is the one year rate, times one plus a two year rate.
You put those together, and that second year is called the forward.
You put those together and that's actually the 1.428 squared.
In other words, what we see is a composite yield, like an average.
The 4.28% is actually two rates, a one year and then the second year put together.
Now just follow the math of it.
I can say then, this is called a forward rate.
It's the one to two year forward rate.
I could say that one plus that second year forward rate is actually the composite two year rate that we see listed.
Squared over one plus, so the second year forward rate is just the composite rate,
1.0428, the one we see, squared divided by one plus 0.0424 minus one.
In other words, the two year rate is actually the one year one rate times the two year rate.
Put together, we see that two year rate that is listed in the tables.
Bear with me. I'll show you what I mean. Watch.
Let me pull this up here and show you.
If I do 1.0428 squared divided by 1.0424 minus one, I get the hidden rate, what we call the forward rate.
The forward rate comes out to be 4.32%.
So what's really happening is we're saying that one plus 0.0424 times one plus 0.0432 is why we actually see
1.0428, one plus 0.0428 to the second power.
It's actually a composite of the one year rate plus the two year forward rate. Watch.
If I did, there will be a little round here. 1.0424 times 1.0432.
Now if I take 1.0428 squared, I should get about the same number.
No, I don't. I did that wrong. Yeah, I do. See? They're the same number.
So in other words, when we see a yield on something like a two year, three year, five year, whatever,
it's actually the composite of a chain of one year rates that takes us out that far.
That's what happens when I take the square root of that. Square root.
Nope, I didn't want to do that. I take the second square root.
Why am I doing that wrong? Second square root. There we go.
Of the answer I got from before. Oh, I can't do that. Quit.
Oh, well, I can't do it because I just deleted what I had done there.
But the square root of that 1.08 whatever was 1.0428.
Now the next thing that I can do here, and I'm going to write a formula for this.
For the three year rate, I would know that one plus the first year's rate, 0.0424,
times one plus the forward rate, 0.0432, times the forward rate on the third year,
should be the same as the composite 1 plus 0.0434 to the third power.
So in other words, for a two year rate, for the two year, you would want to do
one plus the two year rate squared over one plus the one year rate.
For the three year, you would want to do one plus the three year rate
to the third power over one plus the one year, times one plus the two year forward.
This is what I'm going to do here.
One plus the forward rate for three years would be one plus 0.0434 to the third power,
divided by one plus 0.0424, times one plus what you had gotten in the second step, 3.2.
And that should give you one plus the three year forward rate.
And if I do that, I would take 1.0434, 1.04304, 3.4, to the third power,
divided by, and then I pull this off, I open parentheses for the whole thing,
1.0424, 1.0424, times 1.0432, 1.0432.
Close the parentheses and subtract that one off.
So the three year forward rate, the rate from year two to year three, is 4.47%.
So, if we look instead of at composite rates, we look at forward rates,
the one year is the one year.
The two year, the interest rate for year one to year two is 4.32.
And the three year is 4.46, 4.47.
These are the forward rates.
They are not the same as what you see up there.
They are year by year, each year, year by year, what the rates would have to be
to create the composite rate that is the overall ending price divided by beginning price.
It's hidden, it's a hidden part of the data, but it tells us what we are actually seeing.
Let me do really quickly the two year forward rate from the table
and show you what it would look like using the formula.
And I'm also going to create an Excel sheet just for forward rates for use,
in case you're kind of panicking.
So, for the two year, what I would have to do is I would take the second year
of second year composite rate, clear this out,
take the second year composite rate and square it.
That's what you would do for the two year.
I'll take 1 plus.0470, so that's 1.0470.
And I would square that.
And then I would divide it by the one year rate, 1.0503.
And then I would subtract 1.
Now I'm finding the two year forward rate.
What did I do wrong there?
Oh, minus 1, I forgot to put the 1.
Okay.
So it's 4.37%.
So what this is saying is that for the coming year, year one,
we have the forward rate is the yield rate, 5.03.
But in year one to two, the forward rate is, we would say,
the market thinks it's going to be 4.37%.
So in other words, the forward rate here is less than the composite two year rate of 4.70%.
I could even do one more here.
