WEBVTT

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Welcome back to the Deep Dive. Today, we're tackling

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a segment of the financial world that is just

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colossal. I mean, we're talking about a market

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estimated to be four times the size of the global

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equity market, and yet... It often gets overlooked

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or dismissed as too boring. We're talking about

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the world of fixed income. We're talking about

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bonds. When people think of dramatic returns,

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they think of tech stocks or maybe commodities.

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But the bond market is really the engine room

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of global finance. It provides the stability

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and the capital for governments, for corporations,

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for everything in between. We hear terms like

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treasuries and junk bonds all the time. But if

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you actually look closer, these instruments are

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massively diverse and, frankly, surprisingly

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nuanced. That's absolutely right. Our sources

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really confirm this is an area where a little

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bit of knowledge goes a very long way, especially

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for you, the discerning investor. So our mission

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today is simple. We are moving far beyond the

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simple description of a bond as just an IOU.

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We're going to conduct a deep dive into the very

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fabric of debt securities. We'll explore the

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mechanics of pricing, the critical features,

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the extensive taxonomy of bonds, and perhaps

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most importantly, we will dissect the risks that

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make fixed income anything but truly fixed or

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boring. We want you to walk away understanding

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the subtle but profound difference between a

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zero -coupon bond and a Methuselah. I really

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appreciate that focus on nuance. We have a robust

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stack of material defining this instrument, detailing

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its history, laying out its diverse categories

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and warning us about the inherent risks. It's

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time to find those aha moments hidden in the

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fine print of a bond indenture. OK, let's unpack

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that core definition. We often say a bond is

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an IOU, but what does that really mean legally

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and financially? Fundamentally, a bond is an

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instrument of indebtedness. It's a security under

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which the issuer, the debtor, whether that's

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a government or a large corporation. owes the

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holder a specified debt. The holder is the creditor.

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You are the lender. It's really just a formalized

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loan, but it's often broken up into small tradable

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units. And that formality, it carries a real

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legal weight, doesn't it? A significant obligation,

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yes. The issuer is legally bound to provide a

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cash flow based on the terms laid out in the

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bonds contract or its indenture. And this cash

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flow consists of two primary commitments. First,

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repaying the principal, that's the original borrowed

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amount, at a pre -specified maturity date. And

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second, paying interest, which we famously call

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the coupon, over a defined period of time. It's

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so interesting how long this basic concept has

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been around. The source material notes that the

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use of bond as a financial instrument that binds

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one party to pay another dates back to at least

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the 1590s. It ties right back to the etymology

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of the word bind. It is, like you said, an ancient

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concept just modernized. And that heritage is

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important because unlike equity, which can be

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highly adaptable, the terms of debt are historically

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very, very rigid. Once that bond is issued, the

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issuer is bound to that cash flow schedule no

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matter what. So before we get into the structure,

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we have to address this essential distinction,

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the one that separates the bond world from the

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stock world. It's the great divide in investing,

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the difference between ownership and lending.

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This is the critical starting point for any learner.

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You have to get this. When you buy a stock, you

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are buying an equity stake. You are a partial

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owner of the company. You participate in its

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profits and you share in its losses. You're along

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for the ride. Exactly. But when you buy a bond,

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you gain a creditor stake. You are simply a lender.

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Your return is fixed by the contract. You don't

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get to share in any excess profits if the company

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has a blockbuster year. But you're also shielded

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from the immediate losses, right? Right. You

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don't absorb losses until the issuer actually

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defaults on its payments. And this difference

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in status, it matters immensely when that company

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or that entity runs into financial trouble. Where

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do I, as a bondholder, stand in the hierarchy,

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in the pecking order. You stand much, much higher

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than a shareholder. Bondholders, as creditors,

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have priority over stockholders in a bankruptcy

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or liquidation scenario. They get repaid in advance

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of the owners. In many, many high -profile bankruptcies,

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the equity holders are just wiped out entirely.

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Their stock goes to zero. And the bondholders.

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The bondholders still have a chance to claw back

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some percentage of their investment. I mean,

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sometimes it's significantly reduced, but it's

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still more than zero. OK, so you're ahead of

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the shareholders. But are you at the very top

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of the list? Not quite. It's crucial to remember

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that while you are ahead of stockholders, you

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still rank behind secured creditors. A secured

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creditor is often a bank whose loan is backed

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by specific collateral like real estate or machinery.

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They get paid first from the sale of that specific

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collateral. So they have a direct claim on an

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asset. Precisely. Bondholders are typically unsecured

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creditors, meaning they rely on the general assets

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of the company, but they are still definitively

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legally ahead of the shareholders. So if the

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company goes under, the bondholder stands a chance

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of recovery, the stockholder usually does not.

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Another core difference is just the lifespan

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of the instrument itself. Exactly. Stocks generally

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remain outstanding indefinitely. They last as

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long as the company exists. Bonds, on the other

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hand, have a defined term or maturity after which

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the debt is redeemed and the obligation is liquidated.

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The contract is over. Although you did mention

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that rare, almost mythological exception to the

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rule. Yes, the irredeemable bonds or perpetuities.

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They have no maturity date, which means the issuer

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only has to pay the coupon forever and never

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repays the principal. They're historically significant,

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but for all practical purposes, bonds are temporary

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instruments. And one small but important clarification

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from our sources here. We are focusing on long

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-term debt. So what are we excluding based on

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that term length? We are excluding instruments

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that are typically under one year in length.

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Things like short -term commercial paper or bank

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certificates of deposit, CDs, those fall under

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the category of money market instruments. So

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when we talk about bonds, we're really talking

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about securities used for long -term capital

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financing. Correct. And who is participating

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in this massive long -term lending market? Who's

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issuing these things? Oh, the list of issuers

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is comprehensive. You have governments all the

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way down to local authorities. You have credit

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institutions, corporations of all sizes, and

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specialized super... institutions like the World

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Bank or the European Investment Bank. It's a

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truly global ecosystem. And for it to be an ecosystem,

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these things have to be tradable. Crucially,

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yes, almost all modern bonds are negotiable.

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This means ownership can be transferred easily

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in what's called the secondary market. If they

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weren't easily sellable, they just wouldn't be

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attractive to investors. This liquidity is facilitated

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by transfer agents. Historically, this required

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a really cumbersome process, like a medallion

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signature guarantee to verify ownership when

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you were transferring the physical security.

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Today, thankfully, most of this is electronic.

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And with that sheer volume of debt being traded,

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you must need a clear way to identify them. If

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I'm looking at a complex global portfolio, how

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do I know exactly which security I'm looking

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at? That's where standardization comes in. Bonds

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are uniquely identified by the International

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Securities Identification Number, or IS. ISIN.

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Right. It's a 12 -digit alphanumeric code that

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allows the security to be tracked, listed, and

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traded globally. And this is essential given

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that the bond market is often decentralized and

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over -the -counter, or OTC, which is very different

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from stocks that trade on a few central exchanges.

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Okay. Now that we have the foundation... contract

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established, let's break the bond down into its

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core components. We have to start with the amount

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borrowed, the principal. What should you, the

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learner, know about this central figure? The

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principal is the heart of the bond. It's also

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known as the nominal amount, par value, or the

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face amount. This is the figure the issuer uses

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to calculate interest payments, and it is the

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amount the issuer is obliged to repay at the

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end of the term. And there's a standard amount,

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right? For simplicity, yes. Most corporate bonds

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and treasuries are issued with a face value of

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$1 ,000. It just makes the math easier for everyone

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involved. You mentioned in Part 1 that for a

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plain vanilla bond, par is what you get back.

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But what about those exceptions that make things

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complicated? The complexity really arises in

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what are called structured bonds. In these cases,

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the redemption amount might be different from

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the face amount. For example, a bond might have

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its principal repayment linked to the performance

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of a certain stock index, or maybe a basket of

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commodities. So your principal isn't guaranteed?

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Not necessarily. If the index rises, the bondholder

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gets more than the nominal amount. But if it

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falls, they might get less. This adds an element

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of, well... non -fixed return to the fixed income

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world but these are very specialized instruments

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moving on we tackle the dimension of time maturity

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how flexible is the bond market when it comes

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to the term length the term or the tenor can

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be incredibly flexible it can range from slightly

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over one year to many many decades the maturity

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date is fixed when the bond is issued after this

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date Assuming all payments were made, the issuer's

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contractual obligations are complete. And for

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most investors, the easiest way to categorize

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maturity is to look at the standards set by the

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big liquid markets like the U .S. Treasury. Exactly.

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They have very precise terminology based on the

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length of the loan and it's language you hear

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all the time. So you have bills or T -bills.

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These are short -term debt maturing in under

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one year. Then you have notes or T -notes. That's

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medium -term debt maturing between one and 10

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years. And finally, bonds or T -bonds. That's

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long -term debt. maturing between 10 and 30 years.

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And understanding that distinction bill, note,

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bond is essential when you're talking about U

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.S. government debt. Because while they're all

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just debt, they behave very differently in a

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portfolio, especially when it comes to interest

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rate risk. Absolutely. A 30 -year bond is far,

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far more sensitive to interest rate fluctuations

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than a one -year note is. We'll definitely get

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more into that later. Okay, that sets up the

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timing. Now let's discuss the predictable income

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stream, the coupon. What's the standard mechanism

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for payment? The coupon is the interest rate,

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and it's stated as a percentage of the nominal

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value that the issuer pays to the holder. The

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payments are overwhelmingly semi -annual or annual.

