1
00:00:00,000 --> 00:00:08,000
Alan Cring Productions in association with the Emergent Light Studio presents

2
00:00:08,000 --> 00:00:17,000
the Illinois State Collegiate Compendium, Academic Lectures in Business and Economics.

3
00:00:17,000 --> 00:00:24,000
This is Business Finance, FIL 240 for spring semester 2024.

4
00:00:24,000 --> 00:00:29,000
Introduction to Bonds

5
00:00:29,000 --> 00:00:36,000
Today, introduction to Bonds. This is the last lecture before midterm week.

6
00:00:36,000 --> 00:00:41,000
On Monday, we will review for the midterm exam.

7
00:00:41,000 --> 00:00:45,000
Now, there will be two parts to that review.

8
00:00:45,000 --> 00:00:49,000
There will be the part where I tell you what I think you should know.

9
00:00:49,000 --> 00:00:53,000
That's pretty useful since I'll write the exam, I should know what's on it.

10
00:00:53,000 --> 00:00:57,000
And then I open it for you to ask me questions.

11
00:00:57,000 --> 00:01:02,000
And if you say, well, is this going to be on the exam? If it's not, I'll say no.

12
00:01:02,000 --> 00:01:09,000
This is your chance to write your study guide for the midterm exam.

13
00:01:09,000 --> 00:01:14,000
And just for the weekend, just to get you prepping up,

14
00:01:14,000 --> 00:01:19,000
I do allow a 4x6 note card front and back for the exam.

15
00:01:19,000 --> 00:01:23,000
So you should start prepping that for it.

16
00:01:23,000 --> 00:01:30,000
You're also, of course, as I said, your financial analysis formulas sheet.

17
00:01:30,000 --> 00:01:35,000
You can have that. And I expect you to use Excel for the exam.

18
00:01:35,000 --> 00:01:41,000
Those templates that I have provided, the one that will be of principle importance to you

19
00:01:41,000 --> 00:01:50,000
will be the present values and future values template in your files in Canvas.

20
00:01:50,000 --> 00:01:56,000
So that's for you. Make sure that you know how to use it.

21
00:01:56,000 --> 00:02:01,000
And your study, you should be considering your notes as your primary.

22
00:02:01,000 --> 00:02:06,000
And then your quizzes, the midterm looks a lot like the quizzes.

23
00:02:06,000 --> 00:02:11,000
Basically like a big, big version of the quizzes.

24
00:02:11,000 --> 00:02:14,000
And then, of course, the podcasts.

25
00:02:14,000 --> 00:02:19,000
And as I've said before, if it's in the book but I haven't mentioned it,

26
00:02:19,000 --> 00:02:23,000
then it is not on the exam.

27
00:02:23,000 --> 00:02:30,000
If it's in my lecture but not in the book, I guarantee you that I will be asking those kinds of questions.

28
00:02:30,000 --> 00:02:33,000
Some material is both I've talked about it and it's in the book.

29
00:02:33,000 --> 00:02:36,000
Those are obviously fair game.

30
00:02:36,000 --> 00:02:40,000
But use those as your pivots for your studying.

31
00:02:40,000 --> 00:02:43,000
And then on Monday, as I said, we review.

32
00:02:43,000 --> 00:02:45,000
And then on Wednesday, we test.

33
00:02:45,000 --> 00:02:52,000
So that will give you something to look forward to over the coming weekend.

34
00:02:52,000 --> 00:02:58,000
As far as other matters are concerned, yeah?

35
00:02:58,000 --> 00:03:00,000
I was wondering if you know how long it takes to complete the book.

36
00:03:00,000 --> 00:03:04,000
50 questions. It's 75 minutes. It's a class period.

37
00:03:04,000 --> 00:03:11,000
You should be able to finish it within about 45 to 50 minutes.

38
00:03:11,000 --> 00:03:19,000
I make sure that I prepare an exam and I assume that it will take you about 50% longer,

39
00:03:19,000 --> 00:03:25,000
maybe a third longer time than I would take the exam.

40
00:03:25,000 --> 00:03:32,000
And I usually clock it in so I can finish it within about 30 minutes to myself.

41
00:03:32,000 --> 00:03:35,000
And I give you plenty more time than that.

42
00:03:35,000 --> 00:03:47,000
So that's up and coming, something for you to get excited about for the weekend and keep you busy.

43
00:03:47,000 --> 00:03:53,000
Now, as far as the content of the lecture today, this is Chapter 7.

44
00:03:53,000 --> 00:04:00,000
Now, Chapter 7 has terminology and concepts and it has math.

45
00:04:00,000 --> 00:04:06,000
I will not ask any questions about the math from Chapter 7.

46
00:04:06,000 --> 00:04:09,000
Math from other chapters is a fair game.

47
00:04:09,000 --> 00:04:14,000
But the math of Chapter 7, I will put that off until after spring break.

48
00:04:14,000 --> 00:04:21,000
You need to focus on about the first half of Chapter 7 is what I deal with,

49
00:04:21,000 --> 00:04:28,000
the memorization, terminology, concepts insofar as bonds are concerned.

50
00:04:28,000 --> 00:04:30,000
And we'll get to that in just a little bit.

51
00:04:30,000 --> 00:04:34,000
But before we do that, we'll have a quick look at the numbers.

52
00:04:34,000 --> 00:04:41,000
And we can see that this has just been a bouncing day up and down.

53
00:04:41,000 --> 00:04:43,000
It's all been negative.

54
00:04:43,000 --> 00:04:48,000
So there's a general grouchy sentiment in the market today.

55
00:04:48,000 --> 00:04:52,000
It's not anything hugely awful.

56
00:04:52,000 --> 00:04:55,000
The Dow is down 21%.

57
00:04:55,000 --> 00:05:01,000
The S&P 500 is down 0.21%.

58
00:05:01,000 --> 00:05:04,000
And the S&P is down 0.19%.

59
00:05:04,000 --> 00:05:09,000
And the NASDAQ, it's down enough to be noticeable, a little more than a half percent down.

60
00:05:09,000 --> 00:05:12,000
But I mean, it's not anything terrible.

61
00:05:12,000 --> 00:05:20,000
It's just one of those days where we've got the bears are grumpy and they're out winning the happy bulls.

62
00:05:20,000 --> 00:05:23,000
But there's not much to say about it.

63
00:05:23,000 --> 00:05:26,000
Although it's just up and down today.

64
00:05:26,000 --> 00:05:32,000
It's information, good news, bad news kind of trading back and forth through the day.

65
00:05:32,000 --> 00:05:39,000
Now crude, it had actually, again, like it has done a couple of times, it keeps testing.

66
00:05:39,000 --> 00:05:45,000
Remember I told you that trading band between about 72 a barrel and 79 a barrel,

67
00:05:45,000 --> 00:05:52,000
it keeps pushing up to that 79 and then it chickens out and it runs back down below it.

68
00:05:52,000 --> 00:05:58,000
So it really is a what we would call a resistance level.

69
00:05:58,000 --> 00:06:02,000
That's a term we sometimes talk about with stocks, commodities, bonds.

70
00:06:02,000 --> 00:06:07,000
It has a resistance level here at 79.

71
00:06:07,000 --> 00:06:10,000
But it is up there towards the top of it.

72
00:06:10,000 --> 00:06:16,000
Now that can be taken negative because it'll mean somewhat higher, slightly higher gas prices,

73
00:06:16,000 --> 00:06:18,000
which you're seeing at the pumps right now.

74
00:06:18,000 --> 00:06:23,000
But it also might be something of a good sign.

75
00:06:23,000 --> 00:06:27,000
We are now seeing a recovery.

76
00:06:27,000 --> 00:06:32,000
And it may be, I would argue we're in the early phase of an expansion.

77
00:06:32,000 --> 00:06:38,000
That would be attended by more trucks on the road doing deliveries of goods,

78
00:06:38,000 --> 00:06:43,000
more driving by people going places.

79
00:06:43,000 --> 00:06:52,000
So that more demand for gasoline and distillates like diesel and jet fuel

80
00:06:52,000 --> 00:06:57,000
might be a sign of a healthy economy coming.

81
00:06:57,000 --> 00:07:02,000
So just because the oil prices are going up a little bit, and this isn't anything insane

82
00:07:02,000 --> 00:07:07,000
like those $125, $150 per barrel prices,

83
00:07:07,000 --> 00:07:11,000
that might just be a sign of an economy that is recovering,

84
00:07:11,000 --> 00:07:18,000
that is coming back and people are driving around more, trucks, more trucks, fleet trucks on the road,

85
00:07:18,000 --> 00:07:23,000
getting stuff to stores or to industrial sites.

86
00:07:23,000 --> 00:07:25,000
So you can take it for that.

87
00:07:25,000 --> 00:07:27,000
Gold just doesn't want to go anyplace.

88
00:07:27,000 --> 00:07:32,000
It's still sitting above $2,000 an ounce, but it's not surging.

89
00:07:32,000 --> 00:07:36,000
So there's no evidence of some freak out apocalypse

90
00:07:36,000 --> 00:07:42,000
where the gold buyers are buying gold hand over fist.

