Introduction to Bonds

What it means to buy a bond

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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

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
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.

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