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The history of the name is one of my favorite

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financial anecdotes. It's so literal. It truly

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illustrates how physical this market once was.

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When bonds were paper certificates, they literally

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had perforated slips attached to them, the coupons.

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So you'd actually clip them. You would physically

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detach one of these slips every six months, take

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it down to your bank and hand it in to receive

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your interest payment. Hence the coupon rate.

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That process, of course, is entirely electronic

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now, but the name just stuck. And we have two

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major structures for how that coupon payment

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works. Fixed and floating. Give us the rundown

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on why an investor would choose one over the

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other. The fixed rate bond is the default assumption.

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It's what most people think of. The coupon rate

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is constant for the entire life of the bond.

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If you buy a 5 % fixed rate bond with a $1 ,000

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face value, you know exactly what $50 you're

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going to receive every year for the next 10 years.

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So it offers predictability. Total predictability

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of income. Now, floating rate notes or FRNs,

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they do the opposite. They offer dynamic protection.

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The coupon is not static. It varies. It varies

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because it is linked to a money market reference

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rate, something like SOFR. That's the secured

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overnight financing rate or Eurobore in Europe.

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The coupon rate is usually that reference rate

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plus a defined spread. Or margin. So if the reference

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rate goes up, my coupon payment goes up. And

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if the reference rate falls, my payment falls.

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Exactly. The rate is recalculated periodically.

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It could be monthly, quarterly or semi -annually.

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FRNs are excellent instruments if an investor

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is worried about rising interest rates. Right.

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Because in a rising rate environment, the market

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value of a fixed rate bond falls. But an FRN's

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value. It remains relatively stable because its

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interest payment adjusts upwards to meet the

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new market rates. The tradeoff, of course, is

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that the investor gives up that predictability

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of income. OK, we've covered the fixed amounts,

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principal and coupon. But the real rate of return,

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the thing everyone cares about, is defined by

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the yield. And this is where clarity is just

00:12:18.840 --> 00:12:21.899
essential. We have to distinguish the simple

00:12:21.899 --> 00:12:25.059
current yield from the much more complex yield

00:12:25.059 --> 00:12:27.610
to maturity. You absolutely must remember this

00:12:27.610 --> 00:12:29.690
distinction. The coupon rate is the interest

00:12:29.690 --> 00:12:32.070
rate printed on the bond's face. The yield is

00:12:32.070 --> 00:12:34.389
the actual return you, the investor, receive

00:12:34.389 --> 00:12:36.629
based on the price you paid for the bond in the

00:12:36.629 --> 00:12:39.730
market today. They are not the same thing unless

00:12:39.730 --> 00:12:42.950
you buy the bond at exactly its par value. So

00:12:42.950 --> 00:12:44.830
let's start with the simply one, current yield.

00:12:45.240 --> 00:12:47.220
The current yield, or sometimes called the running

00:12:47.220 --> 00:12:49.700
yield, is a simple calculation. You just take

00:12:49.700 --> 00:12:51.700
the annual interest payment and divide it by

00:12:51.700 --> 00:12:54.879
the bond's current market price. If a bond pays

00:12:54.879 --> 00:12:58.980
$50 annually but is trading at $900 today, your

00:12:58.980 --> 00:13:03.539
current yield is 5 .55%. It's a simple cash -on

00:13:03.539 --> 00:13:05.960
-cash measure for right now. Simple, but it doesn't

00:13:05.960 --> 00:13:08.500
tell the whole story. Not at all. Which brings

00:13:08.500 --> 00:13:10.419
us to the gold standard for bond assessment,

00:13:10.779 --> 00:13:14.309
yield to maturity. or YTM. Can you define that

00:13:14.309 --> 00:13:17.059
for us and tell us why it's so critical? YTM,

00:13:17.320 --> 00:13:19.779
also known as the redemption yield, is the estimated

00:13:19.779 --> 00:13:21.940
total rate of return you can anticipate if you

00:13:21.940 --> 00:13:24.259
buy the bond at today's price, hold it all the

00:13:24.259 --> 00:13:26.220
way to maturity, and receive all scheduled coupon

00:13:26.220 --> 00:13:29.000
payments and the final principal. It's the single

00:13:29.000 --> 00:13:31.059
interest rate that equalizes the present value

00:13:31.059 --> 00:13:33.019
of all the bond's future cash flows with its

00:13:33.019 --> 00:13:35.419
current market price. It is, for all intents

00:13:35.419 --> 00:13:37.820
and purposes, the true measure of your anticipated

00:13:37.820 --> 00:13:40.899
compounded return. That sounds definitive, which

00:13:40.899 --> 00:13:43.279
is why people rely on it. But here is the massive

00:13:43.279 --> 00:13:45.960
caveat we must spend time on. The one that undermines

00:13:45.960 --> 00:13:48.519
the certainty many casual investors assume YTM

00:13:48.519 --> 00:13:51.139
offers. This is the critical nuance. I mean,

00:13:51.139 --> 00:13:52.600
it's what financial professionals understand

00:13:52.600 --> 00:13:55.519
well, but it often confuses the general public.

00:13:55.720 --> 00:13:58.220
The YTM you see calculated on your screen when

00:13:58.220 --> 00:14:01.259
you buy a bond, it is only a potential rate of

00:14:01.259 --> 00:14:04.559
return. It is absolutely not a guarantee. OK,

00:14:04.639 --> 00:14:07.080
so why isn't it a guarantee? You only realize

00:14:07.080 --> 00:14:11.940
that exact YTM if two very stringent and frankly

00:14:11.940 --> 00:14:13.840
hypothetical conditions are met throughout the

00:14:13.840 --> 00:14:16.700
entire life of the bond. First, the investor

00:14:16.700 --> 00:14:18.980
has to ensure that all those semiannual coupon

00:14:18.980 --> 00:14:21.539
payments, which are cash flows, are immediately

00:14:21.539 --> 00:14:24.019
reinvested into new assets rather than being

00:14:24.019 --> 00:14:26.100
spent. OK, so you can't use the income. You have

00:14:26.100 --> 00:14:28.259
to put it back to work. Exactly. And second,

00:14:28.500 --> 00:14:31.279
and this is the killer, every single one of those

00:14:31.279 --> 00:14:33.639
coupon payments must be reinvested at the exact

00:14:33.679 --> 00:14:36.080
Exact same interest rate as the initial YTM you

00:14:36.080 --> 00:14:38.100
calculated when you first bought the bond. So,

00:14:38.159 --> 00:14:41.899
if I buy a 15 -year bond today with a calculated

00:14:41.899 --> 00:14:45.840
YTM of 7%, I only truly lock in that 7 % if,

00:14:45.940 --> 00:14:48.240
for the next 15 years, every single coupon I

00:14:48.240 --> 00:14:50.159
receive can be immediately put back into the

00:14:50.159 --> 00:14:52.820
market and earn a consistent, compounding 7 %

00:14:52.820 --> 00:14:55.419
return. Precisely. Which is almost impossible.

00:14:56.319 --> 00:14:58.820
If, over those 15 years, market interest rates

00:14:58.820 --> 00:15:01.820
fall, you are now forced to reinvest your coupons

00:15:01.820 --> 00:15:05.879
at a lower prevailing rate, say 5 % or 4%. This

00:15:05.879 --> 00:15:08.360
shortfall is known as reinvestment risk. And

00:15:08.360 --> 00:15:10.600
it means my actual total return over the bond's

00:15:10.600 --> 00:15:13.759
life will be lower than that initial 7 % YTM

00:15:13.759 --> 00:15:16.700
I was quoted. It will be lower. This is a huge

00:15:16.700 --> 00:15:19.769
point of confusion. The YTM assumes the future

00:15:19.769 --> 00:15:22.190
market perfectly mirrors the present investment

00:15:22.190 --> 00:15:24.850
rate, which, as we know, is almost never true

00:15:24.850 --> 00:15:27.649
in the real world. So YTM is really a theoretical

00:15:27.649 --> 00:15:29.909
calculation. It's a benchmark, not a promise.

00:15:30.149 --> 00:15:32.970
Exactly. For an institutional investor, especially

00:15:32.970 --> 00:15:35.830
one focusing on total return, they have to factor

00:15:35.830 --> 00:15:37.929
in the uncertainty of that future reinvestment

00:15:37.929 --> 00:15:41.070
rate. For an individual, maybe a retiree, who

00:15:41.070 --> 00:15:43.389
is using the coupon payments for immediate income,

00:15:43.629 --> 00:15:46.610
what we call a set liability matching, the reinvestment

00:15:46.610 --> 00:15:48.200
risk might... be irrelevant. Because they're

00:15:48.200 --> 00:15:50.059
spending the cash, not reinvesting it. Right.

00:15:50.179 --> 00:15:53.200
But for portfolio growth, YTM should always be

00:15:53.200 --> 00:15:55.600
viewed as an anticipated rate, one that's highly

00:15:55.600 --> 00:15:57.320
sensitive to future interest rate movements.

00:15:57.600 --> 00:16:01.179
We know the anatomy. Now, how does a bond actually

00:16:01.179 --> 00:16:04.659
get created and sold? Let's start with the corporate

00:16:04.659 --> 00:16:07.940
and institutional side, the primary market, which

00:16:07.940 --> 00:16:10.120
relies heavily on something called underwriting.

