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.
Introduction to Bonds
Today, introduction to Bonds. This is the last lecture before midterm week.
On Monday, we will review for the midterm exam.
Now, there will be two parts to that review.
There will be the part where I tell you what I think you should know.
That's pretty useful since I'll write the exam, I should know what's on it.
And then I open it for you to ask me questions.
And if you say, well, is this going to be on the exam? If it's not, I'll say no.
This is your chance to write your study guide for the midterm exam.
And just for the weekend, just to get you prepping up,
I do allow a 4x6 note card front and back for the exam.
So you should start prepping that for it.
You're also, of course, as I said, your financial analysis formulas sheet.
You can have that. And I expect you to use Excel for the exam.
Those templates that I have provided, the one that will be of principle importance to you
will be the present values and future values template in your files in Canvas.
So that's for you. Make sure that you know how to use it.
And your study, you should be considering your notes as your primary.
And then your quizzes, the midterm looks a lot like the quizzes.
Basically like a big, big version of the quizzes.
And then, of course, the podcasts.
And as I've said before, if it's in the book but I haven't mentioned it,
then it is not on the exam.
If it's in my lecture but not in the book, I guarantee you that I will be asking those kinds of questions.
Some material is both I've talked about it and it's in the book.
Those are obviously fair game.
But use those as your pivots for your studying.
And then on Monday, as I said, we review.
And then on Wednesday, we test.
So that will give you something to look forward to over the coming weekend.
As far as other matters are concerned, yeah?
I was wondering if you know how long it takes to complete the book.
50 questions. It's 75 minutes. It's a class period.
You should be able to finish it within about 45 to 50 minutes.
I make sure that I prepare an exam and I assume that it will take you about 50% longer,
maybe a third longer time than I would take the exam.
And I usually clock it in so I can finish it within about 30 minutes to myself.
And I give you plenty more time than that.
So that's up and coming, something for you to get excited about for the weekend and keep you busy.
Now, as far as the content of the lecture today, this is Chapter 7.
Now, Chapter 7 has terminology and concepts and it has math.
I will not ask any questions about the math from Chapter 7.
Math from other chapters is a fair game.
But the math of Chapter 7, I will put that off until after spring break.
You need to focus on about the first half of Chapter 7 is what I deal with,
the memorization, terminology, concepts insofar as bonds are concerned.
And we'll get to that in just a little bit.
But before we do that, we'll have a quick look at the numbers.
And we can see that this has just been a bouncing day up and down.
It's all been negative.
So there's a general grouchy sentiment in the market today.
It's not anything hugely awful.
The Dow is down 21%.
The S&P 500 is down 0.21%.
And the S&P is down 0.19%.
And the NASDAQ, it's down enough to be noticeable, a little more than a half percent down.
But I mean, it's not anything terrible.
It's just one of those days where we've got the bears are grumpy and they're out winning the happy bulls.
But there's not much to say about it.
Although it's just up and down today.
It's information, good news, bad news kind of trading back and forth through the day.
Now crude, it had actually, again, like it has done a couple of times, it keeps testing.
Remember I told you that trading band between about 72 a barrel and 79 a barrel,
it keeps pushing up to that 79 and then it chickens out and it runs back down below it.
So it really is a what we would call a resistance level.
That's a term we sometimes talk about with stocks, commodities, bonds.
It has a resistance level here at 79.
But it is up there towards the top of it.
Now that can be taken negative because it'll mean somewhat higher, slightly higher gas prices,
which you're seeing at the pumps right now.
But it also might be something of a good sign.
We are now seeing a recovery.
And it may be, I would argue we're in the early phase of an expansion.
That would be attended by more trucks on the road doing deliveries of goods,
more driving by people going places.
So that more demand for gasoline and distillates like diesel and jet fuel
might be a sign of a healthy economy coming.
So just because the oil prices are going up a little bit, and this isn't anything insane
like those $125, $150 per barrel prices,
that might just be a sign of an economy that is recovering,
that is coming back and people are driving around more, trucks, more trucks, fleet trucks on the road,
getting stuff to stores or to industrial sites.
So you can take it for that.
Gold just doesn't want to go anyplace.
It's still sitting above $2,000 an ounce, but it's not surging.
So there's no evidence of some freak out apocalypse
where the gold buyers are buying gold hand over fist.
Taking it over here to the 10-year bond, the yield is definitely down, more than four basis points.
That would mean that the price is up.
That would mean that there is buying in the bond market.
There's buying of bonds.