I could take the three year, 1.0450 to the third power,
divided by the one year, 1.0503 times the two year forward rate,
which we found was 4.37, so that would be 1.0437.
Close the parenthesis, minus the 1, so the three year rate is only 4.10%.
So in other words, the market actually thinks that for the coming year,
the yield on a one year T-bell is going to be 5.03%.
But in year two, the interest rate is going to fall to 4.37%.
And in the third year, year two to three, the actual interest rate for just that year is going to be 4.1%.
That's what this is telling us.
Finding the forward rates tells us not what the overall picture will be.
It's telling us what the picture of the interest rate will be in each of those years.
That's where it's useful to us, because that's what we would really want to do if we're planning ahead.
Well, next year we're going to do this project.
You wouldn't look at the 4.70% as your base for starting your calculations.
You would work with the 4.37% as your base.
If you're going to do this project and borrow the money in the second year.
Now, if you're going to put a project off until the third year,
then I would say that you should be planning for a base risk-free rate of about 4.1%.
That's the use of this.
Now, I'll put this into an Excel sheet for you,
so that you don't have to go through the pain in the ass of these calculations.
But once you've done it a few times with Excel or whatever,
it begins to kind of make sense that what we see in yields
is actually just the composite of what was thought about for each period overall.
And the forward rates tell us how that composite was actually created
by the individual interest rates of each year going forward.
That's what that's all about.
It's a side movement, and they cover a page or two in the textbook.
And I give it to you now, but for now, I will have an Excel sheet up for you
probably late tonight or tomorrow morning,
so that you can do these forward rate calculations on your own
without going through this mess of trying to show you why we do what we do to get them.
But anyway, you put that aside for a while,
put it in the back of your memory, because I won't ask for forward rates on any exam,
but they could be in your homework.
So I cover it.
But for now, we're going to go on to something else.
As a matter of fact, I can kill this now.
Now, this is all memory work.
This is definitions and concepts, so it's fair game for the midterm,
but there's no math in what I'm going to do for you right now.
And in some cases, I go into a little more detail than the book does,
just to tell you what the background story is.
This is bonds.
Now, the first thing to mention about bonds is that the bond market
is about 10 times the size of the stock market.
It is a vast ocean of securities.
Now, remember, when I say, you, madam, issued a bond to me,
that is the same thing as saying that you borrowed money from me.
The bond is what you sell to me, and in exchange for the bond, I give you money.
That's what a bond is.
It's just an agreement to pay back a certain amount of money that's borrowed.
Now, I use the term bond generically, as we all do.
A bond could be, I mean, remember the technical distinction.
A note is less than a year.
I'm sorry, a bill is less than a year.
A note is 1, 2, 7, 10, or 15 years, depending on whom you're talking to.
And a bond is technically something that's very long-term, 20 years or so.
But like I said, that's a little bit slippery.
Notes, we used to say a note was anywhere from 1 to 7 years,
but a bond was anywhere longer than that.
But it's a little bit fuzzy.
But bond is just the generic term for a debt instrument.
Now, about the size of the bond market and why,
if something is 10 times the size of the stock market,
why do we talk about stocks all the time?
We talk about this giant 800-pound gorilla that's wandering around in the monkey cage.
It has to do with, and I've said this before,
but I'll emphasize it here and get a little bit deeper into it.
It has to do with the fact that bonds are boring.
Bonds are not exciting at all.
Bonds don't go up and down and up and down and bounce around,
and you don't see the talking heads,
boy, oh boy, these bonds really did a lot today.
They moved four cents.
Boy, I was exhausted after watching that.
They don't go up and down much at all.
The reason is kind of simple.
Well, there are two reasons.
The first reason is that stocks, you are playing, to some extent,
you're in a casino type of environment, ups and downs, wins and losses.
There is no telling where it will be tomorrow.
You could lose everything you invested if a stock goes to the toilet,
or you could become a multimillionaire in a few weeks.
Literally, they can go anywhere.
Bonds can't go, well, I shouldn't say they can't,
but they rarely would go very far simply because stocks, you're all at risk.
When you buy that stock, you've got no guarantee whatsoever
about what's going to come out of that.
Like I said, you could lose it all tomorrow, or you could become quite wealthy.