00:16:10.539 --> 00:16:12.879
Right. So when a corporation needs to raise a

00:16:12.879 --> 00:16:15.059
large amount of capital via debt, they turn to

00:16:15.059 --> 00:16:17.679
securities firms and investment banks. These

00:16:17.679 --> 00:16:20.220
firms form a syndicate, which is led by a small

00:16:20.220 --> 00:16:22.639
group known as book runners. The syndicate then

00:16:22.639 --> 00:16:25.940
buys the entire issue of the bonds from the issuer.

00:16:26.200 --> 00:16:29.080
They're essentially acting as a middleman. And

00:16:29.080 --> 00:16:31.419
then they turn around and resell those bonds

00:16:31.419 --> 00:16:33.919
to investors like pension funds and mutual funds.

00:16:34.080 --> 00:16:36.139
Why do they do that? Yeah. Why not just have

00:16:36.139 --> 00:16:38.759
the company sell the bonds directly to the public?

00:16:39.159 --> 00:16:41.460
Because the banks take on the underwriting risk.

00:16:41.620 --> 00:16:44.139
The issuer, the corporation, gets their guaranteed

00:16:44.139 --> 00:16:46.500
lump sum of cash immediately. They're happy.

00:16:46.799 --> 00:16:49.019
The banks then assume the risk that they might

00:16:49.019 --> 00:16:51.019
not be able to sell all the bonds to the public

00:16:51.019 --> 00:16:53.120
at the price they're hoping for. And they get

00:16:53.120 --> 00:16:55.179
paid for taking that risk. Of course. They charge

00:16:55.179 --> 00:16:57.039
a fee for this service. And the role of the book

00:16:57.039 --> 00:16:59.480
runner, you said, is pivotal in this process.

00:17:00.080 --> 00:17:02.320
they are the orchestrators they arrange the whole

00:17:02.320 --> 00:17:05.160
issue they advise the issuer on all the critical

00:17:05.160 --> 00:17:08.299
factors timing interest rate the optimal price

00:17:08.299 --> 00:17:11.119
to maximize the proceeds while ensuring the bonds

00:17:11.119 --> 00:17:14.539
actually sell they're listed prominently in any

00:17:14.539 --> 00:17:16.440
announcement of the issue traditionally called

00:17:16.440 --> 00:17:19.420
the tombstone ads which reflects their lead role

00:17:19.420 --> 00:17:22.059
in bringing the debt to market Are there alternatives

00:17:22.059 --> 00:17:25.460
for smaller issuers who maybe can't afford that

00:17:25.460 --> 00:17:29.160
big process? Yes. For smaller or maybe highly

00:17:29.160 --> 00:17:31.660
specialized issues, they might opt for a private

00:17:31.660 --> 00:17:34.440
placement. This avoids the underwriting cost

00:17:34.440 --> 00:17:37.059
entirely because the bonds are sold directly

00:17:37.059 --> 00:17:40.000
to a select, sophisticated group of investors,

00:17:40.299 --> 00:17:43.160
usually large institutions. What's the tradeoff?

00:17:43.259 --> 00:17:45.140
The tradeoff is that these bonds are often less

00:17:45.140 --> 00:17:47.680
liquid. They're not easily tradable in the wider

00:17:47.680 --> 00:17:49.440
secondary market because they weren't registered

00:17:49.440 --> 00:17:52.319
for public sale. And historically, we also had

00:17:52.319 --> 00:17:54.619
something called the tap issue, which was used

00:17:54.619 --> 00:17:57.160
primarily by governments. The government would

00:17:57.160 --> 00:17:59.259
offer bonds over a period of time at a preset

00:17:59.259 --> 00:18:02.660
fixed price, but the volume they issued depended

00:18:02.660 --> 00:18:04.900
on market demand on any given day. So they could

00:18:04.900 --> 00:18:06.599
just tap the market when conditions were right.

00:18:06.619 --> 00:18:09.420
Exactly. It's less common today for major issues.

00:18:09.680 --> 00:18:12.940
Speaking of governments, their bonds, treasuries,

00:18:12.960 --> 00:18:15.440
are typically issued through a different mechanism

00:18:15.440 --> 00:18:18.740
entirely, the auction. How does that differ from

00:18:18.740 --> 00:18:20.680
underwriting? The government auction process

00:18:20.680 --> 00:18:23.279
is more market driven right at the point of sale.

00:18:23.740 --> 00:18:26.339
The government, unlike a corporation in an underwriting

00:18:26.339 --> 00:18:29.440
deal, it fixes the terms, the maturity, and the

00:18:29.440 --> 00:18:32.539
coupon rate in advance. Then banks and approved

00:18:32.539 --> 00:18:34.920
market makers, and sometimes the public, they

00:18:34.920 --> 00:18:37.759
bid for the bonds. The price, and therefore the

00:18:37.759 --> 00:18:39.519
yield that the investor receives, is determined

00:18:39.519 --> 00:18:42.299
by the collective market bids. This method ensures

00:18:42.299 --> 00:18:44.460
that the debt is priced fairly based on current

00:18:44.460 --> 00:18:46.920
supply and demand. Okay, so once the bond is

00:18:46.920 --> 00:18:49.799
issued, it moves into the secondary market. If

00:18:49.799 --> 00:18:51.960
I want to buy an existing bond, what dictates

00:18:51.960 --> 00:18:54.359
its market price? The market price is the outcome

00:18:54.359 --> 00:18:56.839
of a financial calculation. It is the present

00:18:56.839 --> 00:18:59.140
value of all the expected future cash flows,

00:18:59.299 --> 00:19:01.440
that's the stream of coupons and the final principal

00:19:01.440 --> 00:19:04.460
payment, all discounted back to the present using

00:19:04.460 --> 00:19:07.420
the current required yield to maturity. And this

00:19:07.420 --> 00:19:09.619
brings us back to the most critical concept in

00:19:09.619 --> 00:19:12.720
bond valuation, the inverse relationship. When

00:19:12.720 --> 00:19:15.519
market interest rates rise, bond prices must

00:19:15.519 --> 00:19:18.529
fall. And when market interest rates fall, Bond

00:19:18.529 --> 00:19:21.349
prices must rise. Let's just dedicate a moment

00:19:21.349 --> 00:19:23.950
to making sure we all completely grasp why this

00:19:23.950 --> 00:19:25.930
relationship is non -negotiable. It's so fundamental.

00:19:26.230 --> 00:19:28.950
It is. Consider this. A corporation issues a

00:19:28.950 --> 00:19:31.609
10 -year bond two years ago with a 4 % coupon.

00:19:31.849 --> 00:19:34.869
You paid $1 ,000 for it at the time. Today, the

00:19:34.869 --> 00:19:37.390
central bank raises interest rates and new comparable

00:19:37.390 --> 00:19:39.769
eight -year bonds are being issued with a 6 %

00:19:39.769 --> 00:19:42.799
coupon. Okay. Now, if you try to sell your old

00:19:42.799 --> 00:19:45.339
4 % bond for $1 ,000, why would anyone buy it?

00:19:45.380 --> 00:19:47.759
They could just go buy a brand new 6 % bond for

00:19:47.759 --> 00:19:49.819
the same price and get a higher income stream.

00:19:50.019 --> 00:19:52.180
They wouldn't. It makes no sense. They won't.

00:19:52.410 --> 00:19:55.009
Therefore, the market price of your old 4 % bond

00:19:55.009 --> 00:19:58.150
must drop below $1 ,000. It has to trade at a

00:19:58.150 --> 00:20:00.470
discount. And it will keep dropping until the

00:20:00.470 --> 00:20:02.569
overall return it offers, which includes the

00:20:02.569 --> 00:20:04.529
gain you get when it pulls to par at maturity,

00:20:04.769 --> 00:20:07.529
equals the 6 % rate available on the new bonds.

00:20:07.690 --> 00:20:10.190
The price adjusts downward until the yield is

00:20:10.190 --> 00:20:12.630
competitive. This is a mechanism by which the

00:20:12.630 --> 00:20:14.950
bond market maintains equilibrium. That makes

00:20:14.950 --> 00:20:18.029
the mechanics crystal clear. So in the market,

00:20:18.210 --> 00:20:21.640
how are prices quoted? Prices are expressed as

00:20:21.640 --> 00:20:24.140
a percentage of the nominal value or par. Par

00:20:24.140 --> 00:20:26.759
is always 100. So if the price is greater than

00:20:26.759 --> 00:20:29.859
100, say 105, the bond is trading at a premium.

00:20:30.339 --> 00:20:32.740
This usually means market rates have fallen since

00:20:32.740 --> 00:20:35.059
it was issued. If the price is less than 100,

00:20:35.279 --> 00:20:38.339
maybe 95, it is trading at a discount. This means

00:20:38.339 --> 00:20:40.480
market rates have risen or perhaps the perceived

00:20:40.480 --> 00:20:42.920
risk of default has gone up. And when we're discussing

00:20:42.920 --> 00:20:45.279
price, we have to clarify the difference between

00:20:45.279 --> 00:20:47.940
the clean price and the dirty price. This catches

00:20:47.940 --> 00:20:51.069
a lot of people out. It does. So when a coupon

00:20:51.069 --> 00:20:54.109
payment is due, you receive the full interest

00:20:54.109 --> 00:20:56.970
amount for the previous six months. If you buy

00:20:56.970 --> 00:20:59.369
a bond exactly halfway through that six month

00:20:59.369 --> 00:21:02.450
period, the seller is entitled to half of that

00:21:02.450 --> 00:21:04.670
next coupon payment because they held the bond

00:21:04.670 --> 00:21:07.289
for half the period. Fairly fair. Right. So the

00:21:07.289 --> 00:21:10.109
dirty price includes this accrued interest, which

00:21:10.109 --> 00:21:13.250
is common in Europe. The clean price, which is

00:21:13.250 --> 00:21:15.730
the standard quoted price in the U .S. market,

00:21:15.930 --> 00:21:19.130
excludes the accrued interest. But when you actually

00:21:19.130 --> 00:21:21.430
execute a trade, the cash settlement you pay

00:21:21.430 --> 00:21:23.930
is the clean price plus the accrued interest.

