1. Intro to Bonds

Let's talk about bonds. This whole chapter is about bonds, but before we go into all the technical stuff, I wanna talk about what they actually are. Bonds are long-term debt, and you'll typically see companies issuing bonds when they need a whole lot of cash for maybe some new project, or they're building a new building or something like that. You'll even see cities issue bonds to build bridges or to do things on the public schools, and all it is is a long-term debt. So for a company, what that looks like is it's a long-term liability. And it's a liability because in the future, we have to pay it back, and that's the definition of a liability.

A bond schedule will look like this. The first thing you need to know is that the bond has a face value, and that's just the denomination of the bond. Like the face value of a $5 bill is $5. Face value of a $10 bill is $10. You'll have bonds that are face value 50,000. You'll have bonds that are face value 100,000. You could even have a bond that's face value of a million. It doesn't matter. It can be anything. But the face value is what you're going to get paid at maturity. So if this is a five-year timeline and the face value of this bond is 100,000, then at Year 5, you're going to get 100,000 because at maturity, you get the face value.

Now, oftentimes, you'll pay the face value upfront to buy the bond, but that's not always the case. Sometimes you can get it for a little bit less, and sometimes you have to buy it for a little bit more. So the thing you need to remember is at maturity, you're going to get the face value. Whatever's written on the bond, that's how much money you're gonna get. So a bond actually is a piece of paper. I don't know if they actually give you the piece of paper anymore, but it's a financial instrument. It's a piece of paper, and you'll have the face value written on it.

You'll have the interest rate, let's say 10%, and it pays semiannually. And then you'll have a due date, and it'll say something like, I don't know, in five years, whatever five years from now is. So it'll say 20-something. And this is what the bond actually looks like.

If you are the holder of this bond, you're entitled to $100,000 whenever the maturity date is. You're also entitled to 10% interest yearly. But on this one, it's compounded semiannually, so you're gonna get 5% two times a year.

What that leads us to is this idea of promises. A bond makes two promises. The first promise is you're going to get face value at maturity. The second promise is you're going to get regular interest payments. And I say regular instead of annual because it could be semiannual. It could be... I guess it could be anything they want as long as it's a regular interest payment. So when you hold a bond, you have two promises from the company. The first promise is you're going to get whatever's printed on the bond as the face value. You're going to get that at maturity.

That's promise number one. Promise number two is they're going to pay you some amount at regular intervals, and that amount is based on the interest rate that's printed on the bond, and that interest rate is called the coupon rate. And it's called the coupon rate because it's printed on this little coupon. On this bond, it's printed. So the reason I keep saying printed like an insane person is because it matters, because interest rates over time kinda go up and down and all around, and who knows what happens with interest rates, right? But if you have a 10% coupon rate that's printed on the bond, it's going to stay the exact same because this bond entitles you to 10% payments regardless of if the market is above 10% or if the market is below 10%.

It doesn't matter. You still get 10% because the bond you're holding entitles you to 10%. Now, this rate, this one that's fluctuating, this is called the market rate. Now, the market rate goes up and down and backwards and sideways based on anything really, based on the market. Market can do whatever it wants. This 10%, this is called the coupon rate, and it's really important that you remember the difference between the two because you end up using both of them, but at different times. That's why I think this picture of a physical bond, a little piece of paper, is helpful because then you can remember, well, the coupon rate is what's printed on this little bond coupon.

On this little piece of paper that entitles you to the bond, that's where you find the coupon rate. That's where you find all your promises really. Now, let's go ahead and draw out the payment schedule for this bond, and I'm gonna change this five years. I'm gonna knock that down to three. 'Cause I don't wanna do that much work. So we have a three-year, semiannual, 10%, 100,000. The first thing that I recommend doing is putting the 100,000 down at the end. This is the face value. You know that you're gonna get that at the end. So we need six periods here because it's three years semiannually.

Let's see if I can do this. 1, 2, 3, 4, 5, 6. Not bad. So on the sixth period, you get the $100,000. That's promise number one. Now, promise number two is this regular interest. Now, whatever's printed on the bond is what they promise to pay. So if the market rate is 50%, doesn't matter, your bond is stuck down here at 10. So to calculate this, we take the face value times the coupon rate, and then you have to adjust it for semiannually. You have to adjust it for the number of times you get paid per year. So you take the face value times 10.

10% is the annual percentage rate. So since we're doing semiannual, we need to multiply by 6 months every 12 months or half of the year, and we figure out that our interest payments are going to be $5,000. So now our schedule is gonna look like this: $5,000 every period, including this sixth period here. So this is what the bond schedule looks like. We get regular interest payments of $5,000 per period. Then, at the end, we get our regular payment plus the face value back. And that's pretty much it. That's pretty much all there is to a bond. There are a couple of other attributes about bonds that we'll look at, but this is the most important stuff right here.

You need to be able to figure out your regular interest payments, and you need to remember to put your face value down here at the end. Now, the tricky part with these regular interest payments is you could see a problem that says the coupon rate, let's say coupon is 10, market is 12, and you may be tempted to use this market rate. If you use that market rate, you're breaking the promise that was written on the bond. The bond promised you 10%. It just so happens that the market is up at 12. You know what? That's really unfortunate. Your bond gets a lower percentage rate than the market, but it doesn't matter because the bond promises 10%.

The place where you will use this market rate is when you're trying to figure out the present value of the bond, and this is why it gets a little bit confusing. Because to find the present value of the bond, you have to bring all of these 5,000s back at the market rate and not the coupon rate. So when we go into finding the sale price of a bond, you have to bring all this stuff back at i market, the market interest rate. Now, when coupon rate equals market rate, so if the coupon rate was 10% and the market rate was 10%, then the present value is just gonna be the face value.

But we'll go over this in detail in a separate video. For now, just remember that the coupon rate is your promise. So when you're finding the payments, make sure you're using the coupon rate.