91
00:07:42,000 --> 00:07:49,000
Taking it over here to the 10-year bond, the yield is definitely down, more than four basis points.

92
00:07:49,000 --> 00:07:52,000
That would mean that the price is up.

93
00:07:52,000 --> 00:07:57,000
That would mean that there is buying in the bond market.

94
00:07:57,000 --> 00:07:59,000
There's buying of bonds.

95
00:07:59,000 --> 00:08:03,000
So I want to make sure that you can do that.

96
00:08:03,000 --> 00:08:05,000
Think your way through it.

97
00:08:05,000 --> 00:08:09,000
Okay, I see that the yields are down.

98
00:08:09,000 --> 00:08:11,000
That would mean prices are up.

99
00:08:11,000 --> 00:08:16,000
That would mean the demand for bonds has increased.

100
00:08:16,000 --> 00:08:21,000
I would expect you to be able to walk through a chain of logic like that

101
00:08:21,000 --> 00:08:24,000
in a question on the midterm.

102
00:08:24,000 --> 00:08:28,000
Just make sure you've got it down.

103
00:08:28,000 --> 00:08:36,000
Well, now on the other side of the world, Tokyo just didn't have any particular care.

104
00:08:36,000 --> 00:08:47,000
It ended right about where it began, down about.08%, which is pretty much nothing.

105
00:08:47,000 --> 00:08:53,000
There just wasn't any clear direction, bullish or bearish,

106
00:08:53,000 --> 00:08:55,000
although through the day it was bearish.

107
00:08:55,000 --> 00:08:59,000
By the end it had come back to about flat.

108
00:08:59,000 --> 00:09:06,000
London, on the other hand, as you can see in the early trading before the midday,

109
00:09:06,000 --> 00:09:14,000
there was a stream of negative news, bearish news, that kept pushing it down and down.

110
00:09:14,000 --> 00:09:22,000
But about midday, no more news, good or bad, was driving the market in a direction.

111
00:09:22,000 --> 00:09:27,000
So it pretty much just floated for most of the rest of the day.

112
00:09:27,000 --> 00:09:34,000
And that's just that Newton's law of linear motion.

113
00:09:34,000 --> 00:09:40,000
If there's no news, then it doesn't change its direction.

114
00:09:40,000 --> 00:09:42,000
It just goes in the same direction it was.

115
00:09:42,000 --> 00:09:50,000
And so once the bad news had passed and been absorbed into the prices in the morning,

116
00:09:50,000 --> 00:09:56,000
there was no more news, so it just stayed where it was for most of the rest of the day.

117
00:09:56,000 --> 00:09:59,000
And that's sort of like good news.

118
00:09:59,000 --> 00:10:04,000
It must have been something that upset the London market.

119
00:10:04,000 --> 00:10:08,000
Hard to say, though, what it was.

120
00:10:08,000 --> 00:10:12,000
Now, let me take off from this.

121
00:10:12,000 --> 00:10:15,000
I want to show you one last thing.

122
00:10:15,000 --> 00:10:19,000
It's somewhat chapter six, but it's also chapter seven.

123
00:10:19,000 --> 00:10:24,000
And it's a technical, mathematical thing.

124
00:10:24,000 --> 00:10:28,000
And I'm going to show you the background of it, but I will prepare a sheet,

125
00:10:28,000 --> 00:10:32,000
an Excel sheet with you, we'll build one together,

126
00:10:32,000 --> 00:10:37,000
that will be able to do this so that you don't have to suffer through the mathy,

127
00:10:37,000 --> 00:10:39,000
if that's the lack of a better word, part of it.

128
00:10:39,000 --> 00:10:42,000
And it has to do with yields.

129
00:10:42,000 --> 00:10:44,000
You see those yields right there?

130
00:10:44,000 --> 00:10:48,000
I'm not going to use this example first, because this example is weird,

131
00:10:48,000 --> 00:10:50,000
because we've got an inverted yield curve.

132
00:10:50,000 --> 00:10:53,000
It still works, but the numbers look a little bit odd.

133
00:10:53,000 --> 00:10:55,000
But you see those yields right there?

134
00:10:55,000 --> 00:10:57,000
Well, let me do one here.

135
00:10:57,000 --> 00:11:06,000
The yield on a one year, the yield on a two year, and the yield on a three year.

136
00:11:06,000 --> 00:11:10,000
These are better done in whole years.

137
00:11:10,000 --> 00:11:17,000
Suppose the yield on a one year, Treasury, is 4.24%.

138
00:11:17,000 --> 00:11:23,000
The yield on a two year is 4.28%.

139
00:11:23,000 --> 00:11:35,000
The yield on a three year is, let's say, 4.34%.

140
00:11:35,000 --> 00:11:42,000
Now, these are actually composite yields,

141
00:11:42,000 --> 00:11:47,000
to the extent that, like the two year,

142
00:11:47,000 --> 00:11:56,000
that would be ending price over beginning price to the one over two years,

143
00:11:56,000 --> 00:11:58,000
minus one.

144
00:11:58,000 --> 00:12:05,000
The one year would be the ending price over the beginning price

145
00:12:05,000 --> 00:12:09,000
to the one over one, minus one.

146
00:12:09,000 --> 00:12:12,000
Remembering that formula for finding yields.

147
00:12:12,000 --> 00:12:20,000
And the three year would be the ending price over the beginning price

148
00:12:20,000 --> 00:12:23,000
to the one over three years, minus one.

149
00:12:23,000 --> 00:12:29,000
That's what those yields would be.

150
00:12:29,000 --> 00:12:34,000
They are what the market's price is at the beginning, at the end,

151
00:12:34,000 --> 00:12:37,000
divided by the beginning, to one over the number of years.

152
00:12:37,000 --> 00:12:40,000
That's how you calculate a yield.

153
00:12:40,000 --> 00:12:49,000
But they really aren't exactly what happened.

154
00:12:49,000 --> 00:13:02,000
See, that one year is one plus the interest rate for one year.

155
00:13:02,000 --> 00:13:07,000
So the one over one, minus one.

156
00:13:07,000 --> 00:13:16,000
The two year, what we see is a composite, an average, a geometric average.

157
00:13:16,000 --> 00:13:25,000
What really happened was that there was the one year times another rate,

158
00:13:25,000 --> 00:13:27,000
which was the two year.

159
00:13:27,000 --> 00:13:35,000
And those two equaled one plus the yield we see on a two year,

160
00:13:35,000 --> 00:13:38,000
to the second power, minus one.

161
00:13:38,000 --> 00:13:40,000
That's what we see.

162
00:13:40,000 --> 00:13:49,000
But inside of that was a one year, the current rate, plus a rate through the second year.

163
00:13:49,000 --> 00:13:57,000
We call that thing a forward rate.

164
00:13:57,000 --> 00:14:04,000
The rate that is actually the market think is going to happen in the second year.

165
00:14:04,000 --> 00:14:09,000
Not the average of what happened in one through one year one and two,

166
00:14:09,000 --> 00:14:19,000
but it is actually two rates, the one year and then the second year.

167
00:14:19,000 --> 00:14:27,000
And the third one is actually the one year rate,

168
00:14:27,000 --> 00:14:32,000
plus that forward rate from the second year,

169
00:14:32,000 --> 00:14:39,000
times one plus the rate from the third year.

170
00:14:39,000 --> 00:14:42,000
I shouldn't say that minus one.

171
00:14:42,000 --> 00:14:44,000
I should leave that minus one off.

172
00:14:44,000 --> 00:14:50,000
And that's the rate that we actually see is one plus,

173
00:14:50,000 --> 00:14:53,000
the one that we see in those yield curve charts,

174
00:14:53,000 --> 00:15:01,000
is the three year to the third power.

175
00:15:01,000 --> 00:15:03,000
You don't need to worry too much about that.

176
00:15:03,000 --> 00:15:07,000
Just follow how I calculate these.

177
00:15:07,000 --> 00:15:15,000
Now the first year rate is a yield and it is the first year's forward.

178
00:15:15,000 --> 00:15:18,000
We're seeing the forward, the first year.

179
00:15:18,000 --> 00:15:21,000
It's right there in that chart, 5.03%.

180
00:15:21,000 --> 00:15:28,000
In my example here, the one year is 4.24%.

181
00:15:28,000 --> 00:15:44,000
But the second year, rate for the first year is 4.24%.

182
00:15:44,000 --> 00:15:58,000
Now the second year, one plus.0424 times one plus the forward rate,

183
00:15:58,000 --> 00:16:07,000
which we don't see, should be one plus, where the hell did I write it?

184
00:16:07,000 --> 00:16:15,000
.0428 to the second power.

185
00:16:15,000 --> 00:16:19,000
This is how we can tease out the forward rate,

186
00:16:19,000 --> 00:16:28,000
what the markets think the rate interest rate is going to be in just the second year.

187
00:16:28,000 --> 00:16:33,000
The yield tells us what the average of the first and second year is.

188
00:16:33,000 --> 00:16:38,000
But the forward rate would tell us what the market thinks just the second year would be.

189
00:16:38,000 --> 00:16:40,000
So I can work this around.