00:21:24.470 --> 00:21:27.190
This just ensures the seller is compensated for

00:21:27.190 --> 00:21:29.289
the days they held the debt since the last payment.

00:21:29.410 --> 00:21:31.849
A final dynamic related to price is the pull

00:21:31.849 --> 00:21:34.230
-to -par phenomenon. This is a really predictable

00:21:34.230 --> 00:21:37.529
behavioral feature of bonds. As a bond gets closer

00:21:37.529 --> 00:21:40.230
and closer to its maturity date, its market price,

00:21:40.450 --> 00:21:42.849
whether it was trading at a premium of 120 or

00:21:42.849 --> 00:21:45.890
a discount of 80, must gradually converge toward

00:21:45.890 --> 00:21:48.769
the par value of 100. And why is that? Because

00:21:48.769 --> 00:21:51.490
on that maturity date, the issuer is contractually

00:21:51.490 --> 00:21:54.849
obligated to repay exactly 100. No more, no less.

00:21:55.269 --> 00:21:57.670
So the market price has to meet that fixed endpoint.

00:21:58.319 --> 00:22:00.759
This convergence reduces the price volatility

00:22:00.759 --> 00:22:03.140
as maturity gets closer, assuming, of course,

00:22:03.180 --> 00:22:04.920
that the issuer is still financially healthy

00:22:04.920 --> 00:22:07.319
and expected to pay. That leads us perfectly

00:22:07.319 --> 00:22:09.960
into the risk side of the equation. Credit quality.

00:22:10.500 --> 00:22:13.339
What is the fundamental measurement here? Credit

00:22:13.339 --> 00:22:15.599
quality measures the probability that the bondholder

00:22:15.599 --> 00:22:18.680
will receive all promised payments, both coupon

00:22:18.680 --> 00:22:22.460
and principal, on time and in full. This is the

00:22:22.460 --> 00:22:25.259
domain of the big credit rating agencies like

00:22:25.259 --> 00:22:28.400
Standard & Poor's or Moody's. They assign ratings

00:22:28.400 --> 00:22:30.339
from AAA, which is the highest, all the way down

00:22:30.339 --> 00:22:33.420
to D for default. And this rating is what determines

00:22:33.420 --> 00:22:35.299
whether a bond is considered investment grade

00:22:35.299 --> 00:22:38.390
or high yield. Correct. Bonds rated below investment

00:22:38.390 --> 00:22:40.450
grade are universally referred to as high yield

00:22:40.450 --> 00:22:44.009
bonds or the more famous term junk bonds. Investors

00:22:44.009 --> 00:22:46.109
demand a significantly higher yield for these

00:22:46.109 --> 00:22:48.390
because the chance of default is materially higher.

00:22:48.589 --> 00:22:50.869
They need to be compensated for taking on that

00:22:50.869 --> 00:22:53.170
additional credit risk. You touched on this earlier,

00:22:53.250 --> 00:22:56.289
but let's elaborate. Are there truly any risk

00:22:56.289 --> 00:22:59.470
free bonds? We typically treat U .S. Treasury

00:22:59.470 --> 00:23:02.349
bonds as the benchmark for safety. The financial

00:23:02.349 --> 00:23:04.589
world operates under the convention that U .S.

00:23:04.589 --> 00:23:06.650
Treasury bonds are risk free. They're backed

00:23:06.650 --> 00:23:09.069
by the full faith and credit of the U .S. government,

00:23:09.269 --> 00:23:12.420
which can, in theory, always print money to pay

00:23:12.420 --> 00:23:15.599
its debts. However, our sources do note that

00:23:15.599 --> 00:23:19.460
in reality, no bond is entirely risk free. Even

00:23:19.460 --> 00:23:21.539
the most stable governments carry some minute

00:23:21.539 --> 00:23:24.339
residual risk. And we can see evidence of this

00:23:24.339 --> 00:23:26.220
in the market. Oh, absolutely. We see it when

00:23:26.220 --> 00:23:28.180
we look internationally. Different sovereign

00:23:28.180 --> 00:23:30.539
governments, even those within the eurozone where

00:23:30.539 --> 00:23:32.759
the currency risk is removed, issue bonds that

00:23:32.759 --> 00:23:35.200
trade at different yields. This reflects the

00:23:35.200 --> 00:23:36.880
market's perceived differences in their ability

00:23:36.880 --> 00:23:39.819
or willingness to pay. A bond issued by Germany

00:23:39.819 --> 00:23:42.940
might be AAA, but another large developed nation

00:23:42.940 --> 00:23:46.480
might only achieve AA plus nation. This tells

00:23:46.480 --> 00:23:48.500
you the market assesses slightly different risk

00:23:48.500 --> 00:23:51.420
levels, even among the safest debtors. So the

00:23:51.420 --> 00:23:53.660
bond market is acting as this impartial mechanism

00:23:53.660 --> 00:23:56.480
for continuously pricing sovereign risk. All

00:23:56.480 --> 00:23:58.640
day, every day. The universe of fixed income

00:23:58.640 --> 00:24:01.440
is vast, and the terms we use change depending

00:24:01.440 --> 00:24:04.440
on who is issuing the debt. Let's start with

00:24:04.440 --> 00:24:06.759
the taxonomy categorized by the nature of the

00:24:06.759 --> 00:24:09.599
issuer and the security they offer. We begin

00:24:09.599 --> 00:24:12.400
at the top with government bonds or treasury

00:24:12.400 --> 00:24:14.839
bonds issued by sovereign national governments.

00:24:15.079 --> 00:24:18.039
And while the most stable nations are the benchmarks

00:24:18.039 --> 00:24:20.980
for safety, we must never forget the historical

00:24:20.980 --> 00:24:25.559
reality. Nations do default or they restructure

00:24:25.559 --> 00:24:27.480
their debt. It happens more often than people

00:24:27.480 --> 00:24:30.700
think. Absolutely. Argentina, Greece, Russia

00:24:30.700 --> 00:24:33.420
and others serve as stark reminders that sovereign

00:24:33.420 --> 00:24:36.039
risk is always present, even if it feels remote

00:24:36.039 --> 00:24:38.619
for major global powers. Just below that sovereign

00:24:38.619 --> 00:24:42.039
level, we find supranational bonds or supras.

00:24:42.119 --> 00:24:44.779
These are debt instruments issued by organizations

00:24:44.779 --> 00:24:47.299
that transcend national boundaries, like the

00:24:47.299 --> 00:24:49.380
World Bank or the International Monetary Fund.

00:24:49.740 --> 00:24:51.420
Because they are often backed by many highly

00:24:51.420 --> 00:24:53.460
rated member governments, they tend to carry

00:24:53.460 --> 00:24:55.799
extremely good credit ratings, often at the highest

00:24:55.799 --> 00:24:58.740
level, AAA. This makes them favorites for conservative

00:24:58.740 --> 00:25:01.220
institutional investors. Next up are municipal

00:25:01.220 --> 00:25:04.339
bonds or munis, which are issued by local authorities,

00:25:04.559 --> 00:25:08.059
cities or federal states. In the U .S., their

00:25:08.059 --> 00:25:10.920
primary draw is the favorable tax treatment.

00:25:11.240 --> 00:25:13.140
Munis are unique because their interest payments

00:25:13.140 --> 00:25:15.579
are frequently exempt from federal income tax,

00:25:15.759 --> 00:25:17.940
and sometimes they're also exempt from state

00:25:17.940 --> 00:25:21.019
and local taxes if you, the bondholder, reside

00:25:21.019 --> 00:25:23.119
in the state that issued it. So it's a double

00:25:23.119 --> 00:25:26.119
or even triple tax -free income stream. Potentially,

00:25:26.240 --> 00:25:28.759
yes. And this tax advantage means the issuer

00:25:28.759 --> 00:25:30.960
can offer a lower nominal coupon rate than a

00:25:30.960 --> 00:25:33.240
corporate bond, yet the after -trump's return

00:25:33.240 --> 00:25:35.420
for the investor can still be competitive or

00:25:35.420 --> 00:25:38.420
even superior. Within munis, we have a crucial

00:25:38.420 --> 00:25:41.319
subset, revenue bonds. These are interesting

00:25:41.319 --> 00:25:43.640
because they isolate the risk. How exactly does

00:25:43.640 --> 00:25:46.059
that isolation work? Revenue bonds are typically

00:25:46.059 --> 00:25:49.200
non -recourse debt. This means their repayment

00:25:49.200 --> 00:25:51.319
is guaranteed only by the revenues generated

00:25:51.319 --> 00:25:54.220
by a specific, dedicated project they funded.

00:25:54.420 --> 00:25:57.619
For example, a new bridge, a public hospital,

00:25:57.759 --> 00:26:01.099
or a sports stadium. So if the toll road fails

00:26:01.099 --> 00:26:03.079
to generate enough revenue to cover the debt

00:26:03.079 --> 00:26:05.880
payments, the bondholders usually cannot seek

00:26:05.880 --> 00:26:08.400
payment from the city's general tax revenue fund.