So I want to make sure that you can do that.
Think your way through it.
Okay, I see that the yields are down.
That would mean prices are up.
That would mean the demand for bonds has increased.
I would expect you to be able to walk through a chain of logic like that
in a question on the midterm.
Just make sure you've got it down.
Well, now on the other side of the world, Tokyo just didn't have any particular care.
It ended right about where it began, down about.08%, which is pretty much nothing.
There just wasn't any clear direction, bullish or bearish,
although through the day it was bearish.
By the end it had come back to about flat.
London, on the other hand, as you can see in the early trading before the midday,
there was a stream of negative news, bearish news, that kept pushing it down and down.
But about midday, no more news, good or bad, was driving the market in a direction.
So it pretty much just floated for most of the rest of the day.
And that's just that Newton's law of linear motion.
If there's no news, then it doesn't change its direction.
It just goes in the same direction it was.
And so once the bad news had passed and been absorbed into the prices in the morning,
there was no more news, so it just stayed where it was for most of the rest of the day.
And that's sort of like good news.
It must have been something that upset the London market.
Hard to say, though, what it was.
Now, let me take off from this.
I want to show you one last thing.
It's somewhat chapter six, but it's also chapter seven.
And it's a technical, mathematical thing.
And I'm going to show you the background of it, but I will prepare a sheet,
an Excel sheet with you, we'll build one together,
that will be able to do this so that you don't have to suffer through the mathy,
if that's the lack of a better word, part of it.
And it has to do with yields.
You see those yields right there?
I'm not going to use this example first, because this example is weird,
because we've got an inverted yield curve.
It still works, but the numbers look a little bit odd.
But you see those yields right there?
Well, let me do one here.
The yield on a one year, the yield on a two year, and the yield on a three year.
These are better done in whole years.
Suppose the yield on a one year, Treasury, is 4.24%.
The yield on a two year is 4.28%.
The yield on a three year is, let's say, 4.34%.
Now, these are actually composite yields,
to the extent that, like the two year,
that would be ending price over beginning price to the one over two years,
minus one.
The one year would be the ending price over the beginning price
to the one over one, minus one.
Remembering that formula for finding yields.
And the three year would be the ending price over the beginning price
to the one over three years, minus one.
That's what those yields would be.
They are what the market's price is at the beginning, at the end,
divided by the beginning, to one over the number of years.
That's how you calculate a yield.
But they really aren't exactly what happened.
See, that one year is one plus the interest rate for one year.
So the one over one, minus one.
The two year, what we see is a composite, an average, a geometric average.
What really happened was that there was the one year times another rate,
which was the two year.
And those two equaled one plus the yield we see on a two year,
to the second power, minus one.
That's what we see.
But inside of that was a one year, the current rate, plus a rate through the second year.
We call that thing a forward rate.
The rate that is actually the market think is going to happen in the second year.
Not the average of what happened in one through one year one and two,
but it is actually two rates, the one year and then the second year.
And the third one is actually the one year rate,
plus that forward rate from the second year,
times one plus the rate from the third year.
I shouldn't say that minus one.
I should leave that minus one off.
And that's the rate that we actually see is one plus,
the one that we see in those yield curve charts,
is the three year to the third power.
You don't need to worry too much about that.
Just follow how I calculate these.
Now the first year rate is a yield and it is the first year's forward.
We're seeing the forward, the first year.
It's right there in that chart, 5.03%.
In my example here, the one year is 4.24%.
But the second year, rate for the first year is 4.24%.
Now the second year, one plus.0424 times one plus the forward rate,
which we don't see, should be one plus, where the hell did I write it?
.0428 to the second power.
This is how we can tease out the forward rate,
what the markets think the rate interest rate is going to be in just the second year.
The yield tells us what the average of the first and second year is.
But the forward rate would tell us what the market thinks just the second year would be.
So I can work this around.
One plus R1 would be one plus.0428 squared over, that's one plus R2, I'm sorry, over one plus.0424.
So R2, the forward second year, just the second year rate, just the second year rate.
I would pull up the calculator and I would say, okay, I'll take the 1.028 squared and divide it by the 1.04.
.0424, I'm sorry,.0424.
And then I would minus the one.
Is that right?
Oh, I screwed that up.
I keyed something in wrong.
Let me fix that.
I put a 1.028 instead of a 1.0428.
So it's 1.0428 squared divided by 1.0424 and then minus one.
So the forward rate, the second year interest rate, the market thinks it's going to be 4.32.
