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What it means to buy a bond. Created by Sal Khan.
Video transcript
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.