Bonds are debt securities issued to multiple lenders.
The lenders are known as bondholders.
They purchase bonds, usually in $1,000 denominations.
The issuer of corporate bonds is usually
a large corporation like Apple.
In exchange for cash from the bondholders,
they promise to repay the principal amount
of the bond, known as the face value,
and interest over the bond term.
There are advantages for companies that can afford bonds
as a form of debt financing.
Most notable is that they can borrow large sums of money,
like millions or billions of dollars,
with less risk, because the debt is spread out
over hundreds of thousands of bondholders instead of one
bank.
Additionally, bondholders are not like stockholders.
So they have no ownership interest in a company.
Debt financing is cheaper than equity financing,
because interest expense is tax deductible for a business.
And there are often favorable impact
on earnings per share, which could
cause the stock prices to rise.
For more information on stocks and equity financing,
I would encourage you to watch the upcoming playlist
videos on stockholders' equity.
A bond certificate contains contractual information,
for example, the company's name, the principal amount,
the maturity date, the stated annual interest rate,
and the interest payment dates, which
are usually every six months.
There are many types of bonds.
And not all bonds are corporate bonds.
Governments and municipalities also issue bonds.
But that's not the focus of this discussion.
Corporate bonds can be sold as term bonds, which
means all of the bonds mature at the same time.
Or they can be sold as serial bonds, which
means the bonds mature in installments.
Additionally, some bonds are secured bonds,
which means they are secured by a specific asset
in the case of bankruptcy.
Most bonds, however, are unsecured bonds.
And they are known as debentures.
They are backed only by the good name and credit of a company.
Finally, the last two terms related to types of bonds
are convertible bonds and callable bonds.
Some bonds are convertible bonds,
which means they can be converted into stocks.
When converted, the bondholders become stockholders.
And the company no longer pays interest on the bonds.
Bondholders might want to do this if a company's stock
price is really high.
Conversion occurs only when the bondholders want to convert.
A company usually cannot make them convert to stockholders.
Most bonds are callable bonds.
This means that a company can pay off the bonds
earlier than their term.
Usually a company has to pay extra to do this.
Only a company can decide to call bonds.
The bondholders cannot require this.
There are two very important interest rates to consider
when learning about bonds.
I would strongly encourage you to understand
the two and their purpose.
The first is the stated interest rate.
This is the interest rate stated on the face of the bond.
It is only used to determine the amount of interest payment.
And it is sometimes called the coupon rate
or the nominal rate.
The other important interest rate is the market rate.
The market interest rate is used to determine a bond's market
price.
It is also used to determine interest expense
in amortization tables.
It is sometimes called the effective rate
or the real rate.
Bonds are always sold at their market price,
which can change daily, because interest rates change daily.
Technically, the market price is the present value
of the bond's cash flows.
The price is the present value of the interest payments
plus the present value of the face value.
If you would like to see the specifics on bond pricing,
I would encourage you to watch an upcoming
video on how to use Excel to calculate the price of a bond.
Although bonds are priced at their present value,
rarely would a bondholder need to calculate this.
Normally bond prices are published and quoted
as a percentage of their face value.
For example, a quote of 102 means 102% of the face value.
Likewise, a quote of 95 means 95% of the face value.
Let's look at this straightforward example.
What is the market price of a bond
with a market quote of 104?
Well, we would take 104% times the $1,000 face
value, since most bonds are sold in $1,000 increments,
to get $1,040.
And that brings us to our last important concept related
to bond characteristics.
Since market interest rates change regularly,
bond prices change just as frequently.
And the price of the bond is likely to be
different than the face value of the bond.
When the market price of the bond
is greater than the face value, the bond sells at a premium.
When the market price of the bond
is less than the face value, the bond sells at a discount.
For example, let's assume the stated rate of the bond,
which cannot change, is 10%.
In the first scenario, the market rate is 8%.
This means that my bond pays a higher rate of interest
than the market.
Everyone wants to buy my bonds.
So I can charge a higher price.
Thus, my bonds sell at a premium.
When the interest rates are the same,
the bonds sell at their face value.
Finally, when the market rate is higher
than the stated rate of my bonds,
no one wants to buy my bonds.
So I need to lower the price.
Thus, my bonds would sell at a discount in the final scenario.