Because if I did 1.0424 times 1.0432, the result would be one plus.0428 squared.
This is technically called the Fisher effect.
And it's saying, okay, you put together a 4.24 interest rate for the first year with a 4.32% for the second year.
And the overall effect is a 4.28% for the two years combined.
And that's what the market would be creating with the price of the two-year treasury.
Now, taking it one more time, now that I have the one year and the forward on the second year,
I can say that one plus.0424, the first year, times one plus.0432 in the second year,
times the forward rate, one plus the forward rate over the third year, should be one plus.0434 to the third power.
If you don't see how I'm doing this, you're not in any bad shape at all.
Once you've got it in Excel and you do it a couple of times, you get the hang and it begins to make more sense to you.
But solving this, one plus the third year forward rate would be one plus.0434 to the third power
over one plus.0424 times one plus.0432.
Now, this is where you have to watch out for your math, for your calculator entry.
Make sure that denominator is all in parentheses.
But if I do that, if I do that, and if I do it right, I would take 1.0434 to the third power divided by,
I'm going to open parentheses, I'm going to put those two down there,
1.0424 times 1.0432, is that, yeah, 1.0432.
Close the parentheses so I hold that denominator together, and then minus the one that was on the other side.
So the third year forward rate is.0447.
The third year forward rate is 4.47.
So this is what the yield curve says, 4.24, 4.28, 4.34.
But the year by year would be the 4.24, the 4.32, and the 4.47.
That would be each year taken separately instead of as a composite.
It's hidden in the data, but it's useful for us, especially for things like long-term planning of your investments.
Okay, we're going to do a project this year.
So we would start with a risk-free rate of 4.24% to figure out what our cost of capital is.
Well, what if we're going to wait until the second year?
Well, the yield curve says that the rate will be 4.28.
No, it doesn't.
It says that in the second year, the market's right now expecting the rate to be 4.32%.
Well, what happens if we put it off until the third year?
Well, should we start with a risk-free rate of 4.34%?
Well, you shouldn't, because right now the markets are actually whispering that in the third year,
the rates we expect are going to be starting with a risk-free rate of 4.47%.
So these are the rates that are actually being hinted in that year that we're considering starting a project.
The yield curve is just like an average of the rates for two years or the rates for three years.
And like I said, I'm not going to ask this on the midterm.
I don't want my tires slashed.
And when you get down to doing the calculations, I'll have an Excel spreadsheet that can do the heavy lifting for you to get these.
And we usually, it's kind of tricky when we go past three years, and I'll show you why.
The yield curve, you see we got the one, two, three, so we can build it.
But when you get past three, the next treasury security that is listed is at five years.
So you've got a gap of years.
So you get sort of like composite forwards after the third year.
But it's useful for the intermediate term planning for one, two, and three years to know what the markets are saying in the year given that we are going to start a project.
What base rate, risk-free rate, are we looking at for that?
That was a lot like work.
And again, don't be too concerned about it.
You've got a question on the homework like this, and there's a little bit in the book about it.
But I will also provide you with an Excel sheet that will make it a little bit more tolerable to do these calculations.
But for the rest of this lecture, this is the introduction to bonds.
This is all terminology and concepts.
Now, the first thing that I would remind you, and I've said this on many occasions,
and it begins to get to be a little more important now, is that the bond market is ten times the size of the stock market.
It is a vast ocean of securities.
But you don't hear about the bond market.
All you hear about are stocks.
Well, this stock went up today, this stock went down.
I think this stock is a great investment.
Or I would sell this stock.
You don't hear a lot of talk about bonds.
Hardly ever do you hear about them.
The reason is simple.
Stocks are exciting.
They can go all over the place.
You can go from a great price to zero in a day or two.
Or you can become a millionaire in a couple of weeks with stock prices skyrocketing.
That cannot happen with bonds.
Well, it almost would never happen with bonds.
It would almost never happen with bonds.
I mean, theoretically, a stock price, it wouldn't happen.
But a stock price could go to infinity.
A bond price can't.
It just cannot do that.
Or to the point, the bond market is overall boring.
The price of a bond from day to day, up a little bit, down a little bit.
You're not going to get anyone to listen to your investment advice if you're saying,
well, bonds went up three cents today.
Boy, I am exhausted from watching that.
It's not interesting at all.
And there's good reason.
There are two reasons, kind of interrelated.
The first reason is that bondholders, the lenders, have the prior claim to cash flows.
Before shareholders can get a penny in a dividend or plow back into the operations of the corporation to grow the company,
whatever is owed to the bondholders in the current period must be satisfied.
