Welcome, welcome.
Today we're going to talk about bonds and present value techniques because it's important
to understand the concept of present value.
A bond is a very important area, very heavily tested and there's a whole bunch of different
new ones, is a big word for me that relates to bonds.
What is a bond?
A bond is a borrowing agreement whereby the issuer of the bond promises to pay you, the
purchaser of the bond, and a certain amount of money after a certain period of time at
a certain interest rate.
That is what the purchaser of the bond or the issuer rather of the bond is promising
to give to the purchaser.
I've got all these extra money, what should I buy?
Debt or equity?
Debt is bonds, equity is stock.
I buy debt which would be bond, so I'm buying a company's bonds.
Now there's a bunch of different terms that go along with the bonds that we have to understand.
You'll see in your notes it says a bond is a borrowing agreement in which the issuer
promises to repay a certain amount of money which is called the face or the par value
to the purchaser.
After a certain period of time called the term at a certain interest rate and we're
going to look at a couple of different ones called the effective rate or the yield or
the market and all of those mean the same.
The effective rate, the yield, the market.
You can call me Bob or you can call me, like that.
That's what we're looking at as far as the rate.
Let's say for example we have a five year term bond.
It's five year, it's a term bond which we'll learn later.
It's $1,000,000 and let's say for example that the interest rate is 8% and that is called
the stated rate.
Now the stated rate means that's how much they're going to pay me.
That means they're going to pay me interest of 8% of a million dollars or $80,000 a year.
Basically I'm saying hey, I'm going to loan you a $1,000,000.
You are going to pay me 8% a year for $80,000 a year for the next five years.
Five year term, million dollars.
The million dollar is the par value, face value, maturity value, that's how much.
Now, that's great and in this case the stated rate is 8%.
Let's say the effective called the market, called the yield is also 8% then everything's
great.
That means I'm going to loan you a million, you're going to pay me eight and I want to
earn eight, so that's cool, everything's great.
That's when these two are the same which means there's no discount or premium.
However let's say that I could take my money, put it in the bank hypothetically and I could
earn 10%.
I could earn 10% on that money.
If I could earn 10% on the money, why would I loan you my money at 8%.
I mean I don't want 8%, I want 10%.
Well you can't just take the bond, scratch out the eight and make it a 10.
Instead what we're going to have to do is you're going to have to issue me the bonds.
They're going to pay me 8% in cash.
That's the stated rate.
That's called the stated, the face, the coupon, the nominal.
Face, stated, coupon, nominal is similar, that's the stated rate.
The yield is what I effectively want to yield.
If I want to earn 10% then what will happen is you better sell it to me for less than
a million dollars.
What I'm really earning is I'm getting 8% in cash plus I'm earning the difference between
let's say you issue it to me for 900,000.
It's going to grow to a million so I'm earning 8% plus that extra 100,000 over the next five
years.
That would be called a discount.
Let's say in today's day and age, would I like 10%? Sure, so instead you issue it to
yield only 6%.
That means you're going to pay me eight but you only want me to earn six therefore you're
going to charge me more than a million upfront called a premium.
You're going to charge me more that way when I get my 80,000, really that 8% is really
60 of what I've earned but 20 is the premium that I've already prepaid in a sense.
What we're doing is we're playing with that by having a discount or premium that adjust
what I'm really earning.
Those are a couple of terms and we'll expand on this.
I know it's tricky for some people.
A lot of people generally but as we go through it, do some examples, you will love it, you
will become a bondage expert, I mean a bond expert.
Did I say that bondage, yeah?
All right, let's take the kids out of the room now.
All right, let's look at some terms.
Let's look at some terms starting with term bond.
What is a term bond?
A bond that matures at the end of the term hence the name term so that means I'm going
to get $1,000,000 in five years at the end of the what?
The term.
A serial bond, how often do you get up and have cereal?
That's with a C, this is an S but serial means it matures in installments.
Every morning you have cereal, every six months maybe you get some money or every year.
A serial bond does this, if it's $1,000,000 five year term bond, you don't give me any
of that million until the end of the term.
If it's a serial bond, you might be giving me interest on a million the first year and
in 200,000 a principle.
Next year I'm earning interest on not a million but 800 then 600 then 400 then 200 then I
get the rest.
That's called a serial bond, it matures in installments.
We have debenture bonds, denture bonds.
Those are bonds with bad teeth, no.
Debenture bonds are unsecured bonds.
Those are not supported by any collateral as oppose to like a mortgage bond is what?
A bond that's secured by a company's mortgage or they have asset back bonds which are fixed
assets of a company, things like that.
We have the stated face coupon nominal that is the rate printed on the bond represents
the amount of cash.
Back in my example over here, what do we say?
The stated face nominal coupon is 8% of a million.
That's 80,000 of cash interest you're going to get.
You're going to get 80,000 every year.
How much do we want you to earn?
That depends on the effective stated or the effected yield or market.
The next one says carrying amount.
The carrying amount would be your amortized cost.
Now we've been hearing this term amortize cost since section one.
Amortize cost would be face net of unamortized discount or premium.
That's your carrying value, carrying amount, your amortized cost.
What is it net of?
Premium or discount.
It says the face value of the bond plus the premium when the bond was issued above face
value or minus the discount when the bond was issued below face value.
That's going plus the premium or minus the discount which will make more sense once we
go through our effective interest table, the effective interest method.
We have effective rate yield market.
That is the actual rate of interest the company is paying on the bond.
When the bond is issued to the premium, effective rate is lower than the stated rate.
Since the cash interest and principle, repayment are based on the face but the company actually
receive more money than that.
When the bond is issued a discount, the effective rate is higher.
All right, come back over here.
This is the stated rate.
This is the effective market or yield.
If these two are the same, no discount or premium.
In this case I want to earn more than this, you better issue it to me at a discount.
If this versus this, you want to pay me only six but I'm getting eight.
You're going to charge me more upfront, that's going to be a premium.
We're going to have to learn how to amortize these things out but again discount or premium
it's where the difference between the stated and the effective rate.
Convertible bond is a bond that is convertible into for example common stock.
Callable bond is a bond which the issuer has the right to call or redeem prior to its maturity.
The bond may be callable which is not really good for the investor because I have this
bond it's doing great.
Rates go crazy or rates drop really low so I have a good bond and they go, "Man, let's
call it back because we can pay less."
A covenant, this is a covenant which is a restriction.
We have positive covenants, negative covenants.
We'll see this a lot in the BEC exam but a covenant is a restriction the borrower must
agree to.
For example maybe it's like if you go borrow money and let's say the issuer of the bond,
we might say "Okay, you can't pay a dividend "until the bonds are paid off."
We might say you have to have life insurance in all of the officers in case somebody dies,
the company goes under, and we lose our investment.
Those are called covenants, positive covenants are things you have to do.
Negative covenants, things you cannot do.
Those are called covenants are kind of restrictions.
Says FASB ASCA 25 provides that a company may elect the fair value option for assets
and liabilities.
That means that they can look at a financial liability like bonds and then they could elect
that.
It says however, if they're not going to do that then we're going to do the accounting
that we're learning in this chapter.
If you did fair value, just get the investment.
It goes up, income, it goes down, loss, and you�re done.
We're not going to amortize all this stuff, discounts, and premiums and so on.
What is uglier?
Discounts and premiums.
What's going to get tested?
Amortizing discounts and premiums.
Trust me, you need to know that.
Hope for a fair value question, you're not going to see it.
Okay, so that's what we're looking at as far as setting up just the background on bonds,
trying to understand what the heck we're doing.