Finance and capital markets
Introduction to bonds
In this video, we think how bonds work. Topics include what it means to buy a bond, what it means to issue a bond, coupon rates, par value, and maturity. Created by Sal Khan.
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- Why would a company issue bonds? Isn't it much cheaper to raise money through equity financing since they don't have to worry about paying interest and relaying the principal amount back to the bond holders?(15 votes)
- In the most broad sense: bonds are temporary while equity is permanent. In either form of financing, you're trading your company's future profitability for current cash. With bonds you're trading a fixed dollar amount of that profit while with equity you're trading a permanent entitlement to a percentage of your profits. For example, say you take out $100,000 financing when your company is worth $1,000,000 (10% of your total value), and with that financing you manage to increase your company's value to $20,000,000. If you used Bonds, you would only have to repay the $100,000 (plus interest). If you used equity, your financier would be entitled to 10% of your company's value ($2,000,000). Thus, equity is only "cheaper" in the long run if the funds fail to increase the value of your business.(50 votes)
- So what would a companies preferred way of raising capital be, to issue stock, or borrow through bonds?(8 votes)
- In a balanced company the pay-off for equity is higher than the pay-off for debt. If not something is definitely wrong. Given equity holders endure a higher risk they are looking for a higher profit compared to the debt holder who is protected by a layer of equity against any downturn in the activity of the company. In the start-up of a company there is no yield yet on the assets. In that part of the cycle any debt would burn cash and at such a time you are looking for a long term equity investor who isn't urging any immediate return. As the company grows and establishes an asset yield, any debt with a cost below the net asset yield will create leverage towards the equity investor. The return for the equity investor increases as more debt comes into the picture with debt funding that costs less than the net asset yield. Lets say the net asset yield equals 10%. With no debt in the picture the equity holder has a 10% return. If now we are able to attract debt holders that finance half of the balance sheet (with no repayment to the equity holder, balance sheet grows and net asset yield stays the same) and these debt holders agree on a 8% interest rate, what happens to the yield of the equity holder? The equity holder receives an additional lunch of 2% on half of the balance sheet. The debt holder is effectively levering the yield of the equity holder. What if the company refinances its debt at a rate that is higher than the net asset yield? = Asset destruction and destroys shareholder value until that layer is zeroed out.(3 votes)
- How can a company sell shares and make more money when it doesn't even have assets for that value? (1:35)
I thought you figure out the shares price by the assets value, which is $10M(4 votes)
- The share price is the value of the equity divided by number of shares. Since the equity is $10M and the number of shares is 1M, the price per share is $10. What it first does is it prints 500K shares. But, it owns those 500K shares, and so those 500K shares of itself are part of the company's assets. So now, the assets are 500K shares each worth $10, and $10M worth of other assets. So that leaves a total of $15M of assets, and so $15M worth of equity, divided among 1.5M shares, which means that the price per share remained at $10.
Then it sold the 500K shares at the share price of $10, and so it gets $5M. So, it still has $15M worth of assets, and so $15M of equity, divided among 1.5M shares, and so the price per share remains $10.(4 votes)
- Which came first in history, stocks or bonds? Also, what's the best way to determine whether to buy stock in a company or not?(4 votes)
- You pay a factor of current earnings (P/E ratio or price over current earnings). Guessing future earnings right can make you increase the value of your portfolio, but nobody knows unless you have insider info and that the government doesn't like at all. The P/E ratio can also change over time with an expanding or contracting economy, higher or lower inflation figures,... .
So, buying up low P/E stocks in which you believe in the long run is probably the most successful way to invest in stocks. And putting together a portfolio of about 20 stocks gives you the necessary correlation effects. If you found a perceived better stock to include in your portfolio then sell one that has less potential in your eyes.(3 votes)
- Why is the debt 5m for bonds? If they had to pay $1200x5000 people, wouldn't the debt on the books be 6m decreasing by 500k every 6 months?(3 votes)
- No, you have to pay 200 dollars of interest to the bond holder after the maturity date. Asset/ Equity chart like this is a current snapshot not including futures profits or liabilities(5 votes)
- Who will decide the price of shares when they are issued for the first time and also the number of shares ..??