00:26:08.579 --> 00:26:10.940
Their claim is limited to that project's cash

00:26:10.940 --> 00:26:13.599
flow. That makes the credit analysis very localized.

00:26:13.980 --> 00:26:16.240
You're not evaluating the financial health of

00:26:16.240 --> 00:26:18.099
a whole city. You're evaluating the business

00:26:18.099 --> 00:26:21.160
plan for a single bridge. Precisely. And we should

00:26:21.160 --> 00:26:24.400
also mention the Build America bonds, or B -ABS,

00:26:24.539 --> 00:26:27.099
which were authorized back in 2009. These were

00:26:27.099 --> 00:26:29.740
an interesting hybrid. Unlike traditional munis,

00:26:29.799 --> 00:26:31.759
their interest was subject to federal taxation.

00:26:32.059 --> 00:26:34.240
Which seems like a disadvantage. It was, but

00:26:34.240 --> 00:26:36.539
they were exempt in the state of issuance. And

00:26:36.539 --> 00:26:38.819
crucially, they often offered higher yields than

00:26:38.819 --> 00:26:40.880
standard munis because of government subsidies.

00:26:41.240 --> 00:26:43.759
This was designed to attract a broader base of

00:26:43.759 --> 00:26:46.700
taxable investors to municipal projects. We can

00:26:46.700 --> 00:26:49.619
shift gears slightly to corporate bonds issued

00:26:49.619 --> 00:26:51.880
by corporations and the more specialized debt

00:26:51.880 --> 00:26:54.380
instruments, like climate bonds or green bonds.

00:26:54.890 --> 00:26:57.289
These specialized bonds are corporate or government

00:26:57.289 --> 00:27:00.549
debt, where the proceeds are specifically earmarked

00:27:00.549 --> 00:27:03.029
for environmentally beneficial or climate related

00:27:03.029 --> 00:27:05.769
projects. For example, when the UK government

00:27:05.769 --> 00:27:08.970
issued its green bonds in 2021, the expectation

00:27:08.970 --> 00:27:11.369
was that the money raised would only be used

00:27:11.369 --> 00:27:14.049
to fund things like renewable energy or sustainable

00:27:14.049 --> 00:27:16.710
infrastructure. So they satisfy investors looking

00:27:16.710 --> 00:27:19.730
for both a financial return and a specific environmental

00:27:19.730 --> 00:27:22.529
impact. Exactly. It's a growing market. And historically,

00:27:22.650 --> 00:27:24.960
we also see bonds with a very distinct purpose,

00:27:25.160 --> 00:27:28.059
war bonds. These are government bonds issued

00:27:28.059 --> 00:27:31.299
specifically to finance military operations or

00:27:31.299 --> 00:27:34.059
wartime expenditure. They are often sold with

00:27:34.059 --> 00:27:36.619
powerful patriotic appeals and they typically

00:27:36.619 --> 00:27:38.779
offered a lower rate of return than the market

00:27:38.779 --> 00:27:41.200
might otherwise demand. They often served more

00:27:41.200 --> 00:27:43.859
as a patriotic contribution than a pure financial

00:27:43.859 --> 00:27:46.380
investment. Finally, in this issuer category,

00:27:46.700 --> 00:27:49.319
we have the highly complex asset -backed securities,

00:27:49.519 --> 00:27:52.640
ABS, which gained a lot of notoriety in the 2008

00:27:52.640 --> 00:27:56.589
crisis. Right. ABS are bonds whose payments are

00:27:56.589 --> 00:27:59.109
derived from the cash flows of underlying pooled

00:27:59.109 --> 00:28:01.950
assets rather than the general credit worthiness

00:28:01.950 --> 00:28:04.789
of the bank or entity that's issuing them. Think

00:28:04.789 --> 00:28:07.910
of it this way. Instead of a bank keeping 1 ,000

00:28:07.910 --> 00:28:10.289
mortgages on its books, it pools those mortgages

00:28:10.289 --> 00:28:13.109
together, creates a legal trust, and then sells

00:28:13.109 --> 00:28:16.650
bonds mortgage -backed securities, or MBSs, that

00:28:16.650 --> 00:28:18.890
are backed by the homeowner's monthly payments.

00:28:19.150 --> 00:28:21.210
So the bondholder isn't relying on the bank.

00:28:21.269 --> 00:28:23.640
They're relying on the homeowners. Exactly. Other

00:28:23.640 --> 00:28:26.019
examples include CDOs, which are collateralized

00:28:26.019 --> 00:28:29.339
debt obligations, or CMOs. The key is that the

00:28:29.339 --> 00:28:31.660
bondholder is relying solely on the consistent

00:28:31.660 --> 00:28:33.960
performance of the underlying collateral, whether

00:28:33.960 --> 00:28:36.279
that's mortgages, car loans, or student debt,

00:28:36.400 --> 00:28:38.940
to generate the cash flows necessary for repayment.

00:28:39.019 --> 00:28:41.319
Okay, let's move to category B, termed immaturity.

00:28:41.700 --> 00:28:43.900
Beyond the standard treasury definitions, we

00:28:43.900 --> 00:28:46.160
have some remarkable outliers, like the bonds

00:28:46.160 --> 00:28:49.180
with no end date. Yes, the perpetual bonds or

00:28:49.180 --> 00:28:52.059
perps. As we mentioned, they obligate the issuer

00:28:52.059 --> 00:28:54.380
to pay interest indefinitely without ever returning

00:28:54.380 --> 00:28:57.740
the principal. The famous example is the UK Consuls,

00:28:57.839 --> 00:29:00.460
some of which dated back to the 1888 conversion

00:29:00.460 --> 00:29:02.900
or even earlier before they were finally fully

00:29:02.900 --> 00:29:05.460
repaid in modern times. They're essentially an

00:29:05.460 --> 00:29:07.819
annuity that lasts forever. But today, the longest

00:29:07.819 --> 00:29:09.680
debt instrument that is growing in prominence

00:29:09.680 --> 00:29:13.019
is the Methuselah bond. A fantastic term for

00:29:13.019 --> 00:29:16.980
a 50 -year, 70 -year, even 100 -year bond. Their

00:29:16.980 --> 00:29:19.660
increasing issuance, particularly in the UK and

00:29:19.660 --> 00:29:22.299
France, is driven by the specific needs of large

00:29:22.299 --> 00:29:25.059
institutional investors, pension funds and insurance

00:29:25.059 --> 00:29:27.400
companies. Why them specifically? Because these

00:29:27.400 --> 00:29:29.779
entities have extremely long term liabilities,

00:29:30.039 --> 00:29:32.619
they have to pay pensions decades into the future.

00:29:32.819 --> 00:29:35.319
And Methuselah bonds provide an asset with a

00:29:35.319 --> 00:29:37.839
matching long duration, which helps them reduce

00:29:37.839 --> 00:29:40.380
their exposure to that reinvestment risk we talked

00:29:40.380 --> 00:29:43.160
about earlier. And then we have the truly bizarre

00:29:43.160 --> 00:29:46.119
ultra long instruments like the West Shore Railroad

00:29:46.119 --> 00:29:49.799
bond that matures in the year 2361. Financially,

00:29:49.839 --> 00:29:51.900
the present value of receiving your principal

00:29:51.900 --> 00:29:54.920
back in 350 years is negligible. It's almost

00:29:54.920 --> 00:29:58.000
zero. so it behaves like a perpetuity for all

00:29:58.000 --> 00:30:00.660
intents and purposes. A more manageable but still

00:30:00.660 --> 00:30:03.160
distinct maturity structure is the serial bond.

00:30:03.420 --> 00:30:05.480
Instead of a single maturity date where the entire

00:30:05.480 --> 00:30:07.779
principal is due, the principal is paid back

00:30:07.779 --> 00:30:10.640
in scheduled installments over time. For example,

00:30:10.819 --> 00:30:13.539
a $100 million bond issue with a 10 -year term

00:30:13.539 --> 00:30:16.000
might be structured so that $10 million in principal

00:30:16.000 --> 00:30:18.640
matures and is retired every single year for

00:30:18.640 --> 00:30:21.720
10 years. It reduces the total outstanding debt

00:30:21.720 --> 00:30:23.680
load incrementally. Okay, let's transition to

00:30:23.680 --> 00:30:26.599
Category C. By coupon payment conditions, we

00:30:26.599 --> 00:30:28.799
know fixed and floating rates, but the zero coupon

00:30:28.799 --> 00:30:31.079
bond is a fundamental instrument with a really

00:30:31.079 --> 00:30:34.019
unique tax complication. Zero coupon bonds or

00:30:34.019 --> 00:30:36.279
zeros are fundamentally different because they

00:30:36.279 --> 00:30:39.019
pay no regular coupon interest. They are issued

00:30:39.019 --> 00:30:42.180
at a deep discount to their par value. The entire

00:30:42.180 --> 00:30:44.960
return, which represents the interest, is realized

00:30:44.960 --> 00:30:47.140
when the bondholder receives the full principal

00:30:47.140 --> 00:30:49.900
amount at maturity. So if I buy a 10 year on

00:30:49.900 --> 00:30:52.920
thousand dollars zero coupon bond for, say, six

00:30:52.920 --> 00:30:55.259
hundred dollars today, the four hundred dollars

00:30:55.259 --> 00:30:58.240
I will eventually receive is my interest. But

00:30:58.240 --> 00:31:01.859
the tax implication. That's tricky. It is extremely