190
00:16:40,000 --> 00:17:07,000
One plus R1 would be one plus.0428 squared over, that's one plus R2, I'm sorry, over one plus.0424.

191
00:17:07,000 --> 00:17:17,000
So R2, the forward second year, just the second year rate, just the second year rate.

192
00:17:17,000 --> 00:17:46,000
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.

193
00:17:46,000 --> 00:17:51,000
.0424, I'm sorry,.0424.

194
00:17:51,000 --> 00:17:58,000
And then I would minus the one.

195
00:17:58,000 --> 00:17:59,000
Is that right?

196
00:17:59,000 --> 00:18:01,000
Oh, I screwed that up.

197
00:18:01,000 --> 00:18:03,000
I keyed something in wrong.

198
00:18:03,000 --> 00:18:05,000
Let me fix that.

199
00:18:05,000 --> 00:18:19,000
I put a 1.028 instead of a 1.0428.

200
00:18:19,000 --> 00:18:31,000
So it's 1.0428 squared divided by 1.0424 and then minus one.

201
00:18:31,000 --> 00:18:59,000
So the forward rate, the second year interest rate, the market thinks it's going to be 4.32.

202
00:18:59,000 --> 00:19:19,000
Because if I did 1.0424 times 1.0432, the result would be one plus.0428 squared.

203
00:19:19,000 --> 00:19:22,000
This is technically called the Fisher effect.

204
00:19:22,000 --> 00:19:36,000
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.

205
00:19:36,000 --> 00:19:44,000
And the overall effect is a 4.28% for the two years combined.

206
00:19:44,000 --> 00:19:50,000
And that's what the market would be creating with the price of the two-year treasury.

207
00:19:50,000 --> 00:19:59,000
Now, taking it one more time, now that I have the one year and the forward on the second year,

208
00:19:59,000 --> 00:20:12,000
I can say that one plus.0424, the first year, times one plus.0432 in the second year,

209
00:20:12,000 --> 00:20:27,000
times the forward rate, one plus the forward rate over the third year, should be one plus.0434 to the third power.

210
00:20:27,000 --> 00:20:32,000
If you don't see how I'm doing this, you're not in any bad shape at all.

211
00:20:32,000 --> 00:20:39,000
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.

212
00:20:39,000 --> 00:20:55,000
But solving this, one plus the third year forward rate would be one plus.0434 to the third power

213
00:20:55,000 --> 00:21:11,000
over one plus.0424 times one plus.0432.

214
00:21:11,000 --> 00:21:16,000
Now, this is where you have to watch out for your math, for your calculator entry.

215
00:21:16,000 --> 00:21:19,000
Make sure that denominator is all in parentheses.

216
00:21:19,000 --> 00:21:44,000
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,

217
00:21:44,000 --> 00:21:49,000
I'm going to open parentheses, I'm going to put those two down there,

218
00:21:49,000 --> 00:22:08,000
1.0424 times 1.0432, is that, yeah, 1.0432.

219
00:22:08,000 --> 00:22:17,000
Close the parentheses so I hold that denominator together, and then minus the one that was on the other side.

220
00:22:17,000 --> 00:22:31,000
So the third year forward rate is.0447.

221
00:22:31,000 --> 00:22:46,000
The third year forward rate is 4.47.

222
00:22:46,000 --> 00:22:52,000
So this is what the yield curve says, 4.24, 4.28, 4.34.

223
00:22:52,000 --> 00:23:10,000
But the year by year would be the 4.24, the 4.32, and the 4.47.

224
00:23:10,000 --> 00:23:18,000
That would be each year taken separately instead of as a composite.

225
00:23:18,000 --> 00:23:29,000
It's hidden in the data, but it's useful for us, especially for things like long-term planning of your investments.

226
00:23:29,000 --> 00:23:32,000
Okay, we're going to do a project this year.

227
00:23:32,000 --> 00:23:39,000
So we would start with a risk-free rate of 4.24% to figure out what our cost of capital is.

228
00:23:39,000 --> 00:23:44,000
Well, what if we're going to wait until the second year?

229
00:23:44,000 --> 00:23:49,000
Well, the yield curve says that the rate will be 4.28.

230
00:23:49,000 --> 00:23:51,000
No, it doesn't.

231
00:23:51,000 --> 00:24:01,000
It says that in the second year, the market's right now expecting the rate to be 4.32%.

232
00:24:01,000 --> 00:24:05,000
Well, what happens if we put it off until the third year?

233
00:24:05,000 --> 00:24:09,000
Well, should we start with a risk-free rate of 4.34%?

234
00:24:09,000 --> 00:24:18,000
Well, you shouldn't, because right now the markets are actually whispering that in the third year,

235
00:24:18,000 --> 00:24:26,000
the rates we expect are going to be starting with a risk-free rate of 4.47%.

236
00:24:26,000 --> 00:24:37,000
So these are the rates that are actually being hinted in that year that we're considering starting a project.

237
00:24:37,000 --> 00:24:47,000
The yield curve is just like an average of the rates for two years or the rates for three years.

238
00:24:47,000 --> 00:24:51,000
And like I said, I'm not going to ask this on the midterm.

239
00:24:51,000 --> 00:24:53,000
I don't want my tires slashed.

240
00:24:53,000 --> 00:25:05,000
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.

241
00:25:05,000 --> 00:25:12,000
And we usually, it's kind of tricky when we go past three years, and I'll show you why.

242
00:25:12,000 --> 00:25:19,000
The yield curve, you see we got the one, two, three, so we can build it.

243
00:25:19,000 --> 00:25:25,000
But when you get past three, the next treasury security that is listed is at five years.

244
00:25:25,000 --> 00:25:28,000
So you've got a gap of years.

245
00:25:28,000 --> 00:25:34,000
So you get sort of like composite forwards after the third year.

246
00:25:34,000 --> 00:25:48,000
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.

247
00:25:48,000 --> 00:25:55,000
What base rate, risk-free rate, are we looking at for that?

248
00:25:55,000 --> 00:25:58,000
That was a lot like work.

249
00:25:58,000 --> 00:26:01,000
And again, don't be too concerned about it.

250
00:26:01,000 --> 00:26:06,000
You've got a question on the homework like this, and there's a little bit in the book about it.

251
00:26:06,000 --> 00:26:15,000
But I will also provide you with an Excel sheet that will make it a little bit more tolerable to do these calculations.

252
00:26:15,000 --> 00:26:20,000
But for the rest of this lecture, this is the introduction to bonds.

253
00:26:20,000 --> 00:26:24,000
This is all terminology and concepts.

254
00:26:24,000 --> 00:26:30,000
Now, the first thing that I would remind you, and I've said this on many occasions,

255
00:26:30,000 --> 00:26:43,000
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.

256
00:26:43,000 --> 00:26:53,000
It is a vast ocean of securities.

257
00:26:53,000 --> 00:26:56,000
But you don't hear about the bond market.

258
00:26:56,000 --> 00:26:59,000
All you hear about are stocks.

259
00:26:59,000 --> 00:27:01,000
Well, this stock went up today, this stock went down.

260
00:27:01,000 --> 00:27:04,000
I think this stock is a great investment.

261
00:27:04,000 --> 00:27:07,000
Or I would sell this stock.

262
00:27:07,000 --> 00:27:10,000
You don't hear a lot of talk about bonds.

263
00:27:10,000 --> 00:27:14,000
Hardly ever do you hear about them.

264
00:27:14,000 --> 00:27:16,000
The reason is simple.

265
00:27:16,000 --> 00:27:19,000
Stocks are exciting.

266
00:27:19,000 --> 00:27:22,000
They can go all over the place.

267
00:27:22,000 --> 00:27:28,000
You can go from a great price to zero in a day or two.

268
00:27:28,000 --> 00:27:34,000
Or you can become a millionaire in a couple of weeks with stock prices skyrocketing.

269
00:27:34,000 --> 00:27:37,000
That cannot happen with bonds.

270
00:27:37,000 --> 00:27:41,000
Well, it almost would never happen with bonds.

271
00:27:41,000 --> 00:27:45,000
It would almost never happen with bonds.

272
00:27:45,000 --> 00:27:49,000
I mean, theoretically, a stock price, it wouldn't happen.

273
00:27:49,000 --> 00:27:52,000
But a stock price could go to infinity.

274
00:27:52,000 --> 00:27:54,000
A bond price can't.

275
00:27:54,000 --> 00:27:57,000
It just cannot do that.

276
00:27:57,000 --> 00:28:03,000
Or to the point, the bond market is overall boring.

277
00:28:03,000 --> 00:28:09,000
The price of a bond from day to day, up a little bit, down a little bit.

278
00:28:09,000 --> 00:28:14,000
You're not going to get anyone to listen to your investment advice if you're saying,

279
00:28:14,000 --> 00:28:16,000
well, bonds went up three cents today.

280
00:28:16,000 --> 00:28:19,000
Boy, I am exhausted from watching that.

281
00:28:19,000 --> 00:28:21,000
It's not interesting at all.

282
00:28:21,000 --> 00:28:23,000
And there's good reason.

283
00:28:23,000 --> 00:28:26,000
There are two reasons, kind of interrelated.