With bonds, that's not going to happen because, first of all,
bonds have the prior claim to cash flows of a corporation.
They have to get, the bondholders have to get their money.
You cannot give the stockholders a dividend.
You cannot plow money back into the company on behalf of the shareholders
until you have satisfied the current obligations to your bondholders.
That's just the reality of it.
In my own company, I have one outstanding debt.
It is a type of bond, and the lender was a bank.
I have to pay them my interest payments every month.
I have to pay it.
Whether or not I, the owner, get to eat or not, I have to pay the bondholders.
So in other words, with any bond, there's an anchor, the principal, the balance.
That has to be paid.
So they don't whipsaw up and down.
They stay relatively near where the obligation is as far as the cost, the price,
or whatever you want to say.
They're going to be very close to that through the life of the bond.
And so they can't go way up and way down.
There is a fixed obligation involved.
So if I lend you money, madam, I know that it's going to be that much money
that I have to give you back, and you know it too.
So there's not a lot of volatility in the value of that at all.
And the second reason is simply that the bonds are held under a very firm agreement.
It's called the bond indenture agreement.
The bond indenture agreement.
And I'll get into that in just a minute here.
They are a formal kind of contract, and it is established at the very beginning.
And that bond indenture agreement has lots of language in it
that carries the weight of legal obligations.
Unlike stocks, a bond is fixed by this giant contract.
I had actually never seen one of these in the first maybe 20 years that I taught.
I talked about them, and finally I was on a trip to New York City
to visit a friend who worked for an investment banker.
And I just had asked him before I went out there, I said,
do you have a bond indenture agreement so I can actually see one of these contracts
between the lenders and the company?
And he said, yeah, I got one, and he showed it to me, let me look at it.
The thing was like a book.
It's a contract between the lenders and the borrower.
And it is detailed.
I didn't even realize how detailed it is.
But just to give you an idea of how detailed.
Now, remember, an investment banker, they don't just deal with stocks.
They'll deal with bonds.
I came to you, or did I come to you or did you come to me?
I sold the bond to you.
Okay, and I am the investment banker.
I'm the IB.
Now, I'll make a syndicate.
You want to borrow $100 million.
Okay, so essentially you are seeking $100 million loan from me.
Well, I'm going to divvy that up in a syndicate.
I'm not going to do the whole thing myself.
I'm not stupid.
Okay, so we are going to go into a negotiation.
The negotiation will be how much, obviously, and the interest rate.
That's called the coupon.
And there will be a lot of other things.
These are called the covenants of the bond, in that agreement.
Now, there will be how much, among other things, how much, what interest rate.
Now, in our world, we call that the coupon or the coupon rate.
Now, we usually don't fix that until right before the loan, because interest rates could be moving around.
And if we worked that out, like, a month before, interest rates could do something.
So we're going to work it out so that interest rate is very close to what the prevailing interest rate is for a loan of this risk level.
And then there are going to be how long.
That would have to do with the maturity date.
When in the future do I owe this back?
And then there are going to be others.
Among them is one that I will mention here, the bond trustee.
This is a person, a law firm, maybe an accounting firm.
It is an entity that actually oversees the interests of the bondholders during the life of the loan.
So, for example, going back to you, just to continue this.
Now, I have appointed this gentleman as the bond trustee.
He represents my interests as the lender.
You say, well, you know, we want to be on the edge of the field.
We're going to take on this new, really risky project, and boy, we think it will fly and we'll make a lot of money.
And he's going to say, no, you're not.
And you're going to say, well, what do you mean, asshole?
Of course we are.
And he says, no, you're not, because you see, his interest is in making sure that EBIT is above the interest expense for the period.
In other words, he doesn't want, I don't want you to take on a project that could go way up in revenues, great for the shareholders,
or it could cream your company, in which case I would be out my money.
He's not going to let you do that.
He's going to say, no, because you are putting my, what you owe me at risk by doing something like this.
It would be like, for example, that you sort of take out a car loan with me, and then you say, yeah, I'm going to take this car to the NASCAR circuit.
And I'll say, the hell you say.
No, you're not, because my loan is backed by that car I lent you.
You're not going to do that.