So there is much more certainty with bonds than there is stocks.
Unless the company goes to hell, you're going to get your interest payment.
You're going to get your nice little check in the mail.
So that's the first reason.
The second reason is that bonds have an anchor.
At the end of a bond's life, you get your money, the lender gets the money back.
So in other words, it is not whatever the sky's the limit or whatever.
No, you get a specific amount of money.
What you lent comes back.
And so in other words, there's this rock solid anchor.
And so the price can't go very far from that anchor.
It can't.
Because at the end, you get your thousand dollars as our base,
as we always have a thousand as the index base, the face value.
You're going to get it back.
So how can the bond go all over the place if there is an endpoint with a specific amount of money at that endpoint?
Stocks, there's no endpoint.
Stocks live forever, at least theoretically.
So it could go to any value, zero or to infinity and beyond.
So that's why bonds are not as volatile as stocks.
One, the bondholders know they get their money before any shareholders get theirs, prior claim versus residual claim.
And there is a fixed amount that happens at the end of the life of the bond.
So taking those two into account together, let's talk about the mechanism of a bond.
Now, I use the word bond here generically.
Remember I told you about bills, one year or less in time.
Notes, two to seven, ten, fifteen years, whatever.
And bonds, they are from fifteen or twenty years on out to twenty-five, thirty.
Some bonds even go out to fifty years.
There are even some that go longer than that for extremely long-term projects.
So bonds, but I use the term bond for any of them.
A bond, and I will use you as my example straw person.
Okay, you are a corporation and you would like to borrow money.
I am an investment bank.
You don't want to have me buy stock.
You want to do it as debt.
Now there are reasons why that would be.
Remember that once stock is out there, if you issued stock through me, that stock is eternal.
A bond, you are done with it at the end of the life of the bond.
So, taking all of that into consideration.
What's going to happen, sort of in a really summarized way?
You will come to me and you'll start out with, I should like to borrow ten million dollars.
So, I'll say, well, let's get to work on it.
Now, I will probably syndicate that bond, in other words, syndicate the issue.
I'll get together with some other investment banking houses
and we'll divvy up how we'll allocate the ten million dollars we lend you.
Now, what you are going to do is issue a security to me.
It's a bond.
You sell me a bond.
That means you are, and I buy it.
You borrow money from me.
You are issuing a bond.
I am the purchaser of the bond.
The price I'm paying is what I am lending you.
It's like with a home mortgage.
You decide that you want a nice, wonderful house.
You go to me a banker.
What you're actually doing is issuing a bond, and I am agreeing to buy that bond,
and the price is what I lend you.
That's what's going on.
Technically speaking, you are the issuer of the bond.
I am the investor in that bond.
So, we work it out.
We fight it out, we talk, we argue about all the ifs, ands, ors, and buts of it.
And what ultimately comes of that is what's called a bond indenture agreement.
This is the loan contract.
For the first 20 years that I taught, I had never seen the actual bond indenture agreement.
I'd never seen one.
But some years back, I was going to visit a friend of mine who worked for an IAB in New York City,
and I said, Marty, this is kind of a weird request.
Do you have any bond indenture agreements so I could just see one?
He said, sure, I got one.
I got a bunch of them.
Probably hundreds.
I don't think he had hundreds.
But he actually, when I went into his office, he put it on the table.
It was a binder.
It was thick.
It was a contract from hell.
And there are hundreds of thousands of these done.
And so I got to see one and confirmed with all legalese, the who, the what, the when, how much, how long.
Those are parts of it are called the covenants of the bond indenture agreement.
The covenants.
The who.
The how much.
The coupon rate.
That's the interest rate.
Sometimes you'll hear me say coupon.
Technically the coupon is a dollar amount.
The rate is a percentage.
Now, that usually is not set until right before the loan to make sure that that coupon is as close as possible to the prevailing interest rate on debt securities of that risk level.
So that one is like the last thing that's typed in.
So let's say we have let's say a hundred million.
So the coupon rate, let's say it's 8%.
So what that means is that the interest every year will be $8 million.
And this is where I have to stop for a minute because consumer loans are not like corporate and government loans.
In a consumer loan, we calculated those payments on a loan.
Well, those payments pay the interest for the period.
And they also pay some of the balance of the loan off.
They service the debt.
That's the interest.
And they amortize the loan.
That's the balance going down.
With corporate and government debt, all that happens during the life of the loan is the service.
The borrower pays the coupon.