284
00:28:26,000 --> 00:28:36,000
The first reason is that bondholders, the lenders, have the prior claim to cash flows.

285
00:28:36,000 --> 00:28:46,000
Before shareholders can get a penny in a dividend or plow back into the operations of the corporation to grow the company,

286
00:28:46,000 --> 00:28:54,000
whatever is owed to the bondholders in the current period must be satisfied.

287
00:28:54,000 --> 00:29:00,000
So there is much more certainty with bonds than there is stocks.

288
00:29:00,000 --> 00:29:07,000
Unless the company goes to hell, you're going to get your interest payment.

289
00:29:07,000 --> 00:29:10,000
You're going to get your nice little check in the mail.

290
00:29:10,000 --> 00:29:13,000
So that's the first reason.

291
00:29:13,000 --> 00:29:19,000
The second reason is that bonds have an anchor.

292
00:29:19,000 --> 00:29:29,000
At the end of a bond's life, you get your money, the lender gets the money back.

293
00:29:29,000 --> 00:29:34,000
So in other words, it is not whatever the sky's the limit or whatever.

294
00:29:34,000 --> 00:29:38,000
No, you get a specific amount of money.

295
00:29:38,000 --> 00:29:41,000
What you lent comes back.

296
00:29:41,000 --> 00:29:46,000
And so in other words, there's this rock solid anchor.

297
00:29:46,000 --> 00:29:51,000
And so the price can't go very far from that anchor.

298
00:29:51,000 --> 00:29:53,000
It can't.

299
00:29:53,000 --> 00:29:58,000
Because at the end, you get your thousand dollars as our base,

300
00:29:58,000 --> 00:30:05,000
as we always have a thousand as the index base, the face value.

301
00:30:05,000 --> 00:30:07,000
You're going to get it back.

302
00:30:07,000 --> 00:30:15,000
So how can the bond go all over the place if there is an endpoint with a specific amount of money at that endpoint?

303
00:30:15,000 --> 00:30:17,000
Stocks, there's no endpoint.

304
00:30:17,000 --> 00:30:20,000
Stocks live forever, at least theoretically.

305
00:30:20,000 --> 00:30:29,000
So it could go to any value, zero or to infinity and beyond.

306
00:30:29,000 --> 00:30:35,000
So that's why bonds are not as volatile as stocks.

307
00:30:35,000 --> 00:30:44,000
One, the bondholders know they get their money before any shareholders get theirs, prior claim versus residual claim.

308
00:30:44,000 --> 00:30:54,000
And there is a fixed amount that happens at the end of the life of the bond.

309
00:30:54,000 --> 00:31:01,000
So taking those two into account together, let's talk about the mechanism of a bond.

310
00:31:01,000 --> 00:31:04,000
Now, I use the word bond here generically.

311
00:31:04,000 --> 00:31:12,000
Remember I told you about bills, one year or less in time.

312
00:31:12,000 --> 00:31:16,000
Notes, two to seven, ten, fifteen years, whatever.

313
00:31:16,000 --> 00:31:28,000
And bonds, they are from fifteen or twenty years on out to twenty-five, thirty.

314
00:31:28,000 --> 00:31:31,000
Some bonds even go out to fifty years.

315
00:31:31,000 --> 00:31:37,000
There are even some that go longer than that for extremely long-term projects.

316
00:31:37,000 --> 00:31:43,000
So bonds, but I use the term bond for any of them.

317
00:31:43,000 --> 00:31:51,000
A bond, and I will use you as my example straw person.

318
00:31:51,000 --> 00:32:00,000
Okay, you are a corporation and you would like to borrow money.

319
00:32:00,000 --> 00:32:03,000
I am an investment bank.

320
00:32:03,000 --> 00:32:06,000
You don't want to have me buy stock.

321
00:32:06,000 --> 00:32:08,000
You want to do it as debt.

322
00:32:08,000 --> 00:32:10,000
Now there are reasons why that would be.

323
00:32:10,000 --> 00:32:19,000
Remember that once stock is out there, if you issued stock through me, that stock is eternal.

324
00:32:19,000 --> 00:32:25,000
A bond, you are done with it at the end of the life of the bond.

325
00:32:25,000 --> 00:32:32,000
So, taking all of that into consideration.

326
00:32:32,000 --> 00:32:44,000
What's going to happen, sort of in a really summarized way?

327
00:32:44,000 --> 00:32:55,000
You will come to me and you'll start out with, I should like to borrow ten million dollars.

328
00:32:55,000 --> 00:32:58,000
So, I'll say, well, let's get to work on it.

329
00:32:58,000 --> 00:33:04,000
Now, I will probably syndicate that bond, in other words, syndicate the issue.

330
00:33:04,000 --> 00:33:08,000
I'll get together with some other investment banking houses

331
00:33:08,000 --> 00:33:14,000
and we'll divvy up how we'll allocate the ten million dollars we lend you.

332
00:33:14,000 --> 00:33:18,000
Now, what you are going to do is issue a security to me.

333
00:33:18,000 --> 00:33:20,000
It's a bond.

334
00:33:20,000 --> 00:33:22,000
You sell me a bond.

335
00:33:22,000 --> 00:33:26,000
That means you are, and I buy it.

336
00:33:26,000 --> 00:33:28,000
You borrow money from me.

337
00:33:28,000 --> 00:33:31,000
You are issuing a bond.

338
00:33:31,000 --> 00:33:34,000
I am the purchaser of the bond.

339
00:33:34,000 --> 00:33:42,000
The price I'm paying is what I am lending you.

340
00:33:42,000 --> 00:33:47,000
It's like with a home mortgage.

341
00:33:47,000 --> 00:33:51,000
You decide that you want a nice, wonderful house.

342
00:33:51,000 --> 00:33:53,000
You go to me a banker.

343
00:33:53,000 --> 00:34:01,000
What you're actually doing is issuing a bond, and I am agreeing to buy that bond,

344
00:34:01,000 --> 00:34:03,000
and the price is what I lend you.

345
00:34:03,000 --> 00:34:05,000
That's what's going on.

346
00:34:05,000 --> 00:34:09,000
Technically speaking, you are the issuer of the bond.

347
00:34:09,000 --> 00:34:15,000
I am the investor in that bond.

348
00:34:15,000 --> 00:34:18,000
So, we work it out.

349
00:34:18,000 --> 00:34:26,000
We fight it out, we talk, we argue about all the ifs, ands, ors, and buts of it.

350
00:34:26,000 --> 00:34:38,000
And what ultimately comes of that is what's called a bond indenture agreement.

351
00:34:38,000 --> 00:34:45,000
This is the loan contract.

352
00:34:45,000 --> 00:34:52,000
For the first 20 years that I taught, I had never seen the actual bond indenture agreement.

353
00:34:52,000 --> 00:34:55,000
I'd never seen one.

354
00:34:55,000 --> 00:35:06,000
But some years back, I was going to visit a friend of mine who worked for an IAB in New York City,

355
00:35:06,000 --> 00:35:11,000
and I said, Marty, this is kind of a weird request.

356
00:35:11,000 --> 00:35:15,000
Do you have any bond indenture agreements so I could just see one?

357
00:35:15,000 --> 00:35:17,000
He said, sure, I got one.

358
00:35:17,000 --> 00:35:19,000
I got a bunch of them.

359
00:35:19,000 --> 00:35:20,000
Probably hundreds.

360
00:35:20,000 --> 00:35:22,000
I don't think he had hundreds.

361
00:35:22,000 --> 00:35:27,000
But he actually, when I went into his office, he put it on the table.

362
00:35:27,000 --> 00:35:28,000
It was a binder.

363
00:35:28,000 --> 00:35:30,000
It was thick.

364
00:35:30,000 --> 00:35:33,000
It was a contract from hell.

365
00:35:33,000 --> 00:35:37,000
And there are hundreds of thousands of these done.

366
00:35:37,000 --> 00:35:48,000
And so I got to see one and confirmed with all legalese, the who, the what, the when, how much, how long.

367
00:35:48,000 --> 00:35:57,000
Those are parts of it are called the covenants of the bond indenture agreement.

368
00:35:57,000 --> 00:36:02,000
The covenants.

369
00:36:02,000 --> 00:36:05,000
The who.

370
00:36:05,000 --> 00:36:12,000
The how much.

371
00:36:12,000 --> 00:36:14,000
The coupon rate.

372
00:36:14,000 --> 00:36:19,000
That's the interest rate.

373
00:36:19,000 --> 00:36:21,000
Sometimes you'll hear me say coupon.

374
00:36:21,000 --> 00:36:24,000
Technically the coupon is a dollar amount.

375
00:36:24,000 --> 00:36:28,000
The rate is a percentage.

376
00:36:28,000 --> 00:36:43,000
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.

377
00:36:43,000 --> 00:36:50,000
So that one is like the last thing that's typed in.

378
00:36:50,000 --> 00:37:08,000
So let's say we have let's say a hundred million.

379
00:37:08,000 --> 00:37:12,000
So the coupon rate, let's say it's 8%.

380
00:37:12,000 --> 00:37:23,000
So what that means is that the interest every year will be $8 million.