Raising money by issuing shares seems very easy as company just has has to issue new shares at a price....!!
please help me connect the dots....(3 votes)
- The company has to set a price that brings in enough buyers for the number of shares the company wants to sell. Usually an investment bank will help the company gauge demand and come up with a price that will get all the shares sold. Normally the price is intentionally set "too low" so that the people who buy directly from the company will be able to flip them to other buyers and make an immediate profit. This is why you should never buy shares from a recent IPO unless you are getting them in the initial offereing and you plan to flip them. Normally "little guys" don't get much opportunity to buy shares in "hot" offerings like that.(5 votes)
- what is qualitative easing?(3 votes)
- It is a process whereby the FED became an active dominant market player to counter the forces of financial meltdown. They said to all market players: we are going to buy, and a lot of it! This made all market players to not fight the FED. Prices went up again and fast and stabilized. Thanks to this the process of asset destruction came to an end. The FED has a strong view on asset values and the real economy. By pumping up asset values they experimented on boosting the real economy.(3 votes)
- What are the biggest advantages and disadvantages of bonds vs bank loans?(3 votes)
- "...Companies generally pay lower interest rates on bonds relative to bank loans..."
This isn't true. Bank loans are given in a global relationship with the client. The opportunity of secondary business (Forex, insurance, investments) makes banks offer rates lower to fair value based upon credit risks to corporate borrowers. This is a consequence of the competition out there between banks. This also shows in the syndicated loan market. Bonds mostly end up in the portfolios of insurers and pension funds that do not have this secondary business. Some companies have such a high rating that they can borrow at prices below the cost of funding of most banks. They have potential benefit in going to the bond market.(2 votes)
- I believe want to buy bonds in the secondary market and hold til maturity. Can I, or is that only for the big guys too? I do know that Suze Orman likes bonds but does not like bond funds. I am not quite sure why. Any insight would be appreciated.(3 votes)
- depends on the denominations
some bonds have denominations of USD 1000 others USD 100000(1 vote)
- I have several bonds that have a maturity date greater than 5 years. When I bought them they were being offered as a Premimum price but recently they are now being offered at a discount to Par. Should I continue to hold them to maturity at the initial coupon rate?(2 votes)
- At maturity you will get the full face value.
You need to calculate the total return from doing that, and compare to other things you might do with the proceeds of a sale.(1 vote)
Voiceover: 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 company, so you're a partial lender, partial lender, to a company, 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, assets, and it has $10 million in assets. Let's say just for the sake of simplicity, it has no liabilities, 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, $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. The question is, how does it finance it? Well, one way is 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, 500,000 shares at $10 per share, and then that would essentially, it would produce $5 million. This is scenario one. They issue 500,000 shares at $10 a share. They now have 1.5 million shares, but these new owners gave them, collectively, $5 million dollars, so this, the equity would grow by $5 million. We now have 1.5 million shares, so this would now be 1.5 million shares, not one 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. Financing via equity, or by issuing stock. Now, the other way to do it is to borrow the money, to borrow the money, so let me redraw this company. I'll leave this up here just so we can compare the two. Once again, we have $10 million of assets. That's our $10 million of assets. We have $10 million of equity to start off with, $10 million of equity, and instead of issuing stock to get the $5 million, we're going to borrow the money so we could, we're essentially issuing debt, so we issue, we essentially could go to a bank and say, "Hey, bank. Can I borrow $5 million?" So we would have a $5 million 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, 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 of assets, and now we have a factory, but in this 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. The people that I'm borrowing this money from, the people that I'm borrowing this money, this is borrowed money, 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, 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 than, well, they don't get as much of the reward as the new equity holders would. 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 were willing to. If they said, "You're a good, safe company. "We're willing to lend you $5 million." But let's say that no bank wants to individually take on that risk, so you say, "Hey, instead of borrowing $5 million from one entity, "Why don't I borrow it from 5,000 entities?" What I can do instead, instead of borrowing it from one entity, I could issue these certificates. I could issue bonds. That's the topic of this video. I issue these certificates. They have a face value of $1,000. $1,000. This is my face value. Face value, or sometimes you'll hear the notion of par value, 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, annual coupon, and it's actually called, even though this is the interest, I'm essentially going to pay $100 a year. It's called a coupon because when they, 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. 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 principle, the entire face value, so let's say the maturity, maturity is in two years, is in two years. In this situation, in order to raise $5 million, i'm going to have to issue 5,000 of these because 5,000 times 1,000 is 5 million, so times 5,000. 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 semi-annually, so let me draw a little timeline here, and this tends to be the case in the US and western Europe. If this is today. 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 because I said this bond matures in 24 months. What is this, if you own, if you hold this bond, this certificate, what do you get? Well, it's going to pay you 10% annually, so $100 a year. $100 per year. But they actually pay the coupons semi-annually, 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's 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.