00:31:01.859 --> 00:31:04.759
tricky, particularly in the US. In many jurisdictions,

00:31:05.079 --> 00:31:07.440
the IRS views the accretion of that interest,

00:31:07.519 --> 00:31:09.980
that $400 difference, as income that's earned

00:31:09.980 --> 00:31:12.279
annually, even though you haven't received a

00:31:12.279 --> 00:31:14.799
single dollar of cash flow yet. This is called

00:31:14.799 --> 00:31:17.059
imputed interest. So you've received no cash,

00:31:17.140 --> 00:31:19.519
but you get a tax bill every year on the portion

00:31:19.519 --> 00:31:21.220
of the discount that has accrued since the last

00:31:21.220 --> 00:31:24.579
period. Exactly. This makes zeros highly inefficient

00:31:24.579 --> 00:31:27.119
for taxable accounts. But it also makes them

00:31:27.119 --> 00:31:29.059
incredibly valuable for tax -deferred accounts

00:31:29.059 --> 00:31:31.079
like retirement funds, where the interest can

00:31:31.079 --> 00:31:33.519
compound without that immediate taxation. That

00:31:33.519 --> 00:31:36.099
makes the tax treatment a crucial deciding factor

00:31:36.099 --> 00:31:38.900
for using zeros. And you also mentioned that

00:31:38.900 --> 00:31:41.440
zeros can be engineered. Explain the fascinating

00:31:41.440 --> 00:31:44.470
process of stripping. Stripping is the act of

00:31:44.470 --> 00:31:46.849
surgically separating the components of a regular

00:31:46.849 --> 00:31:49.799
fixed -rate bond. A financial institution can

00:31:49.799 --> 00:31:52.599
take a 20 -year bond that has 40 semi -annual

00:31:52.599 --> 00:31:55.119
coupons, and they can separate those 40 coupon

00:31:55.119 --> 00:31:57.400
payments and the final principal payment into

00:31:57.400 --> 00:32:00.480
41 individual zero coupon instruments. Creating

00:32:00.480 --> 00:32:02.920
a whole new set of securities from one original

00:32:02.920 --> 00:32:05.500
bond. Right. This creates what are called interest

00:32:05.500 --> 00:32:08.680
-only I .O. strips and a principal -only P .O.

00:32:08.700 --> 00:32:11.140
strip. Stripping allows institutions to create

00:32:11.140 --> 00:32:14.000
bonds with extremely precise maturity dates and

00:32:14.000 --> 00:32:16.680
highly specific duration characteristics, which

00:32:16.680 --> 00:32:18.900
is essential for duration. matching in complex

00:32:18.900 --> 00:32:21.559
portfolios. We also have bonds designed specifically

00:32:21.559 --> 00:32:23.759
to counteract the greatest enemy of fixed income,

00:32:23.940 --> 00:32:27.299
inflation. These are inflation index bonds, known

00:32:27.299 --> 00:32:29.940
as linkers in the UK or tippiest treasury inflation

00:32:29.940 --> 00:32:32.920
protected securities in the US. Their design

00:32:32.920 --> 00:32:35.680
is really genius. The bond's principal amount

00:32:35.680 --> 00:32:38.140
and the interest payments are indexed to an inflation

00:32:38.140 --> 00:32:41.160
measure, like the Consumer Price Index, CPI.

00:32:41.279 --> 00:32:43.779
So how does that work in practice? If inflation

00:32:43.779 --> 00:32:46.220
spikes, the face value of the bond is adjusted

00:32:46.220 --> 00:32:48.940
upwards. And because the coupon rate is applied

00:32:48.940 --> 00:32:51.359
to that adjusted face value, the dollar amount

00:32:51.359 --> 00:32:54.440
of the coupon payment also increases. You get

00:32:54.440 --> 00:32:57.180
guaranteed protection against inflation, eroding

00:32:57.180 --> 00:32:59.720
your purchasing power. What's the catch? The

00:32:59.720 --> 00:33:02.059
tradeoff is that they offer a real interest rate.

00:33:02.460 --> 00:33:04.900
That's the return above inflation, which is typically

00:33:04.900 --> 00:33:07.359
lower than the nominal rate you'd get on a comparable

00:33:07.359 --> 00:33:10.480
fixed bond. Let's move to Category D documentation

00:33:10.480 --> 00:33:13.859
and jurisdiction. This involves some remarkable

00:33:13.859 --> 00:33:18.000
historical context, starting with the now largely

00:33:18.000 --> 00:33:20.680
prohibited bearer bond. Bearer bonds were the

00:33:20.680 --> 00:33:23.059
ultimate financial relic. They were issued without

00:33:23.059 --> 00:33:25.519
the holder's name recorded anywhere. The physical

00:33:25.519 --> 00:33:28.039
paper certificate was the sole evidence of ownership.

00:33:28.700 --> 00:33:31.440
Whoever held it, the bearer, was the owner, and

00:33:31.440 --> 00:33:33.559
they collected the physical coupons. Despite

00:33:33.559 --> 00:33:38.019
the obvious risk of loss or theft or fire, why

00:33:38.019 --> 00:33:40.279
were they so highly prized for so long? They

00:33:40.279 --> 00:33:43.299
provided perfect anonymity. For decades, they

00:33:43.299 --> 00:33:45.359
were the instrument of choice for tax evasion,

00:33:45.400 --> 00:33:47.619
money laundering, and capital flight because

00:33:47.619 --> 00:33:50.240
the owner simply could not be traced by any tax

00:33:50.240 --> 00:33:52.880
authority. And this tension between privacy and

00:33:52.880 --> 00:33:55.839
regulation ultimately led to their demise. It

00:33:55.839 --> 00:33:58.579
did. The U .S. government prohibited the issuance

00:33:58.579 --> 00:34:02.000
of tax exempt state and local bearer bonds entirely

00:34:02.000 --> 00:34:05.779
back in 1983. So the modern solution ensuring

00:34:05.779 --> 00:34:09.119
traceability is the registered bond. Registered

00:34:09.119 --> 00:34:11.559
bonds require the owner's name and address to

00:34:11.559 --> 00:34:13.860
be recorded by the issuer or an official transfer

00:34:13.860 --> 00:34:16.559
agent. All payments are sent directly to that

00:34:16.559 --> 00:34:18.860
registered owner. If the paper certificate is

00:34:18.860 --> 00:34:21.079
lost, the owner is safe because the records still

00:34:21.079 --> 00:34:24.139
exist. They're much safer, but historically they

00:34:24.139 --> 00:34:26.480
were less liquid than bearer bonds because transferring

00:34:26.480 --> 00:34:28.780
ownership required canceling the old bond and

00:34:28.780 --> 00:34:31.679
issuing a new one. But today, even registered

00:34:31.679 --> 00:34:34.639
bonds are largely outdated due to the book entry

00:34:34.639 --> 00:34:37.480
bond. Book entry bonds are entirely electronic.

00:34:37.840 --> 00:34:40.659
There is no physical paper certificate at all.

00:34:41.300 --> 00:34:44.219
Ownership exists only as an entry on the ledger

00:34:44.219 --> 00:34:46.440
of the issuer or the clearing system. This is

00:34:46.440 --> 00:34:48.559
the standard today. It offers maximal security,

00:34:48.880 --> 00:34:52.079
liquidity, and minimal administrative cost. Finally,

00:34:52.079 --> 00:34:54.440
we should briefly acknowledge foreign currency

00:34:54.440 --> 00:34:57.630
bonds like the samurai bond. These are bonds

00:34:57.630 --> 00:35:00.329
issued by an entity outside of its home country,

00:35:00.449 --> 00:35:03.369
but denominated in the foreign currency. So a

00:35:03.369 --> 00:35:05.670
company or government issuing a samurai bond

00:35:05.670 --> 00:35:08.849
is a non -Japanese entity issuing bonds denominated

00:35:08.849 --> 00:35:11.530
in Japanese yen, governed by Japanese law. Why

00:35:11.530 --> 00:35:13.929
do that? They do this to tap into foreign capital

00:35:13.929 --> 00:35:16.309
markets or perhaps to hedge exchange rate risk.

00:35:16.449 --> 00:35:19.010
But for a government... issuing debt in a foreign

00:35:19.010 --> 00:35:22.369
currency is a very serious commitment. They sacrifice

00:35:22.369 --> 00:35:24.570
the option to inflate their domestic currency

00:35:24.570 --> 00:35:27.610
to effectively reduce the real value of the debt

00:35:27.610 --> 00:35:30.590
owed. They lock themselves into the foreign currency's

00:35:30.590 --> 00:35:33.210
value, which can be catastrophic if that foreign

00:35:33.210 --> 00:35:35.510
currency strengthens significantly against their

00:35:35.510 --> 00:35:39.030
own. The bond world isn't static. It often incorporates

00:35:39.030 --> 00:35:41.710
mechanisms for flexibility known as embedded

00:35:41.710 --> 00:35:45.280
options. These grant either the issuer or the

00:35:45.280 --> 00:35:48.900
holder the right to alter the terms, which significantly

00:35:48.900 --> 00:35:52.679
changes the risk profile. Let's start with Calibility,

00:35:52.960 --> 00:35:55.579
which is an option that favors the issuer. Calibility

00:35:55.579 --> 00:35:58.079
gives the issuer the right, but not the obligation,

00:35:58.440 --> 00:36:00.519
to repay the debt before the stated maturity

00:36:00.519 --> 00:36:03.619
date. It's fundamentally a refinancing option

00:36:03.619 --> 00:36:06.460
for the issuer, and it's analogous to a homeowner

00:36:06.460 --> 00:36:09.679
refinancing a mortgage. How so? If interest rates

00:36:09.679 --> 00:36:11.760
fall significantly after the bond is issued,

00:36:12.000 --> 00:36:14.940
the issuer can call the bond back, pay off the

00:36:14.940 --> 00:36:17.639
principal, and then issue new debt at a lower

00:36:17.639 --> 00:36:20.400
prevailing coupon rate, saving themselves a lot

00:36:20.400 --> 00:36:22.360
of money in interest payments. And the issuer

00:36:22.360 --> 00:36:24.280
is usually willing to pay a little extra to gain

00:36:24.280 --> 00:36:27.380
that flexibility, right? Often, yes. While most

00:36:27.380 --> 00:36:29.920
callable bonds allow redemption at par, especially

00:36:29.920 --> 00:36:32.500
high yield callable bonds may require the issuer

00:36:32.500 --> 00:36:34.760
to pay what's called a call premium to the investor.