Matter of fact, if you look at a lot of home loans, the mortgage agreement, there are covenants that say what you cannot do with that house.
You decided, for example, that you, sir, were going to buy a house, and you were going to turn it into a brothel.
Yes, it will be popular, especially in this part of the country, where nothing happens that's exciting.
But the thing, though, is that I, as a lender, am going to say, no, you are not, because I get nothing out of that.
But you could end up in bankruptcy.
You could be raided by the police.
You could have a mosh pit some night, and they burn down the damn place because they're all so happy.
No, you're not going to do that.
Now, understand that when you borrow money for a loan, that's a bond.
You're issuing a bond to a bank.
That's what you're doing.
You're issuing a bond.
The price of the bond is what I lend you.
So you're issuing a security.
When you borrow for a car, you're issuing a note, a five, six-year note.
And I, as the buyer of that note, the price I'm paying is what I am lending you so you can have that car.
So the bond trustee makes sure that no...
Oh, and also, well, we feel like we're going to give out a really great dividend this year.
And the bond trustee says, no, you're not.
You're going to put that money into retained earnings, because this year, yeah, it was great.
You want to give candy to your shareholders.
We get it.
But what happens if next year sucks?
We want to make sure that you have enough money in the bank to cover our interest.
That's why the bond trustee is important, that it goes to that prior claim.
They're going to cover.
They're going to protect themselves.
So they want to make sure that your earnings for interest and taxes is high enough,
well enough away from what you owe in interest expense that we're okay.
In other words, the times interest earned is well enough above one so that we don't have to worry
about whether you're going to have a problem taking care of your payments.
Now, the next thing, what did I write there?
Okay.
Consumer loans versus corporate and government loans.
They're different animals.
With consumer loans, the payments, you know, you calculate with Excel those payments.
There is, those payments are designed to pay the interest for the period on the balance of the loan
and some extra to pay down the balance.
In other words, the payments service the loan, pay the interest it's due for the period,
and they amortize the loan, service and amortize the loan, both.
Corporate and government debt doesn't work like that.
In corporate and government debt, the payments are only the interest, the coupon.
So in other words, let's say that that $10 million, we had, we talked about that one.
It's a 20-year, 8%, 20-40-4.
And it's for $10 million.
What this says is every year for 20 years, you will pay the lenders, the bondholders,
8% times $10 million.
And then at the end of 20 years, at year 20, 2024 to 2044, at the end of year 20,
you will pay one last coupon payment of $800,000.
Is that right? No.
You'll pay one last of those, plus you will pay back the $10 million.
So in other words, the loan is not amortizing.
That's the way corporate and government debt works.
All the borrower pays is the interest every year.
And then at the end, it pays its last interest payment and it pays off the loan.
The whole shebang that it borrowed.
Good times.
Now in reality, the bond indenture agreement is going to have some mechanism
where the company is putting away enough money every year so that the $10 million is already there
and the company is not, oh my God, it's year 20, we owe $10 million.
There are two general ways that that is taken care of.
One is what's called a sinking fund,
where the company has to put like maybe a million dollars in the bank every year for the first 10 years
so that the bondholders know that that $10 million and even more is there when the company has to pay off the loan.
Sinking funds are very common.
There's another trick that is done too.
I don't think it is as common, but maybe it is,
where the company actually buys back part of the bonds every year
so that by the time 20 years has made it,
they just buy back what's left of the bonds that are still out there in the open market.
That's another way that it's often done.
Like I said, I don't know whether it's more common.
Sinking funds used to be the way.
A long time ago, I would not have even brought up this other way.
It wouldn't have occurred to me, but it does seem to have some popularity now.
In other words, you're kind of paying off the loan as you go along, but it's in chunks.
You're just going out there into the open market, me the borrower,
well, in this case, she the borrower, is just going out there.
Maybe next year you buy $2 million of the bond issue,
and the next year you buy $1 million of the bond issue.
And so by the time 20 years comes, there's just a little bit of the original issue
still floating around out there, and you buy that up.
That's another way that it's done.
Okay.
That's kind of the outline of how it works.
Now, let me go through some of the technicalities of it.
Whenever we talk about bonds, we scale them all to a face value.
In other words, a principal amount.
The face value, the FV, if you will, is $1,000.