381
00:37:23,000 --> 00:37:35,000
And this is where I have to stop for a minute because consumer loans are not like corporate and government loans.

382
00:37:35,000 --> 00:37:39,000
In a consumer loan, we calculated those payments on a loan.

383
00:37:39,000 --> 00:37:45,000
Well, those payments pay the interest for the period.

384
00:37:45,000 --> 00:37:52,000
And they also pay some of the balance of the loan off.

385
00:37:52,000 --> 00:37:54,000
They service the debt.

386
00:37:54,000 --> 00:37:56,000
That's the interest.

387
00:37:56,000 --> 00:38:00,000
And they amortize the loan.

388
00:38:00,000 --> 00:38:03,000
That's the balance going down.

389
00:38:03,000 --> 00:38:11,000
With corporate and government debt, all that happens during the life of the loan is the service.

390
00:38:11,000 --> 00:38:15,000
The borrower pays the coupon.

391
00:38:15,000 --> 00:38:22,000
Does not touch the principal, the face value as we call it.

392
00:38:22,000 --> 00:38:24,000
Doesn't touch it.

393
00:38:24,000 --> 00:38:37,000
At the end, one last coupon is paid and the whole hundred million is paid back all at once.

394
00:38:37,000 --> 00:38:41,000
Now, practically speaking, they're not going to do that.

395
00:38:41,000 --> 00:38:46,000
The bond covenants will have something like a sinking fund.

396
00:38:46,000 --> 00:38:57,000
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.

397
00:38:57,000 --> 00:39:06,000
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,

398
00:39:06,000 --> 00:39:14,000
pay off some of the debt, that is, every year over the life.

399
00:39:14,000 --> 00:39:19,000
And by the end, there's not a hundred million, there might be five million.

400
00:39:19,000 --> 00:39:27,000
They have to agree that they're killing off some of the debt by buying it back in the open market.

401
00:39:27,000 --> 00:39:29,000
But one way or the other.

402
00:39:29,000 --> 00:39:30,000
Okay.

403
00:39:30,000 --> 00:39:35,000
Now, the next thing is the maturity date.

404
00:39:35,000 --> 00:39:43,000
When does it have to be paid off?

405
00:39:43,000 --> 00:39:46,000
Let's say that it's 2044.

406
00:39:46,000 --> 00:39:53,000
This is a 20-year loan.

407
00:39:53,000 --> 00:39:55,000
2044.

408
00:39:55,000 --> 00:40:10,000
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.

409
00:40:10,000 --> 00:40:23,000
And then in the year 2044, one last coupon is paid and the hundred million is killed, paid off, all at once.

410
00:40:23,000 --> 00:40:27,000
That's how corporate and government debt works.

411
00:40:27,000 --> 00:40:38,000
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.

412
00:40:38,000 --> 00:40:40,000
This is different.

413
00:40:40,000 --> 00:40:46,000
Corporate and government debt works like this.

414
00:40:46,000 --> 00:41:03,000
Now, unless otherwise specified, we always do things with a base face value of $1,000.

415
00:41:03,000 --> 00:41:14,000
So in other words, technically, the borrower here would have issued $100,000, $1,000 bonds.

416
00:41:14,000 --> 00:41:22,000
It just makes it a lot easier for us to do the calculations if we do it this way.

417
00:41:22,000 --> 00:41:28,000
This is called the face value.

418
00:41:28,000 --> 00:41:35,000
You'll hear me say face or face value on a calculator or in Excel, it's FV.

419
00:41:35,000 --> 00:41:52,000
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.

420
00:41:52,000 --> 00:41:59,000
Kind of unfortunately, you probably won't see the price.

421
00:41:59,000 --> 00:42:03,000
You will see something that is one-tenth of the price.

422
00:42:03,000 --> 00:42:08,000
The reference is on the hundred.

423
00:42:08,000 --> 00:42:27,000
So if the price of the bond, let's say, is $992, it would quote at 99.20 or in our parlance, 99.20.

424
00:42:27,000 --> 00:42:40,000
If the price of the bond were, let's say, $1,015, then we would quote 101.50 on the hundred.

425
00:42:40,000 --> 00:42:43,000
That's not a dollar amount.

426
00:42:43,000 --> 00:42:46,000
Unfortunately, there are some places where they show that as a dollar amount.

427
00:42:46,000 --> 00:42:48,000
It's not.

428
00:42:48,000 --> 00:42:51,000
I have a great story about that.

429
00:42:51,000 --> 00:43:07,000
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.

430
00:43:07,000 --> 00:43:09,000
There's one rich fellow I knew.

431
00:43:09,000 --> 00:43:12,000
He was an optometrist.

432
00:43:12,000 --> 00:43:14,000
He thought he was a genius.

433
00:43:14,000 --> 00:43:15,000
And he put in an order.

434
00:43:15,000 --> 00:43:21,000
He saw these bonds and he bought 10 of them.

435
00:43:21,000 --> 00:43:25,000
Not two hours later, he was cussing and swearing.

436
00:43:25,000 --> 00:43:30,000
He called me on the phone, cussing me out, and he said, I just got ripped off.

437
00:43:30,000 --> 00:43:42,000
I just got $9,980 taken out of my account for 10 bonds that cost $99.80 each.

438
00:43:42,000 --> 00:43:44,000
I'm like, Frank, you moron.

439
00:43:44,000 --> 00:43:45,000
That was a quote.

440
00:43:45,000 --> 00:43:47,000
That's not the price.

441
00:43:47,000 --> 00:43:49,000
Who made that up?

442
00:43:49,000 --> 00:43:52,000
Well, that's been around for about two centuries.

443
00:43:52,000 --> 00:43:54,000
Here's why.

444
00:43:54,000 --> 00:44:12,000
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,

445
00:44:12,000 --> 00:44:24,000
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.

446
00:44:24,000 --> 00:44:32,000
So all of these fancy people would buy their giant broad sheet and look at everything and get ready for the morning's trading.

447
00:44:32,000 --> 00:44:43,000
Well, the thing was that they had to get literally hundreds and hundreds of stock and bond prices onto the columns of that sheet.

448
00:44:43,000 --> 00:44:52,000
To save a little bit of column space, they made the bond prices a tenth.

449
00:44:52,000 --> 00:44:56,000
That's where that tradition of quoting on the tenth came from.

450
00:44:56,000 --> 00:45:07,000
And stock prices, only since, probably right around when you were born, stock prices didn't used to be quoted in dollars and cents.

451
00:45:07,000 --> 00:45:10,000
They were quoted in dollars and fractions.

452
00:45:10,000 --> 00:45:15,000
Like a stock would be 17 and a quarter.

453
00:45:15,000 --> 00:45:29,000
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.

454
00:45:29,000 --> 00:45:33,000
So that's where that tradition came from, if it sounds a little odd.

455
00:45:33,000 --> 00:45:38,000
Here's what's, for you though, here's what drives me crazy.

456
00:45:38,000 --> 00:45:45,000
There are two big things that we use Excel to calculate, the bond price and the bond yield.

457
00:45:45,000 --> 00:45:56,000
Okay, now, calculating the bond price, it comes out as a price, $992 or $1,015.

458
00:45:56,000 --> 00:46:03,000
But the bond quote, you have to enter information on the hundred.

459
00:46:03,000 --> 00:46:06,000
You don't put in the price, you put it on the hundred.

460
00:46:06,000 --> 00:46:17,000
So when you get to that Excel sheet that I have built for bonds, you'll see a big warning on the hundred.

461
00:46:17,000 --> 00:46:22,000
Just to tell you, don't put in, I'll give you a price, that's what we all talk, we talk in prices.

462
00:46:22,000 --> 00:46:26,000
But you don't put in a price, you put in a tenth of the price, for God's sake.

463
00:46:26,000 --> 00:46:31,000
Don't ask me why, it's just that's how it's done.

464
00:46:31,000 --> 00:46:41,000
Oh Lord, okay, but anyway, let me go on here about this, these two things.

465
00:46:41,000 --> 00:46:48,000
Here's, now the bond price is going to swing around the face value,

466
00:46:48,000 --> 00:46:51,000
because at the end you're going to get your $1,000 back.

467
00:46:51,000 --> 00:46:59,000
So it's not going to go far, usually, from that $1,000.

468
00:46:59,000 --> 00:47:06,000
It will swing around it slowly, it almost never would be a really strong movement.

469
00:47:06,000 --> 00:47:13,000
Like stocks can go up by percentage of 2%, half a percent.

470
00:47:13,000 --> 00:47:18,000
These don't move very much at all from day to day in normal situations.

471
00:47:18,000 --> 00:47:20,000
But why do they move at all?

472
00:47:20,000 --> 00:47:28,000
If you're going to get the $1,000 back at the end, why would the bond price move from $1,000?

473
00:47:28,000 --> 00:47:30,000
That's what you're going to get back.

474
00:47:30,000 --> 00:47:34,000
And the coupons are going to pay you, make it good all along the way,

475
00:47:34,000 --> 00:47:39,000
so they're servicing it completely, so it should stay at $1,000.

476
00:47:39,000 --> 00:47:43,000
Here's why it won't stay quite at $1,000.