00:36:34.940 --> 00:36:37.300
This is to compensate them for losing that high

00:36:37.300 --> 00:36:39.519
rate income stream earlier than expected. And

00:36:39.519 --> 00:36:41.900
we have three basic structures for when a bond

00:36:41.900 --> 00:36:44.539
can be called. The simplest is the European callable,

00:36:44.679 --> 00:36:48.139
which has only one defined call date. The American

00:36:48.139 --> 00:36:50.420
callable is the most flexible for the issuer.

00:36:50.519 --> 00:36:53.079
It can be called at any time, usually after an

00:36:53.079 --> 00:36:54.739
initial protection period, all the way until

00:36:54.739 --> 00:36:58.260
maturity. And the Bermudan callable offers flexibility

00:36:58.260 --> 00:37:01.880
on multiple specified dates, which usually coincide

00:37:01.880 --> 00:37:04.239
with coupon payment dates. Okay, on the flip

00:37:04.239 --> 00:37:06.840
side, we have putability, which gives the power

00:37:06.840 --> 00:37:09.320
back to the holder. Putability gives the holder

00:37:09.320 --> 00:37:12.239
the right to force the issuer to repay the bond

00:37:12.239 --> 00:37:15.469
before maturity. These are extremely popular

00:37:15.469 --> 00:37:17.630
with investors because they offer interest rate

00:37:17.630 --> 00:37:19.730
protection and liquidity. How does it protect

00:37:19.730 --> 00:37:22.449
them? If market rates rise sharply, which would

00:37:22.449 --> 00:37:25.090
reduce the value of their bond, the investor

00:37:25.090 --> 00:37:28.789
can put the bond back to the issuer at par, recover

00:37:28.789 --> 00:37:31.289
their capital, and immediately reinvest it at

00:37:31.289 --> 00:37:34.309
the new higher market rate. And there's a specialized

00:37:34.309 --> 00:37:36.469
version of this that's often included in municipal

00:37:36.469 --> 00:37:39.440
bonds. Yeah. The death put. Right. The death

00:37:39.440 --> 00:37:42.619
put or survivor's option allows the estate of

00:37:42.619 --> 00:37:45.599
a deceased bondholder to sell the bond back to

00:37:45.599 --> 00:37:48.739
the issuer at face value. This just provides

00:37:48.739 --> 00:37:51.260
the estate with immediate liquidity without having

00:37:51.260 --> 00:37:53.559
to sell the bond on the open market, where it

00:37:53.559 --> 00:37:55.579
might be trading at a discount. We must also

00:37:55.579 --> 00:37:58.260
discuss the popular hybrid, convertible bonds.

00:37:58.739 --> 00:38:01.199
Convertibles are fascinating. They combine the

00:38:01.199 --> 00:38:03.559
safety of debt with the potential of equity.

00:38:04.059 --> 00:38:06.500
They give the holder the option to exchange the

00:38:06.500 --> 00:38:09.159
bond for a predetermined number of the issuer's

00:38:09.159 --> 00:38:11.219
common stock shares. So you get the best of both

00:38:11.219 --> 00:38:14.139
worlds. You can. If the company's stock performs

00:38:14.139 --> 00:38:17.079
well, the bondholder can convert their debt into

00:38:17.079 --> 00:38:19.960
equity and participate in the upside. If the

00:38:19.960 --> 00:38:22.300
stock performs poorly, they simply keep the bond

00:38:22.300 --> 00:38:24.519
and continue receiving their fixed coupon payments.

00:38:24.860 --> 00:38:26.969
And finally, the sinking fund provision. This

00:38:26.969 --> 00:38:29.389
is a covenant that requires the issuer to retire

00:38:29.389 --> 00:38:32.110
a certain specified portion of the bond issue

00:38:32.110 --> 00:38:35.050
periodically before maturity. The issuer can

00:38:35.050 --> 00:38:37.369
meet this obligation either by buying bonds on

00:38:37.369 --> 00:38:39.670
the open market or by randomly calling selected

00:38:39.670 --> 00:38:42.710
bonds in the issue. It provides additional security

00:38:42.710 --> 00:38:44.750
to the bondholders because it systematically

00:38:44.750 --> 00:38:47.530
reduces the outstanding debt exposure over time.

00:38:47.789 --> 00:38:49.670
Now, for what might be the most crucial part

00:38:49.670 --> 00:38:53.230
of this deep dive, the investment reality. Bonds

00:38:53.230 --> 00:38:55.969
are often mislabeled as simple or even risk free.

00:38:56.360 --> 00:38:59.619
What are the specific serious risks that bond

00:38:59.619 --> 00:39:02.579
investors face? That perceived safety is so misleading.

00:39:02.840 --> 00:39:05.519
Bonds are profoundly exposed to risks that stocks

00:39:05.519 --> 00:39:07.980
don't face. And the most notable one is interest

00:39:07.980 --> 00:39:10.699
rate risk. We covered the inverse relationship,

00:39:10.860 --> 00:39:13.019
but let's look at the actual consequence. If

00:39:13.019 --> 00:39:15.420
you hold a long -term fixed rate bond and interest

00:39:15.420 --> 00:39:18.500
rates rise, the capital value of that bond falls,

00:39:18.739 --> 00:39:21.239
sometimes sharply. If you're forced to sell that

00:39:21.239 --> 00:39:23.199
bond before maturity for some reason, you will

00:39:23.199 --> 00:39:25.630
realize a capital loss. How do professionals

00:39:25.630 --> 00:39:28.050
quantify this exposure to interest rate risk?

00:39:28.269 --> 00:39:30.349
It sounds like we need a measure that goes beyond

00:39:30.349 --> 00:39:32.769
just the simple maturity date. We do, and we

00:39:32.769 --> 00:39:35.469
use the term duration. Duration is the single

00:39:35.469 --> 00:39:38.349
most important measure in fixed income. Conceptually,

00:39:38.389 --> 00:39:40.989
it measures a bond's sensitivity to changes in

00:39:40.989 --> 00:39:42.809
interest rates. Can you give an example? Yeah.

00:39:42.969 --> 00:39:45.510
A 10 -year bond might have a duration of, say,

00:39:45.590 --> 00:39:48.940
7. This means that if market interest rates rise

00:39:48.940 --> 00:39:51.920
by 1%, the bond price is expected to fall by

00:39:51.920 --> 00:39:55.980
roughly 7%. The key rule is the longer the maturity

00:39:55.980 --> 00:39:58.460
and the lower the coupon rate, the higher the

00:39:58.460 --> 00:40:00.980
duration and therefore the higher the interest

00:40:00.980 --> 00:40:04.179
rate risk. Next, we have credit or default risk,

00:40:04.360 --> 00:40:06.940
the chance that the issuer simply fails to pay.

00:40:07.309 --> 00:40:09.590
And this is a risk that's distinct from interest

00:40:09.590 --> 00:40:12.730
rates. An unexpected downgrade by a rating agency

00:40:12.730 --> 00:40:16.070
like S &P or Moody's driven by deteriorating

00:40:16.070 --> 00:40:18.070
corporate health or unexpected political events

00:40:18.070 --> 00:40:20.530
in a sovereign nation will cause the market price

00:40:20.530 --> 00:40:23.309
of the bond to plummet immediately. Why immediately?

00:40:23.590 --> 00:40:25.489
Because the probability of you receiving your

00:40:25.489 --> 00:40:27.769
future cash flows has suddenly decreased and

00:40:27.769 --> 00:40:30.449
the market in response requires a much higher

00:40:30.449 --> 00:40:32.750
risk premium, a higher yield to hold that debt.

00:40:32.869 --> 00:40:35.610
So the price has to drop. And the ultimate realization

00:40:35.610 --> 00:40:39.559
of that risk. is bankruptcy risk. Even with priority

00:40:39.559 --> 00:40:42.239
over stockholders, bondholders don't always walk

00:40:42.239 --> 00:40:44.840
away whole. Not at all. There is no guarantee

00:40:44.840 --> 00:40:47.659
of full repayment. The WorldCom bankruptcy in

00:40:47.659 --> 00:40:50.500
the early 2000s is a classic cautionary tale.

