Video Transcript: Key Features of Bonds

Hello, welcome. We're going to be discussing the key features of bonds. What is  a bond? A bond is a long term debt instrument in which a borrower agrees to  make payments principal and interest on specific dates to the holder of a bond.  So it's a debt instrument. People, companies, corporations, issue bonds to fund  their operations, to raise capital. So when there's corporation that issues bonds,  they're looking to raise money in the debt market, and they're going to pay an  interest payment on those bonds, semi annually, which is twice a year, every six  months or annually, on specific dates, and they will come to maturation or to  maturity, and the entire sum will be paid Back at that time. Bond markets are  primarily traded on the over the counter. Market. Over the counter market is kind of a discretionary market that usually houses low end pink pink sheet stocks. If  you don't know what those are, Google it, right? So primarily trade over the  counter. So it's hard to trade bonds because bonds aren't very active in price  movement. So the only time that prices move on bonds is when interest rates  change, and that's very seldom. Most bonds are owned and traded amongst  large financial institution. So there's not a lot of, you know, there's not a lot of  consumers like you and I going out to the bond market and buying bonds. Now  there are, but just not. It's pretty rare. The Wall Street Journal reports key  developments in the treasury, corporate and municipal market. So treasury  bonds, T bills, corporate bonds and municipal markets. So our municipal, local  principalities can sell bonds to fund their government as well. So the key  features of a bond, let's discuss par value. Par value is the face value of a bond, and the entire face value of the bond is paid out at maturity. Typically, bonds sell  for a par value of $1,000 coupon interest rate is the state of the interest rate. It's  generally fixed paid by the issuer of the bond multiply by par value to give the  dollar payment of interest maturity date, years until the bond must be repaid,  Issue Date, when the bond was issued, and yield to maturity, the rate of return  earned on a Bond held until maturity, or better known as the promised yield.  Let's talk about a call provision of a bond. A call provision allows issuers to  refund the bond issue if interest rates decline. This helps the issuer, but it hurts  the investor, right? We don't if you are an investor in a bond, you don't want your bond to be called early, because you will not get those interest payments from  them now if Now, usually a call provision has to be worked into a bond  agreement. Not all bonds have call provisions, but they will be stated before you buy the bond, you'll know if it's got a call provision or not. So if interest rates go  down a lot of times. Companies will call those bonds then re issue those bonds  at a lower interest rate. Right? Bond investors require higher yields on callable  bonds. Why is that? Because if I'm an investor, I'm in I'm taking on greater risk  that the issuer of the bond will call it early, so I'm going to demand a greater  return for the risk that I have to take in order to buy these bonds, and if they offer a call provision, I need to be compensated for that additional risk. In many  cases, callable bonds include a deferred call provision and declining call 

premium. So as time goes forward, they only if there's a call provision, they only  have an X amount of time to enact that call provision. Let's say it's a five year  bond. After three years, the call provision is void, and they have to wait till  maturity to pay the rest of the bond out, and then there's a declining call  premium as well. So we a premium is anything that we get above market rate  interest. So we want a premium on callable bonds because. The additional risk  that we have to undertake by buying a bond that is callable, because they can  call it and buy it back early, and we won't get all of our full investment. We will  receive our initial investment back, but we won't be able to get all of our coupon  payments over the time of the bond if it's called so as time goes on, and if there  is a deferred call provision and a deferred declining call premium. We've talked  about how the deferred call provision works, where, after three years of a five  year bond or something like that, the callable option, the call option is, is void.  Same thing with the declining call premium as time goes and there's a three  year call provision that premium that you are making on your investment. Let's  say you get a 10% coupon, and for the call provision, they're paying out 12%  Well, as the deferred call provision comes further out on the time horizon, that  premium also declines, so it's going to go down from 12 to 11 to 10% once the  deferred call provision is up. What is a sinking fund provision to pay off a loan  over its life, rather than all at maturity. So instead of paying off the face value of  that bond issuance at the end of the maturity date, they can pay off that face  value or that $1,000 debt over the life of the bond, instead of all at the end in a  lump sum at the end of maturity, similar to amortization on a term loan, same  thing like amortization, how we've talked about before, you'll have greater  interest payments in the beginning, and as time goes we will decrease those  interest payments. Same thing with the principal the principal amount will start  out lower, and as we go through on the amortization schedule, that principal  amount will become greater. So the sinking fund reduces risk to the investor,  and it shortens the average maturity time, but not good for investors if rates  decline after issuance right, because we want to make sure that we are  receiving the maximum potential for our return through the interest Rate. What is the value of a 10 year, 10% annual coupon bond, if the return is 10% so let's  look what we'll have to do first is we will have to calculate out over 10 years,  right? We're going to have to figure out what is the bond value. So first we'll look at this. So the formula, the value of the bond equals $100 over one plus the rate, which is 10% raised to n 1, plus .10. This is year one raised to one. As we work  through this, we'll find that year one value $90.91 so now we're going to add this year, two $100 divided by one plus .10 raised to two. So we'll do one plus .1  equals raised to two, 100 divided by so this is, excuse me, this is 100 divided by  1.21 and gives us 82.64, we're going to do this for all 10 periods. So plus 100  divided by one plus .10 raised to the third. So we'll do one plus .1 equals raised  to the third. Is 1.33 100 so we'll do 100 divided by 1.33 this is 75.19 so Okay, 