477
00:47:43,000 --> 00:47:50,000
You see, this rate, the coupon rate, is set at the day of the loan.

478
00:47:50,000 --> 00:47:54,000
It's almost the day of the loan.

479
00:47:54,000 --> 00:47:59,000
Well, what happens if interest rates in the economy go up?

480
00:47:59,000 --> 00:48:06,000
The lender is stuck with 8% for 20 long years in this case.

481
00:48:06,000 --> 00:48:09,000
So in that case, I'm going to say this sucks.

482
00:48:09,000 --> 00:48:14,000
And there's going to be a lot of investors who will want to get rid of these bonds,

483
00:48:14,000 --> 00:48:18,000
whose coupon is lower than the market wants.

484
00:48:18,000 --> 00:48:23,000
So in that case like that, the price will go down.

485
00:48:23,000 --> 00:48:32,000
If the coupon is less than the market price,

486
00:48:32,000 --> 00:48:35,000
we call the market price the yield, the market rate.

487
00:48:35,000 --> 00:48:38,000
Let me put that as market rate, not price.

488
00:48:38,000 --> 00:48:43,000
Let me put that as market rate.

489
00:48:43,000 --> 00:48:48,000
That will cause the bond price to go down below $1,000.

490
00:48:48,000 --> 00:48:59,000
We say that below $1,000, the bond is selling at a discount to par,

491
00:48:59,000 --> 00:49:05,000
reflecting the fact that the coupon, which is fixed for the life of the loan,

492
00:49:05,000 --> 00:49:09,000
is below what the market wants.

493
00:49:09,000 --> 00:49:16,000
On the other hand, suppose that interest rates fall below 8%.

494
00:49:16,000 --> 00:49:19,000
Well, that would make the market happy.

495
00:49:19,000 --> 00:49:23,000
You would have buyers trying to get a hold of these.

496
00:49:23,000 --> 00:49:36,000
So when the coupon is larger than the market rate, the yield,

497
00:49:36,000 --> 00:49:41,000
then the bond is going to push up above $1,000.

498
00:49:41,000 --> 00:49:54,000
In this case, we say the bond is selling at a premium to par.

499
00:49:54,000 --> 00:49:56,000
They don't go far.

500
00:49:56,000 --> 00:50:00,000
I mean, you've got a company.

501
00:50:00,000 --> 00:50:04,000
Another thing that can happen is that after a bond is issued,

502
00:50:04,000 --> 00:50:08,000
the company itself could become riskier.

503
00:50:08,000 --> 00:50:11,000
So the market will say 8% isn't enough to cover the risk.

504
00:50:11,000 --> 00:50:15,000
Or a company could become healthier.

505
00:50:15,000 --> 00:50:22,000
So sometimes it's not just the economy that can move a premium and discount.

506
00:50:22,000 --> 00:50:24,000
It can be the company itself.

507
00:50:24,000 --> 00:50:30,000
Like, for example, Sears, it was a very, very healthy company many years ago.

508
00:50:30,000 --> 00:50:34,000
Its bonds sold right at about par.

509
00:50:34,000 --> 00:50:36,000
But then it started getting into terrible trouble.

510
00:50:36,000 --> 00:50:42,000
So those old bonds that were priced when the company was healthy,

511
00:50:42,000 --> 00:50:46,000
investors said that's not enough to cover the risk of this.

512
00:50:46,000 --> 00:50:51,000
And so there was a lot of selling of those bonds, and the price went down.

513
00:50:51,000 --> 00:50:56,000
On the other hand, there are some companies that were, at the time they borrowed the money,

514
00:50:56,000 --> 00:50:58,000
they were pretty darn risky.

515
00:50:58,000 --> 00:51:00,000
And so they had high coupon rates.

516
00:51:00,000 --> 00:51:05,000
But as time went along, they got healthier and stronger.

517
00:51:05,000 --> 00:51:10,000
And so now they would never have to pay that much in interest.

518
00:51:10,000 --> 00:51:14,000
And so those bonds sell at a premium to par

519
00:51:14,000 --> 00:51:19,000
because the coupon is way higher than the risk of the company is now.

520
00:51:19,000 --> 00:51:22,000
And you see it play out both ways.

521
00:51:22,000 --> 00:51:27,000
I mean, but like I said, it rarely goes too far.

522
00:51:27,000 --> 00:51:34,000
However, some companies, if a company is like JCPenney or Sears,

523
00:51:34,000 --> 00:51:37,000
they have virtually died.

524
00:51:37,000 --> 00:51:44,000
In a case like that, there's so much selling that the price goes way, way down.

525
00:51:44,000 --> 00:51:47,000
So the yield goes way, way up on them.

526
00:51:47,000 --> 00:51:52,000
And those we actually call junk bonds.

527
00:51:52,000 --> 00:51:55,000
Okay, junk is not a nice term.

528
00:51:55,000 --> 00:52:00,000
We say high yield investments.

529
00:52:00,000 --> 00:52:02,000
Those are out there.

530
00:52:02,000 --> 00:52:10,000
But most bonds, they float around the par value.

531
00:52:10,000 --> 00:52:18,000
But you might notice that I am linking this up to price and yield.

532
00:52:18,000 --> 00:52:25,000
Notice when the yield goes up above the coupon, the price goes down.

533
00:52:25,000 --> 00:52:30,000
As the yield goes down, the price goes up.

534
00:52:30,000 --> 00:52:38,000
I've been saying that almost every day about those bonds quotes that you see on the ticker board.

535
00:52:38,000 --> 00:52:41,000
That's what's going on here.

536
00:52:41,000 --> 00:52:45,000
Price and yield are inversely related.

537
00:52:45,000 --> 00:52:54,000
Now, oh, there's one more term, one more thing I want to give you over here just to cover something.

538
00:52:54,000 --> 00:52:58,000
The term of a bond.

539
00:52:58,000 --> 00:53:03,000
The term is how long the bond has left in its life.

540
00:53:03,000 --> 00:53:07,000
Like right now, see that 2044 bond there?

541
00:53:07,000 --> 00:53:09,000
Its term is 20 years.

542
00:53:09,000 --> 00:53:14,000
But suppose that we all live to the year 2030.

543
00:53:14,000 --> 00:53:16,000
That's going to happen for me.

544
00:53:16,000 --> 00:53:21,000
But we live that, well, then the term would be 14.

545
00:53:21,000 --> 00:53:32,000
Now, oddly, really the term is all that matters to doing the math calculations, price and yield.

546
00:53:32,000 --> 00:53:42,000
Strangely, and I'm not sure why this is, but Excel wants to know when the bond was issued.

547
00:53:42,000 --> 00:53:44,000
It's called the settlement date.

548
00:53:44,000 --> 00:53:50,000
For the life of me, I don't know why Excel wants this.

549
00:53:50,000 --> 00:53:59,000
So to create an Excel sheet, I kind of had to do some fancy footwork.

550
00:53:59,000 --> 00:54:03,000
Because usually you know the date of maturity.

551
00:54:03,000 --> 00:54:06,000
And you know the term.

552
00:54:06,000 --> 00:54:15,000
But Excel wants the date of maturity, the term, and the stupid settlement date when it was actually issued.

553
00:54:15,000 --> 00:54:20,000
And I'm like, for a lot of bonds, you don't see that in the quote.

554
00:54:20,000 --> 00:54:22,000
When did the, what was the date?

555
00:54:22,000 --> 00:54:24,000
They want it down to the day.

556
00:54:24,000 --> 00:54:28,000
And so I figured out how to fool Excel on that.

557
00:54:28,000 --> 00:54:32,000
But I would certainly not expect any sane person to bother.

558
00:54:32,000 --> 00:54:34,000
Hmm.

559
00:54:34,000 --> 00:54:35,000
Let me go on.

560
00:54:35,000 --> 00:54:39,000
Let me get out of this more technical side of it here.

561
00:54:39,000 --> 00:54:43,000
Probably forgot something I always do on this.

562
00:54:43,000 --> 00:54:49,000
But what kinds of bonds are out there?

563
00:54:49,000 --> 00:54:55,000
It is a veritable bestiary of bonds.

564
00:54:55,000 --> 00:55:03,000
It just drives a normal person, what kinds of bonds are there?

565
00:55:03,000 --> 00:55:06,000
What kind of a bond did you just name?

566
00:55:06,000 --> 00:55:12,000
The first classic famous bond would be a treasury.

567
00:55:12,000 --> 00:55:17,000
The government borrows money.

568
00:55:17,000 --> 00:55:22,000
If it's borrowing it for a few months, we call it a treasury bill, a T-bill.

569
00:55:22,000 --> 00:55:31,000
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.

570
00:55:31,000 --> 00:55:42,000
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.

571
00:55:42,000 --> 00:55:50,000
I'll show you something right now.

572
00:55:50,000 --> 00:55:54,000
I'm going to pull this out.

573
00:55:54,000 --> 00:56:04,000
I'll ask you, madam, at the very top of this one dollar bill, what do those three words at the top say?

574
00:56:04,000 --> 00:56:08,000
Federal Reserve Note.

575
00:56:08,000 --> 00:56:10,000
You can check it for yourself.

576
00:56:10,000 --> 00:56:12,000
This is a note.

