Introduction to Bonds What it means to buy a bond
Introduction to Bonds
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- [MUSIC PLAYING]
- In this video, I want to give you a general idea of what a
- bond is and why a company might even issue them in the
- first place.
- And just at a very high level, a bond is essentially a way
- for someone to participate in lending to a compny, so you're
- a partial lender.
- And just to make that more concrete, let's imagine some
- type of company that has $10 million in assets.
- So these are its assets right there.
- And it has $10 million in assets.
- And let's say just for the sake of simplicity it has no
- So all of that value, all of that $10 million, is what is
- owned by the owners or by the equity, this owner's equity.
- So this is $10 million in equity.
- And if we had, let's say, a million shares.
- I'll write it down.
- If we have a million shares and if we believe this $10
- million number, that implies that each share is
- worth $10 per share.
- Now let's say this company is doing really well
- and it wants to expand.
- It wants to increase its assets by $5 million so it can
- go out and buy a $5 million factory.
- So it wants-- let me draw it right here-- it wants another
- $5 million in assets that it needs to build that factory,
- or essentially a $5 million factory.
- And the question is, how does it finance it?
- Well, one way is that they could just issue more equity.
- If they're able to get a price of $10 per share, they could
- issue another 500,000 shares at $10 per share.
- And then that would
- essentially produce $5 million.
- So this is scenario one.
- They issue 500,000 shares at $10 dollars a share.
- They now have 1.5 million shares.
- But these new owners gave them collectively $5 million.
- So the equity would grow by $5 million.
- We now have 1.5 million shares.
- So this would now be 1.5 million shares, not 1 million.
- And that new money from these new shareholders would go into
- the asset side, and then we would use that to actually buy
- the factory.
- What I just described is essentially issuing equity or
- financing via equity or by issuing stock.
- Now the other way to do it is to borrow the money.
- So let me re-draw this company.
- I'll leave this up here just so we can compare the two.
- So once again we have $10 million of assets.
- We have $10 million of equity to start off with.
- And instead of issuing stock to get the $5 million, we're
- going to borrow the money.
- So we're essentially issuing debt.
- We could go to a bank and say, hey, bank,
- can I borrow $5 million?
- So we would have $5 million in liability.
- It would be debt. $5 million of debt.
- And the bank would give us $5 million of cash that we can
- then go use to buy our factory.
- So in either situation, the asset side of our balance
- sheet looks identical, or the assets of
- the company are identical.
- We had our $10 million in assets and
- now we have a factory.
- But in the first situation, I was able to raise that money
- by increasing the number of shareholders, by increasing
- the number of people that I have to split the profits of
- this company with.
- In this situation, I was able to raise the money by
- borrowing it.
- So the people that I'm borrowing this money from--
- this is borrowed money-- they don't get a cut of the profits
- of this company.
- What they do is they get paid interest on their money that
- they're lending to us before these guys get
- any profits at all.
- In fact, that interest is considered an expense.
- So these guys get interest.
- And even if this company does super, super well and becomes
- very, very profitable, these guys only get their interest.
- Likewise, if the company does really bad and these guys
- suffer, as long as the company doesn't go bankrupt, these
- guys are still going to get their interest. So they're
- going to be a lot safer.
- They don't get as much of the reward as the new equity
- holders would, but they also don't get as much of the risk.
- Now this is just straight-up debt.
- And you could just get this from any bank, if they're
- willing to.
- If they said, oh you're a good safe company, we're willing to
- let you $5 million.
- But let's say that no bank wants to individually
- take on that risk.
- So you say, hey why, instead of borrowing $5 million from
- one entity, why don't I borrow it from 5,000 entities?
- So what I can do instead of borrowing it from one entity,
- I could issue these certificates.
- I could issue bonds.
- And that's the topic of this video.
- So I issue these certificates.
- They have a face value of $1,000.
- This is my face value.
- Or sometimes you'll hear the notion of par value.
- And I'll say what interest I'm going to pay on it.
- So let's say I say it has a 10% annual coupon.
- And even though this is the interest, I'm essentially
- going to pay $100 a year.
- It's called a coupon because when bonds were first issued,
- they would actually throw these little coupons on the
- bond itself and the owner of the certificate could rip off
- or cut off one of these coupons and then go to the
- person borrowing, or the entity borrowing the money,
- and get their actual interest payment.
- So that's why it's actually called coupons, but they don't
- actually attach those coupons anymore.
- And it has some maturity date.
- The date that not only will I pay your interest back, but
- I'll pay the entire principal back, the entire face value.
- So let's say the maturity is in 2 years.
- So in this situation, in order to raise $5 million, I'm going
- to have to issue 5,000 of these cause 5,000 times 1,000
- is 5 million.
- So if you wanted to lend $1,000 to this company so that
- they could expand.
- And if you think 10% is a good interest rate and it's a safe
- company, you would essentially buy one of these bonds.
- Maybe you buy it for $1,000.
- And when you buy that bond for $1,000, you are essentially
- lending this company that $1,000.
- And if you did that 5,000 times or if that happened
- 5,000 times amongst a bunch of different people, this company
- would be able to raise its $5 million.
- Now just to be clear how the actual payments work, the
- coupons tend to get paid semiannually.
- So let me draw a little timeline here.
- And this tends to be the case in the U.S.
- and in Western Europe.
- If this is today, this is in 6 months.
- This is in 12 months or 1 year.
- This is in 18 months.
- And this is in 24 months.
- And I'm only going up to 24 months cause I said this bond
- matures in 24 months.
- So if you hold this bond, this certificate, what do you get?
- Well it's going to pay you 10% annually, so $100 a year.
- But they actually pay the coupon semiannually.
- So you get $100 a year, but you get half
- of it every 6 months.
- So you're going to get $50 after 6 months.
- You're going to get $50 after 12 months, or after another 6
- months, you're going to get another $50 here.
- You're going to get a final $50 there.
- And they're also going to have to pay you back the original
- amount of the loan.
- They're also going to have to pay you the $1,000.
- So that last payment is going to be the coupon of $50 plus
- the $1,000.
- And so you will have essentially been getting this
- 10% annual interest.
- Now, when the company does this, they'll probably have to
- issue some type of new bond, because all of a sudden they
- have to pay all of these people this huge lump sum of
- money, if they haven't been able to earn it from the
- factories yet.
- And we could talk about that in a future video.
- [MUSIC PLAYING]
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