In other words, if it's a $10 million issue, we just make it $1,000 per bond for what?
100,000 bonds?
100,000?
Yeah.
No.
For 10,000 bonds.
We just make it face value as is always $1,000.
I don't even put that in to any kind of a question I would give you.
You just know that it's $1,000.
The problem is, long, long, long ago, in the 19th century,
at the beginning of every day, before the markets opened on Wall Street,
all these brokers and traders and dealers would be moving down the street,
trying to find some place to buy some coffee.
They would go by the printing houses, which at the beginning of every day,
just after sunrise, they would print out these big, broad sheets that listed the closing prices
of all the stocks and closings on all the bonds.
But they had to make the columns very narrow to get everything in the broadsheet.
And this thing became the convention that we never quoted a price.
We quoted on the hundred.
So in other words, if the actual price of a bond was $992,
we would quote 99.20, or in our parlance, 99.20.
And that has stayed to this day, that bonds, what you see is a quote, not a price.
I have kind of a funny story.
Many years ago, this old kind of rich guy, he was an optometrist.
He thought he was a genius in the stock market.
Before people had, many people had computers and all that.
He had one, he had some stock market software, and he decided he was going to buy some bonds.
And so he put in an order to buy these bonds.
And they were at, he saw the quote, 99.20, and he said, buy 10 of them.
And when they came back with the confirmation, he was out close to $10,000.
He just had a fit. He was threatening to kill people.
They're charging me 10 times what the price was.
And he called me on the phone, and he's cussing and swearing, said, Frank, that's a quote.
It's a tenth of the price.
Well, who invented that?
Some people like 200 years ago, you moron.
He didn't know.
So be careful when you look at those prices, what look like prices, on the ticker symbols and all that,
and on your software, your TD Ameritrade, thinkorswim, or your Robinhood.
Those are quotes. Those aren't bond prices.
So always be careful of that.
So you might see me, if it looks like it's a small number, that's a quote.
And I would say, quoting.
That should not have a dollar sign on it because it isn't a dollar.
Now, interestingly, Excel is weird.
I'm going to walk you through a couple of templates for bonds.
And on one side, you put in the price to get one thing.
On the other side, you have to put in the quote to get what you want.
And I have no idea who at Excel thought this, Microsoft, thought this up.
But it's really strange that one side, you would put $992.
But in this other template part, you would have to put 99.2.
I have no idea where that came from.
Okay, now a little term here, PAR.
PAR is $1,000 or 100 on the 100.
It is the exact price at which the loan was originally made, we hope.
So, see this bond right here, this $992 one?
We would say that that bond is selling at a discount to PAR.
On the other hand, if I saw a $1,015, we would say that that is selling at a premium to PAR.
That's our terminology.
Now, why would a bond sell at a discount or a premium to a thousand?
You're paying the interest along the way, so this isn't affecting the principal, which is the thousand.
Well, you see, the next part of this is the coupon.
Or you might hear it called the coupon rate.
This is the interest rate that was agreed upon to start the loan.
That's the coupon.
When you borrow money at an APR of 6.19%, technically that's the coupon.
That's the interest you must pay every month in the case of a bond.
Or in the case of a car loan or a mortgage loan.
It is fixed at the beginning.
So what happens if interest rates in the economy go somewhere else?
Let's say that I have a coupon rate of, let's say, 8%, like I had here.
Well, what happens if interest rates go up?
You're stuck with 8%, so that's why the price that you could sell the bond at, if you want to dump it,
would go down because it's not as valuable.
Whoever buys that is going to get 8% when interest rates are higher than that.
So people were going to buy bonds, I'm not buying that until I can get it at a deal.
On the other hand, so in other words, at a discount, coupon would be less than the market rate.
The market rate is what we call the yield.
However, suppose that you've got an 8% bond and interest rates in the economy drop.
Oh, you've got candy. So people are going to want to get a hold of that.
Demand will go up and the price will go up.
So in other words, this would happen if the coupon becomes more than the market rate.
That is, the yield.
This sounds more complicated than it is. It really just boils down to some basic ideas, basic concepts.
But, maturity date.
When it's all over, like that 2044, that has a maturity date probably exactly 20 years after the date of the loan.