Does not touch the principal, the face value as we call it.
Doesn't touch it.
At the end, one last coupon is paid and the whole hundred million is paid back all at once.
Now, practically speaking, they're not going to do that.
The bond covenants will have something like a sinking fund.
Well, the company has to put in $10 million every year into a fund so that way before the bond is due, it's paid off.
Or another trick on this, and I don't know how popular it is, is the borrower agrees to buy back some of the debt,
pay off some of the debt, that is, every year over the life.
And by the end, there's not a hundred million, there might be five million.
They have to agree that they're killing off some of the debt by buying it back in the open market.
But one way or the other.
Okay.
Now, the next thing is the maturity date.
When does it have to be paid off?
Let's say that it's 2044.
This is a 20-year loan.
2044.
So in other words, for the next 20 years, every year, the lender or whoever has bought the bond from the lender gets a check for $8 million.
And then in the year 2044, one last coupon is paid and the hundred million is killed, paid off, all at once.
That's how corporate and government debt works.
It's not like consumer debt where at the end, your last payment is just a regular payment and you get the title to the car or the title to the house or whatever.
This is different.
Corporate and government debt works like this.
Now, unless otherwise specified, we always do things with a base face value of $1,000.
So in other words, technically, the borrower here would have issued $100,000, $1,000 bonds.
It just makes it a lot easier for us to do the calculations if we do it this way.
This is called the face value.
You'll hear me say face or face value on a calculator or in Excel, it's FV.
This is called, once the bond is out there and it's being traded, bought, and sold, we call the thousand the par value, par.
Kind of unfortunately, you probably won't see the price.
You will see something that is one-tenth of the price.
The reference is on the hundred.
So if the price of the bond, let's say, is $992, it would quote at 99.20 or in our parlance, 99.20.
If the price of the bond were, let's say, $1,015, then we would quote 101.50 on the hundred.
That's not a dollar amount.
Unfortunately, there are some places where they show that as a dollar amount.
It's not.
I have a great story about that.
Many years ago, before a lot of people had computers, there were a few rich people who had computers and they had access to the pre-internet and they could get stock prices, bond prices.
There's one rich fellow I knew.
He was an optometrist.
He thought he was a genius.
And he put in an order.
He saw these bonds and he bought 10 of them.
Not two hours later, he was cussing and swearing.
He called me on the phone, cussing me out, and he said, I just got ripped off.
I just got $9,980 taken out of my account for 10 bonds that cost $99.80 each.
I'm like, Frank, you moron.
That was a quote.
That's not the price.
Who made that up?
Well, that's been around for about two centuries.
Here's why.
Back before there was an internet in that ancient, ancient time, the 19th century, 20th century, for most of that, the Wall Street would, the sun would come up and then all the traders and brokers and dealers and wheelers and dealers would be,
go down the Wall Street, and there were these printing shops that would print out on a broad sheet the ending prices for the night before.
So all of these fancy people would buy their giant broad sheet and look at everything and get ready for the morning's trading.
Well, the thing was that they had to get literally hundreds and hundreds of stock and bond prices onto the columns of that sheet.
To save a little bit of column space, they made the bond prices a tenth.
That's where that tradition of quoting on the tenth came from.
And stock prices, only since, probably right around when you were born, stock prices didn't used to be quoted in dollars and cents.
They were quoted in dollars and fractions.
Like a stock would be 17 and a quarter.
And they wouldn't, so all they would have to do is just put not $17.25, it would be 17, and then a tiny little space and a one, which was one of four.
So that's where that tradition came from, if it sounds a little odd.
Here's what's, for you though, here's what drives me crazy.
There are two big things that we use Excel to calculate, the bond price and the bond yield.
Okay, now, calculating the bond price, it comes out as a price, $992 or $1,015.
But the bond quote, you have to enter information on the hundred.
You don't put in the price, you put it on the hundred.
So when you get to that Excel sheet that I have built for bonds, you'll see a big warning on the hundred.
Just to tell you, don't put in, I'll give you a price, that's what we all talk, we talk in prices.
But you don't put in a price, you put in a tenth of the price, for God's sake.
Don't ask me why, it's just that's how it's done.
Oh Lord, okay, but anyway, let me go on here about this, these two things.
Here's, now the bond price is going to swing around the face value,
because at the end you're going to get your $1,000 back.
So it's not going to go far, usually, from that $1,000.
It will swing around it slowly, it almost never would be a really strong movement.
Like stocks can go up by percentage of 2%, half a percent.