577
00:56:12,000 --> 00:56:16,000
This is an IOU the government owes you.

578
00:56:16,000 --> 00:56:18,000
That's what it is.

579
00:56:18,000 --> 00:56:20,000
It's a bill.

580
00:56:20,000 --> 00:56:22,000
How do they pay this off?

581
00:56:22,000 --> 00:56:25,000
This is a treasury note.

582
00:56:25,000 --> 00:56:27,000
How do they pay it off?

583
00:56:27,000 --> 00:56:35,000
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.

584
00:56:35,000 --> 00:56:37,000
That's how they pay off.

585
00:56:37,000 --> 00:56:40,000
That's how the government pays off its debts.

586
00:56:40,000 --> 00:56:44,000
Is it just prints more of them?

587
00:56:44,000 --> 00:56:46,000
That's a treasury.

588
00:56:46,000 --> 00:56:52,000
Now, they are typically, I mean, an auction.

589
00:56:52,000 --> 00:56:59,000
The government borrows money because we don't collect enough taxes for our spending levels.

590
00:56:59,000 --> 00:57:10,000
What they'll do is they'll hold auctions where they will put different variety of these on the table.

591
00:57:10,000 --> 00:57:11,000
Sometimes.

592
00:57:11,000 --> 00:57:12,000
Sometimes it's just one.

593
00:57:12,000 --> 00:57:18,000
They'll maybe put some T-bills, some T-notes, and T-bonds on the table.

594
00:57:18,000 --> 00:57:22,000
And then investors will come and buy them.

595
00:57:22,000 --> 00:57:29,000
In other words, those investors are lending the government money, which the government will pay back.

596
00:57:29,000 --> 00:57:32,000
You buy a one-year T-bill.

597
00:57:32,000 --> 00:57:34,000
They do the short stuff.

598
00:57:34,000 --> 00:57:36,000
They just do it at a discount.

599
00:57:36,000 --> 00:57:42,000
So you pay $980 and in one year you'll get $1,000.

600
00:57:42,000 --> 00:57:46,000
So you get $20 for an investment of $980.

601
00:57:46,000 --> 00:57:48,000
What were they?

602
00:57:48,000 --> 00:57:50,000
Well, who buys these?

603
00:57:50,000 --> 00:57:53,000
Who is lending the government money?

604
00:57:53,000 --> 00:57:59,000
Well, in a backhanded way, you do to some extent.

605
00:57:59,000 --> 00:58:06,000
But the vast majority is through investment funds, mutual funds, trusts.

606
00:58:06,000 --> 00:58:15,000
And the biggest player that lends our government money buys that debt, those debt securities, our nations.

607
00:58:15,000 --> 00:58:20,000
China is a massive buyer, a massive lender.

608
00:58:20,000 --> 00:58:24,000
Well, how do the Chinese have all that money that they can...

609
00:58:24,000 --> 00:58:26,000
Remember, they have to buy in dollars.

610
00:58:26,000 --> 00:58:28,000
How do they have all those dollars?

611
00:58:28,000 --> 00:58:30,000
Oh, that's because we buy their stuff.

612
00:58:30,000 --> 00:58:34,000
You buy a toaster from China.

613
00:58:34,000 --> 00:58:39,000
You are importing a toaster and you're exporting that number of dollars,

614
00:58:39,000 --> 00:58:43,000
which then become foreign reserve in the People's Bank of China.

615
00:58:43,000 --> 00:58:47,000
China can't use those dollars anywhere in the United States, so what do they do?

616
00:58:47,000 --> 00:58:55,000
They just lend us back the money that we paid them to the tune of billions and billions of dollars.

617
00:58:55,000 --> 00:58:57,000
Who else does?

618
00:58:57,000 --> 00:59:04,000
The Arabs do, because we import oil and export dollars to their central banks.

619
00:59:04,000 --> 00:59:10,000
Japan, we buy their import cars and their radios and stuff.

620
00:59:10,000 --> 00:59:15,000
We export dollars to the Bank of Japan.

621
00:59:15,000 --> 00:59:23,000
A big one is Canada is a massive buyer, because these are countries that support us,

622
00:59:23,000 --> 00:59:31,000
because we can't afford to live the way we do with all of our spending.

623
00:59:31,000 --> 00:59:40,000
And it's not that it's on everything from services that we all rely on.

624
00:59:40,000 --> 00:59:45,000
Actually, welfare and all that is a very small part.

625
00:59:45,000 --> 00:59:52,000
Our defense industry, to make ourselves the armed weapon of the world, is a massive amount.

626
00:59:52,000 --> 00:59:58,000
We just spend money hand over fist, and yet we can't raise our taxes enough to pay for it,

627
00:59:58,000 --> 01:00:05,000
so the rest of the world takes care of us babies, because we can't care for our own dirty diapers.

628
01:00:05,000 --> 01:00:08,000
That's just the reality of it.

629
01:00:08,000 --> 01:00:10,000
Just a little warning shot to you there.

630
01:00:10,000 --> 01:00:16,000
Now, here's another interesting thing that the book doesn't mention, agency debt.

631
01:00:16,000 --> 01:00:23,000
Agency debt is debt that is issued by agencies of the United States government.

632
01:00:23,000 --> 01:00:30,000
Now, treasuries are low coupon because they're backed by the full face and credit of the United States.

633
01:00:30,000 --> 01:00:36,000
Agencies, however, some agencies borrow money on their own.

634
01:00:36,000 --> 01:00:41,000
They issue their own debt.

635
01:00:41,000 --> 01:00:46,000
An example of an agency, the Tennessee Valley Authority, TVA.

636
01:00:46,000 --> 01:00:48,000
There are a number of agencies out there.

637
01:00:48,000 --> 01:00:51,000
They borrow their own money.

638
01:00:51,000 --> 01:00:55,000
The treasury doesn't borrow for them.

639
01:00:55,000 --> 01:00:57,000
They borrow for themselves.

640
01:00:57,000 --> 01:01:01,000
Now, two interesting points about that.

641
01:01:01,000 --> 01:01:09,000
Agency debt technically does not have, is not backed by the full face and credit of the United States.

642
01:01:09,000 --> 01:01:18,000
We kind of assume that if an agency was about to default, the fed, the treasury would come in and make the debt whole.

643
01:01:18,000 --> 01:01:20,000
But it's not in writing.

644
01:01:20,000 --> 01:01:23,000
Now, agency debt, that's one thing.

645
01:01:23,000 --> 01:01:29,000
Agency debt, another part about it is that when we see the national debt,

646
01:01:29,000 --> 01:01:35,000
that's usually just the sum of all of the treasury paper out there.

647
01:01:35,000 --> 01:01:40,000
It does not include the agency paper out there.

648
01:01:40,000 --> 01:01:42,000
You have to dig to see what that is.

649
01:01:42,000 --> 01:01:45,000
And it can be a whopper.

650
01:01:45,000 --> 01:01:50,000
Now, I may be a little wrong about the timeline of this,

651
01:01:50,000 --> 01:01:56,000
but the agency debt was surging in the first decade of the 21st century.

652
01:01:56,000 --> 01:02:06,000
It was going up dramatically to the point where it was a noticeable part of our overall debt obligation as a country.

653
01:02:06,000 --> 01:02:16,000
It fell in the Obama administration down to surprisingly, and I'm not sure how,

654
01:02:16,000 --> 01:02:24,000
but it was, a lot of it had to do with the fees that were being paid to the agencies by their constituencies,

655
01:02:24,000 --> 01:02:28,000
and they were paying off their debt and they weren't needing to borrow more.

656
01:02:28,000 --> 01:02:34,000
And then it has gone back, it went back up after that administration.

657
01:02:34,000 --> 01:02:36,000
It went up noticeably.

658
01:02:36,000 --> 01:02:42,000
And if I remember the numbers right, it has begun to ease back off.

659
01:02:42,000 --> 01:02:48,000
But it is a noticeable amount of money on the national debt.

660
01:02:48,000 --> 01:02:58,000
You take the national debt that's official and this shadow debt that belongs to the age that was issued by the agencies,

661
01:02:58,000 --> 01:03:04,000
it's kind of a noticeable little piece of the overall debt the country owes.

662
01:03:04,000 --> 01:03:06,000
So there's that.

663
01:03:06,000 --> 01:03:11,000
Now, the next one are munis, municipals.

664
01:03:11,000 --> 01:03:25,000
Municipals, what we call munis, are issued by sovereigns below the level of the feds.

665
01:03:25,000 --> 01:03:29,000
States, cities, school districts.

666
01:03:29,000 --> 01:03:37,000
Now the thing about munis is that the interest is tax free at the federal level.

667
01:03:37,000 --> 01:03:45,000
So these are, so they carry a lower coupon than a normal corporate debt would,

668
01:03:45,000 --> 01:03:48,000
because you don't pay any federal tax.

669
01:03:48,000 --> 01:03:54,000
But that is advantageous only to the highest tax bracket investors,

670
01:03:54,000 --> 01:04:00,000
because they're the ones who would benefit the most from tax free status.

671
01:04:00,000 --> 01:04:03,000
You should not buy munis.