moving on. So you can see where we're going with this, right? We're going to  calculate out the present value of the bond. And this is the payment. This is the  present value of the $100 payment that we're going to receive as a coupon  payment. So 100 divided by one plus .10 raised to the fourth. So one plus .1  raised to the fourth is 1.46 100 divided by 1.46 equals 68.49 100 divided by one  plus .10 raised to the fifth. One plus .1 raised to the fifth. 1.61 100. 100 divided  by 1.61 $62.11, moving on, 100 divided by one plus .10 raised to the sixth. One  plus .1 raised to the sixth is 1.77 divided by 100 100 divided by 1.77 plus 56.50,  100, divided by one plus .10 raised to the seventh, 1.95 over 100 so plus 51.28  there is a much simpler way to do this. I'm going to show you how to do it, but I  want to show you how it all works out, right, and then how you'll be able to do  the exact same thing very simply and easily on a financial calculator. This seems very tedious and very long, and it is, but there's a point and a reason why I want  to do this for you, so you can see how the whole thing has worked out, and then  how we can simplify it with a simple financial calculator. 1.10 1.10 raised to the  eighth is 2.14 over 100 100 divided by 2.14 is 46.73, is so we're trying to figure  out what is the value of this bond, right the 10 year, 10% return, $100 coupon  payment bond, we want to know what is the value of it based on these metrics?  We know it's 10 years. We know it's a 10% return. You know, we're going to get  $100 coupon payment. So off the coupon payment and the discounted interest  rate, how are we going to find the value of the bond? This is what we're going  through this so you can see, how do you derive the value of the bond? And this  is the math to do it. So I just want to make sure that we know this right. It's  important. So 1.1 raised to the ninth, 2.3 and 100 divided by 2.36 is 42.37 so  now we're going to calculate the coupon payment, the discounted coupon  payment. Year 10. But also remember that we're going to receive the $1,000  lump sum payment of $1,000 at the end of maturity. So we're going to have to  also calculate that in so first, we'll calculate the discounted payment period, the  discounted interest received for year 10. Okay, so 1.1 raised to 10 is 2.59 100  100 divided by 2.59 And is 38.61, plus three. So then we'll go 1000 for the lump  sum at the end of maturity, one plus .0 raised to 10, this will give us 385. 54,  now, when we add all of these up, we'll find out the value of the bond is $1,000  all of that for this. So I want to show you now how we can much more simply  calculate the value of a bond. So let's assume the bond has a $1,000 lump sum, the par value due at maturity. The maturity is 10 years and annual $100 coupon  payments beginning at year one and continuing through year 10. The price of  the bond can be found by solving for the present value of these cash flows. So  I've got my financial calculator, okay, so now you can see the example on your  slide. So to use a financial calculator, it's very simple. Make sure it's all cleared  out and zeroed out, right? And you can see we have the end function. For the  number of periods, we have the IY or the interest rate function, the present value function, the payment function and the future value function. So it's really simple 

to use, right? So for the number of periods, we're just going to simply enter 10  and press N, and it's locked in. Okay? Now for the interest, it's 10 hit IY, it's  locked in. Now for our $100 coupon payment, $100 press payment, it's locked in now we know our future value received of this bond is going to be in full at the  end of maturity, the future value is 1000 now to solve for present value, all we  have to do is hit in the upper left hand corner, compute and present value. You'll  see we have a negative $1,000 now remember, in previous videos, I explained  that present value will always be listed in negative terms. A negative 1000 notice on your chart. Negative 1000 is the output for present value. This is a very  simple tool to use. Instead of having to run through all of this calculation to get  the same answer. This took me about 10 minutes to get to this took me about 10 seconds. So if we could practice with the financial calculator, maybe we'll add a  tutorial on to this on how to use a financial calculator. But we plan on using this  and utilizing this tool to make these calculations much more simple