These don't move very much at all from day to day in normal situations.
But why do they move at all?
If you're going to get the $1,000 back at the end, why would the bond price move from $1,000?
That's what you're going to get back.
And the coupons are going to pay you, make it good all along the way,
so they're servicing it completely, so it should stay at $1,000.
Here's why it won't stay quite at $1,000.
You see, this rate, the coupon rate, is set at the day of the loan.
It's almost the day of the loan.
Well, what happens if interest rates in the economy go up?
The lender is stuck with 8% for 20 long years in this case.
So in that case, I'm going to say this sucks.
And there's going to be a lot of investors who will want to get rid of these bonds,
whose coupon is lower than the market wants.
So in that case like that, the price will go down.
If the coupon is less than the market price,
we call the market price the yield, the market rate.
Let me put that as market rate, not price.
Let me put that as market rate.
That will cause the bond price to go down below $1,000.
We say that below $1,000, the bond is selling at a discount to par,
reflecting the fact that the coupon, which is fixed for the life of the loan,
is below what the market wants.
On the other hand, suppose that interest rates fall below 8%.
Well, that would make the market happy.
You would have buyers trying to get a hold of these.
So when the coupon is larger than the market rate, the yield,
then the bond is going to push up above $1,000.
In this case, we say the bond is selling at a premium to par.
They don't go far.
I mean, you've got a company.
Another thing that can happen is that after a bond is issued,
the company itself could become riskier.
So the market will say 8% isn't enough to cover the risk.
Or a company could become healthier.
So sometimes it's not just the economy that can move a premium and discount.
It can be the company itself.
Like, for example, Sears, it was a very, very healthy company many years ago.
Its bonds sold right at about par.
But then it started getting into terrible trouble.
So those old bonds that were priced when the company was healthy,
investors said that's not enough to cover the risk of this.
And so there was a lot of selling of those bonds, and the price went down.
On the other hand, there are some companies that were, at the time they borrowed the money,
they were pretty darn risky.
And so they had high coupon rates.
But as time went along, they got healthier and stronger.
And so now they would never have to pay that much in interest.
And so those bonds sell at a premium to par
because the coupon is way higher than the risk of the company is now.
And you see it play out both ways.
I mean, but like I said, it rarely goes too far.
However, some companies, if a company is like JCPenney or Sears,
they have virtually died.
In a case like that, there's so much selling that the price goes way, way down.
So the yield goes way, way up on them.
And those we actually call junk bonds.
Okay, junk is not a nice term.
We say high yield investments.
Those are out there.
But most bonds, they float around the par value.
But you might notice that I am linking this up to price and yield.
Notice when the yield goes up above the coupon, the price goes down.
As the yield goes down, the price goes up.
I've been saying that almost every day about those bonds quotes that you see on the ticker board.
That's what's going on here.
Price and yield are inversely related.
Now, oh, there's one more term, one more thing I want to give you over here just to cover something.
The term of a bond.
The term is how long the bond has left in its life.
Like right now, see that 2044 bond there?
Its term is 20 years.
But suppose that we all live to the year 2030.
That's going to happen for me.
But we live that, well, then the term would be 14.
Now, oddly, really the term is all that matters to doing the math calculations, price and yield.
Strangely, and I'm not sure why this is, but Excel wants to know when the bond was issued.
It's called the settlement date.
For the life of me, I don't know why Excel wants this.
So to create an Excel sheet, I kind of had to do some fancy footwork.
Because usually you know the date of maturity.
And you know the term.
But Excel wants the date of maturity, the term, and the stupid settlement date when it was actually issued.
And I'm like, for a lot of bonds, you don't see that in the quote.
When did the, what was the date?
They want it down to the day.
And so I figured out how to fool Excel on that.
But I would certainly not expect any sane person to bother.
Hmm.
Let me go on.
Let me get out of this more technical side of it here.
Probably forgot something I always do on this.
But what kinds of bonds are out there?
It is a veritable bestiary of bonds.
It just drives a normal person, what kinds of bonds are there?
What kind of a bond did you just name?
The first classic famous bond would be a treasury.
The government borrows money.
If it's borrowing it for a few months, we call it a treasury bill, a T-bill.
If it's borrowing it for an intermediate amount of time, one to seven years, one to ten years, we call it a treasury note, a T-note.
If it's selling for a longer time period, like 15, 20, 25, 30 years, 20 or 30 years, we would call it a treasury bond.
I'll show you something right now.
I'm going to pull this out.