You can have maturity rates, I mean, one year, two year, three year, five year, seven year, ten, 20, 30.
There are even some maturity dates that are 50 years in the future.
There are some that are even longer, like 100 years.
If you've got a very, very long term project.
Like for example, companies that would be borrowing to start the process of mining asteroids.
Those bonds would have to be awfully long before they start, because the project wouldn't even start paying hardly at all for a long, long time.
So you can have bonds that are very, very long. I believe some countries have like 50 or 100 year bonds.
Because the government, the treasury, needs to borrow money for that long for some monster, very long term project.
And all that good stuff.
Now, one more term, which is the word term.
How long does the bond have before maturity?
You see that bond, if I issue a bond this year, the maturity is 2044.
But we can talk about that bond, well, what happens if we're in the year 2030?
Well, the maturity date is 2024, but that bond has only 14 years left.
So in other words, the maturity is a fixed number. The term gets smaller and smaller as you go along.
So that's the term of a bond. And actually, I hate it, hate it, hate it.
Technically, to do the math of bonds, all you need is the maturity date.
Technically, you just need the term of a bond. Because a bond's price and yield are wholly, are dependent upon the term,
not the date of maturity. It drives me crazy that Excel insists that you put in when the bond started.
Instead of just saying, here's the term of the bond. But I made it in the template, so that's not hard to do.
Anyway, that's some background on it. Now, let me tell you about bonds.
Treasury bonds, those are bonds issued by the government. And when you buy a treasury bond, you're lending the government money.
The government is constantly selling treasury bonds and bills and notes.
They are an auction, the treasury auction might have $10 billion of treasury bills, short-term borrowings.
Might have another $30 billion of treasury notes. Those are one to seven year.
And then it might have $25 billion in treasury bonds. And it's an auction market. It used to be a physical location, now it's all electronic.
And these lenders just go right up to the table and they buy at the auction. They buy at the auction.
And those lenders, they can be insurance, life insurance companies, they could be trust funds, they could be corporate borrowers.
Corporate lenders have got a pile of money.
Countries, whole nations go to our auctions and buy our treasury debt. In other words, they lend us money.
China is a huge lender. They buy up vast numbers of our treasury bonds.
So we have the treasuries. That's one type of bond.
Those are government issued, backed by the full faith and credit of the United States government.
They're very safe, so they have very low coupon rates. Very safe.
Now there's one, the book doesn't mention this one, but it's kind of an important one.
There is what is called agency, what are called agency bonds.
Agency bonds are bonds that are issued by agencies of the United States government.
They're not technically treasuries.
And they're technically not even backed by the full faith and credit of the United States.
Everyone assumes that they kind of are, but they actually technically aren't.
Now an agency like the Tennessee Valley Authority is an agency. It issues its own bonds.
You could buy TVA bonds. There are a lot of different agencies.
And interestingly enough, when we see the national debt, we don't see, all we see is how much outstanding debt, bonds, notes and bills, the treasury has.
Very rarely do you see one that includes the agency debt.
Now if I remember the timeline right, the agency debt surged for quite a few years.
I mean like 15, 20 percent of the whole United States debt.
But it declined quite a bit during the Obama administration.
And then it came back up, I might be wrong about this, but it came back up under the Trump administration.
And I think it has gone back down during the Biden administration.
But it's still debt. You might say, well I'd like to invest, lend money that's pretty safe.
Well you can't beat that. Even if it's agency debt, it'll pay a little more in a coupon than straight treasury debt.
Just because we're not sure if there's no default risk.
Another one, the next one that I would bring up are municipals.
Munis. These are issued by sovereign entities below the federal level.
States will issue their municipals.
Now the one thing about municipals is if I buy a Muni, the interest payments I get are not taxed at the federal level.
That's kind of cool. And so their coupons are lower because they're tax free.
But the problem is of course only the richest in the top tax brackets would get the full impact of that tax free status.
Because they'd have the most to gain or not lose from not having to pay tax on.
Now Munis, they could be like for sewers and water.
You're putting in those so a city could put out a bond issue to pay for that.
School districts have them because they want money.
I mean they're out there. And then there are a couple other types.
I may mention them on Monday. But that's all I have for you today. I thank you.