00:40:50.659 --> 00:40:53.340
Despite bondholders ranking high up the liquidation

00:40:53.340 --> 00:40:55.920
chain after the lengthy legal process and the

00:40:55.920 --> 00:40:58.400
claims of secured creditors were settled, the

00:40:58.400 --> 00:41:01.420
bondholders recovered only 35 .7 cents on the

00:41:01.420 --> 00:41:04.760
dollar in 2004. The recovery amount is highly

00:41:04.760 --> 00:41:06.900
dependent on the quality and liquidity of the

00:41:06.900 --> 00:41:09.199
remaining assets. We also discussed the risk

00:41:09.199 --> 00:41:11.820
associated with flexibility call and reinvestment

00:41:11.820 --> 00:41:14.380
risk. This is the risk that arises when an issuer

00:41:14.380 --> 00:41:17.179
calls a bond early. And as we established, that

00:41:17.179 --> 00:41:19.500
happens almost exclusively when interest rates

00:41:19.500 --> 00:41:22.019
have fallen. So the investor receives their principal

00:41:22.019 --> 00:41:24.519
back, but is forced to take that money and reinvest

00:41:24.519 --> 00:41:26.860
it in the current environment, which now offers

00:41:26.860 --> 00:41:29.760
much lower prevailing interest rates. The investor

00:41:29.760 --> 00:41:32.519
loses their locked in high coupon and is forced

00:41:32.519 --> 00:41:34.920
to accept a lower yield moving forward. We should

00:41:34.920 --> 00:41:36.780
acknowledge a few more crucial risks that often

00:41:36.780 --> 00:41:40.130
get glossed over. First, liquidity risk. Liquidity

00:41:40.130 --> 00:41:42.150
risk is the risk that you cannot sell your bond

00:41:42.150 --> 00:41:44.190
quickly without significantly depressing its

00:41:44.190 --> 00:41:46.869
price. While major government bonds are highly

00:41:46.869 --> 00:41:49.789
liquid, many niche corporate bonds or complex

00:41:49.789 --> 00:41:52.909
municipal bonds can be very thinly traded. If

00:41:52.909 --> 00:41:54.929
you need to sell quickly, you might be forced

00:41:54.929 --> 00:41:57.650
to accept a deep discount just to find a buyer.

00:41:57.769 --> 00:42:00.199
And what about event risk? Event risk is the

00:42:00.199 --> 00:42:03.019
chance that a single sudden corporate event,

00:42:03.219 --> 00:42:06.780
like a massive leveraged buyout, an LBO, or a

00:42:06.780 --> 00:42:09.579
significant operational disaster, causes the

00:42:09.579 --> 00:42:12.440
credit quality of the issuer to instantly deteriorate.

00:42:12.639 --> 00:42:15.619
These events are unanticipated and often lead

00:42:15.619 --> 00:42:18.280
to massive immediate price drops. And finally,

00:42:18.340 --> 00:42:20.860
let's define inflation risk in the context of

00:42:20.860 --> 00:42:23.860
fixed bonds. Inflation risk is the simple but

00:42:23.860 --> 00:42:26.239
corrosive risk that if inflation rises unexpectedly,

00:42:26.760 --> 00:42:29.119
the fixed payments you receive from your bond,

00:42:29.239 --> 00:42:31.119
your coupon and your final principal will buy

00:42:31.119 --> 00:42:33.599
less in the future than they do today. Your nominal

00:42:33.599 --> 00:42:36.340
return might be positive, but your real inflation

00:42:36.340 --> 00:42:38.840
adjusted return could easily be negative. And

00:42:38.840 --> 00:42:41.460
this is precisely why inflation index bonds exist

00:42:41.460 --> 00:42:44.340
to specifically eliminate this risk. It's clear

00:42:44.340 --> 00:42:47.000
the bond market is a maze of interwoven complexities.

00:42:47.789 --> 00:42:49.630
And unlike the stock markets we often see on

00:42:49.630 --> 00:42:52.409
TV, the structure of the bond market itself is

00:42:52.409 --> 00:42:56.389
different. Most developed bond markets, the corporate

00:42:56.389 --> 00:42:58.329
debt market, the government debt market, they

00:42:58.329 --> 00:43:01.090
do not trade on centralized exchanges like the

00:43:01.090 --> 00:43:04.889
NYSE. They are decentralized, dealer -based,

00:43:05.090 --> 00:43:08.349
over -the -counter OTC markets. Liquidity is

00:43:08.349 --> 00:43:10.590
provided by large banks and securities firms

00:43:10.590 --> 00:43:12.989
that act as dealers. They commit significant

00:43:12.989 --> 00:43:15.690
risk capital, buying and selling bonds and holding

00:43:15.690 --> 00:43:18.329
them in inventory to ensure that when an institutional

00:43:18.329 --> 00:43:21.030
client wants to buy or sell, there is always

00:43:21.030 --> 00:43:23.949
a counterparty. This facilitates the massive

00:43:23.949 --> 00:43:26.510
daily volume of trading. And just like stocks,

00:43:26.650 --> 00:43:29.170
investors rely on large indices to track performance.

00:43:29.190 --> 00:43:32.360
Yes. Bond indices such as the Bloomberg Barclays

00:43:32.360 --> 00:43:34.820
U .S. Aggregate Index or the Citigroup Big Bigger

00:43:34.820 --> 00:43:37.340
are critical tools. They're used by institutional

00:43:37.340 --> 00:43:39.679
investors and mutual fund managers to measure

00:43:39.679 --> 00:43:41.679
the performance of broad segments of the bond

00:43:41.679 --> 00:43:44.219
market, allowing them to benchmark their portfolios

00:43:44.219 --> 00:43:46.139
and assess the overall health of the market.

00:43:46.360 --> 00:43:48.639
Hashtag tag to outro outro. We have executed

00:43:48.639 --> 00:43:51.480
a thorough and comprehensive tour of the fixed

00:43:51.480 --> 00:43:54.210
income landscape. I mean, we've moved from a

00:43:54.210 --> 00:43:57.389
simple IOU to understanding callable zero coupon

00:43:57.389 --> 00:44:00.230
bonds. The depth of the mechanics here is truly

00:44:00.230 --> 00:44:02.469
profound, and we've uncovered some essential

00:44:02.469 --> 00:44:05.030
knowledge nuggets for you. Absolutely. The foundational

00:44:05.030 --> 00:44:07.369
takeaway has to be the legal reality that you

00:44:07.369 --> 00:44:10.250
are a creditor with priority, not an owner. That

00:44:10.250 --> 00:44:13.030
simple fact fundamentally structures your entire

00:44:13.030 --> 00:44:16.030
risk and return profile. That is non -negotiable.

00:44:16.170 --> 00:44:18.469
And the complexity hidden within the core features

00:44:18.469 --> 00:44:21.750
is immense, specifically the yield to maturity.

00:44:22.360 --> 00:44:24.599
Understanding that realizing the calculated YTM

00:44:24.599 --> 00:44:27.699
requires the almost impossible condition of perfectly

00:44:27.699 --> 00:44:30.019
reinvesting all future coupons at that exact

00:44:30.019 --> 00:44:32.360
same rate, that's a critical piece of knowledge

00:44:32.360 --> 00:44:34.840
often overlooked by individual investors. We

00:44:34.840 --> 00:44:37.179
also saw how history shaped the market mechanics,

00:44:37.360 --> 00:44:40.239
didn't we? From the physical clipping of coupons

00:44:40.239 --> 00:44:43.780
to the rise and fall of the bearer bond, an instrument

00:44:43.780 --> 00:44:46.340
of perfect anonymity that provided a vehicle

00:44:46.340 --> 00:44:48.800
for tax evasion until it was strictly prohibited.

00:44:49.719 --> 00:44:52.380
Analyzing a bond's specific features, its coupon

00:44:52.380 --> 00:44:54.800
structure, its duration, its embedded options,

00:44:55.059 --> 00:44:57.900
is the only way to correctly price the risk you

00:44:57.900 --> 00:44:59.980
are taking on. We established that governments

00:44:59.980 --> 00:45:02.519
sometimes default, and even risk -free bonds

00:45:02.519 --> 00:45:05.599
carry some residual risk. We also touched upon

00:45:05.599 --> 00:45:08.239
the historical longevity of perpetual in ultra

00:45:08.239 --> 00:45:11.099
-long -term debt instruments, like the UK consuls

00:45:11.099 --> 00:45:13.599
and the modern Methuselah bonds, which mature

00:45:13.599 --> 00:45:15.960
many decades after they're issued. And this raises

00:45:15.960 --> 00:45:17.900
an important quote that connects finance to the

00:45:17.900 --> 00:45:20.159
very nature of governance and intergenerational

00:45:20.159 --> 00:45:23.179
responsibility. If a government issues a 100

00:45:23.179 --> 00:45:25.920
-year Methuselah bond today, how does that ultra

00:45:25.920 --> 00:45:28.239
-long -term debt fundamentally change the issuer's

00:45:28.239 --> 00:45:30.659
incentive structure compared to issuing short

00:45:30.659 --> 00:45:33.420
-term, five -year debt? And how might that decision

00:45:33.420 --> 00:45:36.039
burden or benefit generations far in the future

00:45:36.039 --> 00:45:38.199
who weren't even born when the debt was incurred?

00:45:38.239 --> 00:45:41.059
A fascinating long -term economic question to

00:45:41.059 --> 00:45:43.320
take with you and explore further. Thank you

00:45:43.320 --> 00:45:45.340
for diving deep with us. We'll see you next time

00:45:45.340 --> 00:45:46.380
on The Deep Drive.