I'll ask you, madam, at the very top of this one dollar bill, what do those three words at the top say?
Federal Reserve Note.
You can check it for yourself.
This is a note.
This is an IOU the government owes you.
That's what it is.
It's a bill.
How do they pay this off?
This is a treasury note.
How do they pay it off?
Well, in five to seven years or so, this goes back to the Fed and they shred it up and they print another one or two.
That's how they pay off.
That's how the government pays off its debts.
Is it just prints more of them?
That's a treasury.
Now, they are typically, I mean, an auction.
The government borrows money because we don't collect enough taxes for our spending levels.
What they'll do is they'll hold auctions where they will put different variety of these on the table.
Sometimes.
Sometimes it's just one.
They'll maybe put some T-bills, some T-notes, and T-bonds on the table.
And then investors will come and buy them.
In other words, those investors are lending the government money, which the government will pay back.
You buy a one-year T-bill.
They do the short stuff.
They just do it at a discount.
So you pay $980 and in one year you'll get $1,000.
So you get $20 for an investment of $980.
What were they?
Well, who buys these?
Who is lending the government money?
Well, in a backhanded way, you do to some extent.
But the vast majority is through investment funds, mutual funds, trusts.
And the biggest player that lends our government money buys that debt, those debt securities, our nations.
China is a massive buyer, a massive lender.
Well, how do the Chinese have all that money that they can...
Remember, they have to buy in dollars.
How do they have all those dollars?
Oh, that's because we buy their stuff.
You buy a toaster from China.
You are importing a toaster and you're exporting that number of dollars,
which then become foreign reserve in the People's Bank of China.
China can't use those dollars anywhere in the United States, so what do they do?
They just lend us back the money that we paid them to the tune of billions and billions of dollars.
Who else does?
The Arabs do, because we import oil and export dollars to their central banks.
Japan, we buy their import cars and their radios and stuff.
We export dollars to the Bank of Japan.
A big one is Canada is a massive buyer, because these are countries that support us,
because we can't afford to live the way we do with all of our spending.
And it's not that it's on everything from services that we all rely on.
Actually, welfare and all that is a very small part.
Our defense industry, to make ourselves the armed weapon of the world, is a massive amount.
We just spend money hand over fist, and yet we can't raise our taxes enough to pay for it,
so the rest of the world takes care of us babies, because we can't care for our own dirty diapers.
That's just the reality of it.
Just a little warning shot to you there.
Now, here's another interesting thing that the book doesn't mention, agency debt.
Agency debt is debt that is issued by agencies of the United States government.
Now, treasuries are low coupon because they're backed by the full face and credit of the United States.
Agencies, however, some agencies borrow money on their own.
They issue their own debt.
An example of an agency, the Tennessee Valley Authority, TVA.
There are a number of agencies out there.
They borrow their own money.
The treasury doesn't borrow for them.
They borrow for themselves.
Now, two interesting points about that.
Agency debt technically does not have, is not backed by the full face and credit of the United States.
We kind of assume that if an agency was about to default, the fed, the treasury would come in and make the debt whole.
But it's not in writing.
Now, agency debt, that's one thing.
Agency debt, another part about it is that when we see the national debt,
that's usually just the sum of all of the treasury paper out there.
It does not include the agency paper out there.
You have to dig to see what that is.
And it can be a whopper.
Now, I may be a little wrong about the timeline of this,
but the agency debt was surging in the first decade of the 21st century.
It was going up dramatically to the point where it was a noticeable part of our overall debt obligation as a country.
It fell in the Obama administration down to surprisingly, and I'm not sure how,
but it was, a lot of it had to do with the fees that were being paid to the agencies by their constituencies,
and they were paying off their debt and they weren't needing to borrow more.
And then it has gone back, it went back up after that administration.
It went up noticeably.
And if I remember the numbers right, it has begun to ease back off.
But it is a noticeable amount of money on the national debt.
You take the national debt that's official and this shadow debt that belongs to the age that was issued by the agencies,
it's kind of a noticeable little piece of the overall debt the country owes.
So there's that.
Now, the next one are munis, municipals.
Municipals, what we call munis, are issued by sovereigns below the level of the feds.
States, cities, school districts.
Now the thing about munis is that the interest is tax free at the federal level.
So these are, so they carry a lower coupon than a normal corporate debt would,
because you don't pay any federal tax.
But that is advantageous only to the highest tax bracket investors,
because they're the ones who would benefit the most from tax free status.
You should not buy munis.