672
01:04:03,000 --> 01:04:07,000
You just shouldn't, because they pay a low coupon rate,

673
01:04:07,000 --> 01:04:14,000
because that's adjusted for the fact that they're tax free to the richest people.

674
01:04:14,000 --> 01:04:19,000
So if you get $1,000 in interest from a muni,

675
01:04:19,000 --> 01:04:25,000
well, you don't pay that tax of 39%.

676
01:04:25,000 --> 01:04:28,000
That'd be $390.

677
01:04:28,000 --> 01:04:35,000
But if you're a lower class citizen, you would, let's say you're in a 10% tax bracket,

678
01:04:35,000 --> 01:04:38,000
all you'd get would be $100.

679
01:04:38,000 --> 01:04:42,000
And you could do much better by just buying a plain old corporate debt instrument.

680
01:04:42,000 --> 01:04:45,000
You'd make more, even though you pay tax on it,

681
01:04:45,000 --> 01:04:50,000
you'd make more off the coupon on a fully taxed instrument.

682
01:04:50,000 --> 01:04:53,000
Munis, there are different varieties.

683
01:04:53,000 --> 01:04:59,000
I had some genius in my first class, which is finance majors,

684
01:04:59,000 --> 01:05:02,000
try to make a big thing about distinctions.

685
01:05:02,000 --> 01:05:12,000
But overall, municipals, they're like a city wants a new water system or a new sewerage system.

686
01:05:12,000 --> 01:05:15,000
Well, that's going to be a long-term obligation.

687
01:05:15,000 --> 01:05:21,000
They would go to the munis market, to high tax bracket investors,

688
01:05:21,000 --> 01:05:24,000
and they would sell them a bond issue.

689
01:05:24,000 --> 01:05:26,000
Well, we've got to fix the sewer system.

690
01:05:26,000 --> 01:05:29,000
Okay, that's going to cost us $15 million to do it.

691
01:05:29,000 --> 01:05:32,000
Okay, they issue $15 million in munis.

692
01:05:32,000 --> 01:05:36,000
A school district wants to build a new high school.

693
01:05:36,000 --> 01:05:40,000
That would be technically a muni, a municipal.

694
01:05:40,000 --> 01:05:44,000
Now, some municipals are just general obligations.

695
01:05:44,000 --> 01:05:49,000
But some, and the terminology has changed a little bit over the years,

696
01:05:49,000 --> 01:05:52,000
but a lot of times, like a school district,

697
01:05:52,000 --> 01:06:01,000
they will raise the property tax for, let's say, the life of the bond, 20 years.

698
01:06:01,000 --> 01:06:09,000
And that extra will be how they pay the bond, the bond for the school.

699
01:06:09,000 --> 01:06:14,000
That way, the bondholders say, okay, we know we're going to get our money

700
01:06:14,000 --> 01:06:21,000
because we've got this revenue that is specifically earmarked to pay us.

701
01:06:21,000 --> 01:06:26,000
And that's why you vote for these school district tax levies.

702
01:06:26,000 --> 01:06:30,000
That is the voter's approval to raise your property taxes

703
01:06:30,000 --> 01:06:36,000
so that this bond can be issued and taken care of.

704
01:06:36,000 --> 01:06:38,000
That's how it works.

705
01:06:38,000 --> 01:06:42,000
Now, there are a few other kinds of bonds in this animal thing.

706
01:06:42,000 --> 01:06:52,000
Classic, classic are the corporate bonds.

707
01:06:52,000 --> 01:06:57,000
And they come in different risk categories, AAA, AA.

708
01:06:57,000 --> 01:07:04,000
And as it goes down in quality, then, of course, the coupon would be higher.

709
01:07:04,000 --> 01:07:11,000
That's why companies want to get these rating agencies to see them as very healthy,

710
01:07:11,000 --> 01:07:17,000
because if you get a AAA rating, you can negotiate a bond coupon

711
01:07:17,000 --> 01:07:23,000
that is lower than if you've got a AA or a single A.

712
01:07:23,000 --> 01:07:27,000
As a matter of fact, that was what happened with Netflix.

713
01:07:27,000 --> 01:07:35,000
Its bond rating, a couple of years ago, it borrowed over a billion dollars on notes.

714
01:07:35,000 --> 01:07:41,000
And the rating agency said, are you joking? This is bad news.

715
01:07:41,000 --> 01:07:44,000
You're not in all that great shape.

716
01:07:44,000 --> 01:07:48,000
And so they gave the bond a junk rating.

717
01:07:48,000 --> 01:07:52,000
I think it was a B rating, if I'm not mistaken, one of the Bs.

718
01:07:52,000 --> 01:07:56,000
And, of course, the coupon was stupidly high.

719
01:07:56,000 --> 01:08:02,000
At the time, that was a very high coupon rate on that bond.

720
01:08:02,000 --> 01:08:06,000
They call it a note. It was 15 years. That's what drives me crazy.

721
01:08:06,000 --> 01:08:09,000
15 years, they called it a note instead of a bond.

722
01:08:09,000 --> 01:08:19,000
But one way or the other, the coupon was rather steep because it had a low grade, low rating.

723
01:08:19,000 --> 01:08:24,000
Now, there's other kinds of bonds. One is a foreign bond.

724
01:08:24,000 --> 01:08:27,000
They are actually kind of popular.

725
01:08:27,000 --> 01:08:36,000
A foreign bond is a bond that is issued, but it pays its coupon and its face back in another currency.

726
01:08:36,000 --> 01:08:43,000
Like there are companies here in the United States that issue bonds that are denominated in euros.

727
01:08:43,000 --> 01:08:48,000
We pay you in euros. The coupons will come to you in euros.

728
01:08:48,000 --> 01:08:53,000
And the face value will be paid in euros. That would be a foreign bond.

729
01:08:53,000 --> 01:08:57,000
There are countries where they issue foreign bonds here.

730
01:08:57,000 --> 01:09:06,000
We will pay you in American dollars, even though that might not be our country's currency.

731
01:09:06,000 --> 01:09:15,000
One that I'm very familiar with, I teach in the summers in the Republic of Panama.

732
01:09:15,000 --> 01:09:28,000
They issued two different bonds. I think the total of the two different issues was a couple of billion dollars.

733
01:09:28,000 --> 01:09:34,000
It was not their currency, the Balboa. It was dollars.

734
01:09:34,000 --> 01:09:37,000
They would pay the coupons and they would pay the interest.

735
01:09:37,000 --> 01:09:40,000
Now, why did they do that?

736
01:09:40,000 --> 01:09:46,000
Well, first of all, the Balboa is pegged to the dollar, but there was another reason.

737
01:09:46,000 --> 01:09:48,000
Remember I told you about China?

738
01:09:48,000 --> 01:09:54,000
What currency do they hold hundreds of billions of dollars? The People's Bank of China?

739
01:09:54,000 --> 01:10:02,000
It's dollars. So, then the Panamanians were not stupid.

740
01:10:02,000 --> 01:10:06,000
They issued in dollars because then they were saying,

741
01:10:06,000 --> 01:10:12,000
China, you got dollars, we'll take your dollars, we'll pay you back in dollars.

742
01:10:12,000 --> 01:10:23,000
And so, they by denominating in dollars, they magnetized their need for capital by making it pay off in dollars.

743
01:10:23,000 --> 01:10:31,000
There is even one more that I would mention, commodity bonds.

744
01:10:31,000 --> 01:10:36,000
The famous example was after World War II.

745
01:10:36,000 --> 01:10:41,000
The United States committed itself to rebuilding Europe.

746
01:10:41,000 --> 01:10:53,000
Basically, the Allies and the Axis had turned Europe into a debris field.

747
01:10:53,000 --> 01:10:56,000
Everything was brought to the freaking ground.

748
01:10:56,000 --> 01:11:01,000
There's a good movie that showed it kind of in its spectacular destruction,

749
01:11:01,000 --> 01:11:04,000
it was called Museum Men a few years ago.

750
01:11:04,000 --> 01:11:09,000
Good movie, but we said, we'll rebuild you.

751
01:11:09,000 --> 01:11:13,000
And it was in our interest because otherwise the damn Soviets would have said,

752
01:11:13,000 --> 01:11:16,000
we will rebuild you, comrade. So, we did it.

753
01:11:16,000 --> 01:11:25,000
But what we did was we issued the bonds that would pay back in gold from Fort Knox.

754
01:11:25,000 --> 01:11:32,000
It was a brilliant idea because of course the bond issues were subscribed fully.

755
01:11:32,000 --> 01:11:34,000
Oh, wow, gold.

756
01:11:34,000 --> 01:11:39,000
The bad part was that you know who was buying most of those bonds?

757
01:11:39,000 --> 01:11:44,000
The rich, ancient European families.

758
01:11:44,000 --> 01:11:53,000
So, what we did was they lent us the money, we paid it back in our gold in the countries where they lived

759
01:11:53,000 --> 01:11:56,000
that we rebuilt.

760
01:11:56,000 --> 01:12:00,000
We nearly wiped out Fort Knox, by the way.

761
01:12:00,000 --> 01:12:23,000
Anyway, that's all I have for you today. I thank all of you.