You just shouldn't, because they pay a low coupon rate,
because that's adjusted for the fact that they're tax free to the richest people.
So if you get $1,000 in interest from a muni,
well, you don't pay that tax of 39%.
That'd be $390.
But if you're a lower class citizen, you would, let's say you're in a 10% tax bracket,
all you'd get would be $100.
And you could do much better by just buying a plain old corporate debt instrument.
You'd make more, even though you pay tax on it,
you'd make more off the coupon on a fully taxed instrument.
Munis, there are different varieties.
I had some genius in my first class, which is finance majors,
try to make a big thing about distinctions.
But overall, municipals, they're like a city wants a new water system or a new sewerage system.
Well, that's going to be a long-term obligation.
They would go to the munis market, to high tax bracket investors,
and they would sell them a bond issue.
Well, we've got to fix the sewer system.
Okay, that's going to cost us $15 million to do it.
Okay, they issue $15 million in munis.
A school district wants to build a new high school.
That would be technically a muni, a municipal.
Now, some municipals are just general obligations.
But some, and the terminology has changed a little bit over the years,
but a lot of times, like a school district,
they will raise the property tax for, let's say, the life of the bond, 20 years.
And that extra will be how they pay the bond, the bond for the school.
That way, the bondholders say, okay, we know we're going to get our money
because we've got this revenue that is specifically earmarked to pay us.
And that's why you vote for these school district tax levies.
That is the voter's approval to raise your property taxes
so that this bond can be issued and taken care of.
That's how it works.
Now, there are a few other kinds of bonds in this animal thing.
Classic, classic are the corporate bonds.
And they come in different risk categories, AAA, AA.
And as it goes down in quality, then, of course, the coupon would be higher.
That's why companies want to get these rating agencies to see them as very healthy,
because if you get a AAA rating, you can negotiate a bond coupon
that is lower than if you've got a AA or a single A.
As a matter of fact, that was what happened with Netflix.
Its bond rating, a couple of years ago, it borrowed over a billion dollars on notes.
And the rating agency said, are you joking? This is bad news.
You're not in all that great shape.
And so they gave the bond a junk rating.
I think it was a B rating, if I'm not mistaken, one of the Bs.
And, of course, the coupon was stupidly high.
At the time, that was a very high coupon rate on that bond.
They call it a note. It was 15 years. That's what drives me crazy.
15 years, they called it a note instead of a bond.
But one way or the other, the coupon was rather steep because it had a low grade, low rating.
Now, there's other kinds of bonds. One is a foreign bond.
They are actually kind of popular.
A foreign bond is a bond that is issued, but it pays its coupon and its face back in another currency.
Like there are companies here in the United States that issue bonds that are denominated in euros.
We pay you in euros. The coupons will come to you in euros.
And the face value will be paid in euros. That would be a foreign bond.
There are countries where they issue foreign bonds here.
We will pay you in American dollars, even though that might not be our country's currency.
One that I'm very familiar with, I teach in the summers in the Republic of Panama.
They issued two different bonds. I think the total of the two different issues was a couple of billion dollars.
It was not their currency, the Balboa. It was dollars.
They would pay the coupons and they would pay the interest.
Now, why did they do that?
Well, first of all, the Balboa is pegged to the dollar, but there was another reason.
Remember I told you about China?
What currency do they hold hundreds of billions of dollars? The People's Bank of China?
It's dollars. So, then the Panamanians were not stupid.
They issued in dollars because then they were saying,
China, you got dollars, we'll take your dollars, we'll pay you back in dollars.
And so, they by denominating in dollars, they magnetized their need for capital by making it pay off in dollars.
There is even one more that I would mention, commodity bonds.
The famous example was after World War II.
The United States committed itself to rebuilding Europe.
Basically, the Allies and the Axis had turned Europe into a debris field.
Everything was brought to the freaking ground.
There's a good movie that showed it kind of in its spectacular destruction,
it was called Museum Men a few years ago.
Good movie, but we said, we'll rebuild you.
And it was in our interest because otherwise the damn Soviets would have said,
we will rebuild you, comrade. So, we did it.
But what we did was we issued the bonds that would pay back in gold from Fort Knox.
It was a brilliant idea because of course the bond issues were subscribed fully.
Oh, wow, gold.
The bad part was that you know who was buying most of those bonds?
The rich, ancient European families.
So, what we did was they lent us the money, we paid it back in our gold in the countries where they lived
that we rebuilt.
We nearly wiped out Fort Knox, by the way.
Anyway, that's all I have for you today. I thank all of you.