6. What is a Bond Video Lecture | Become an Expert: Value Investing - Business Basics

the hello and welcome the course want
you to lesson one plays upon in his
lessons we've learned about the wonders
who uses bonds
appointments
and wise bond investments of this
so let's get started
the person understand uh... argues that
it's nothing more than a one says i
describe the following scenario just
kato mine this weekend throughout this
lesson
okay so let's start off with a high
representative from a large business
that will call the business realestate
empires this is the c_f_o_ his name is
jack and has the chief financial officer
checked is responsible for
making sure that any table financing
that
goes through the business all runs
through jackson jack's responsible for
that and so jack was given admission
from the c_e_o_ the chief executive
officer that he did that come up with
financing for five hundred million
dollars in order to do
i'm construct the company's new
headquarters building so here's the new
uh... rules the umpires headquarter
building bet jack is going to be
financing and this building cost five
hundred million dollars uh... jackson
have to get out the and try to find out
my so how does jack finance a building
of that size if into come up with that
much money for his corporation and
like anything else he would start at the
back so
jack would go to the bank and sit down
with uh... personal backing obviously be
meeting with uh... some pretty high
level people for
alone of that size what they do is they
sit down and they'd look at all the
things that we review torrent unit one
we're assessing the value of the stock
of the bank would do a very similar
thing with the people looking at the
health of the company that would
that'd be the first step at the banquet
didn't even see if they could lend that
amount of money to
uh... corporation like this so would say
that after chapin sat down with
representatives of the bank
and they determined that
unit jack's company it was healthy
enough to spin order take on alone of
that size of five hundred million
dollars which is enormous
uh... the bank decides they're going to
go ahead and facility
that one how the bank is going to is you
that money to jack's businesses they're
gonna do it through
for bonds
and so what ideas i just created kind of
generic bond here
and what the best thing to do is they're
going to make five hundred thousand
bonds
and each one has apartheid thousand
dollars
and what the bank's refusing to take
these slips of paper these bonds and
they're gonna sell these bonds to
investors
and the money that their investors pay
them through the sponsors can be to save
money but the bank hamesha reject
so the bank reach five hundred thousand
bonds each bonds thousand dollars when
you multiply those numbers together you
get the five hundred million dollars to
check would be uh... going after built
the headquarters building so
what the bank does is the bank comes up
with the rough coupon rate much to say
that it's five percent
uh... based off of the risk and the
interest rates that are all happening
during the time when jack could have
gone to try to get the loan
answer based off of that they're gonna
go ahead and issue
they uh... bonnet five percent
so is jack comes in
he's we come back to the bank in the
banks and sit down the back gate at this
point
has issued an annual budget but they're
still gonna facilitate the land they're
gonna go ahead and get jacks company
dot five hundred million dollars that
they need order to absurd financing bill
in the building thingy after they do
that after they give japanese five
hundred million dollars
there now sitting on this five hundred
thousand bonds that they're not
distributed start selling to investors
so let's go to the next step here
skaters are investors answer the bank
after jackson equation jackpot is five
hundred million dollars from the bank
and now the bank is going to go ahead
initiated start selling these five
hundred thousand bonds to all all sorts
of investors how one investor might buy
it
you know if alyssa bonds the next person
might buy a hundred bonds bit the bank
is going to be selling each one of the
response
and the bank instead of charging
thousand dollars they might charge per
thousand five dollars for each bonds
sold
and that difference
uh... that five dollar difference will
call it will is what's called the
underwriters fee and that's how it that
makes them on because they're selling
off all the sponsor
uh... because of some five hundred
thousand bonds let's say a market for
about five dollars that's how the banks
making their money so the investors get
their bond
and they pay a thousand five dollars to
get into that bond and money all that
slip of paper
but they're actually gunnery cdcl says
the coupon rate is five percent
and so they're going to receive five
percent of thousand dollars katie in
five percent goes off apartheid not the
price that they pay for the bond
gets really important to technet so
they're gonna make five percent a year
on the thousand dollars so every single
year at fifty dollars
and bonds are typically pay
two times a year so that these investors
if you give one of these investors have
one bond day bc twenty five dollars
after six months of owning it meant next
six months to get another twenty five
dollars
and they keep getting this twenty five
dollar payments for the total term of
the bond to be thirty years
and then this is also a very important
part at the very end of that thirty
years
they've received
there are thousands all her par value
investment back
and that would be paid by checks company
so
jack's jack's company would also be
making that coupon payment about five
percent each
each paying so
after the bank sells off that bond
the relationship at that point is now
between jacket investors
so
let me go ahead and recap this real fast
you can see how the flow of money
whitaker
uh... during this transaction
needed the five hundred million dollars
the bank supply and that five hundred
million dollars so you can see uh...
might get on reports chair
after jack received the five hundred
million dollars the bank now has five
hundred thousand bonds that they now
need to start selling to investors now
if they don't sell all the bonds
initially offered investors in the banks
continued tahoe
or the bonds
open the bank would receive the coupon
payments is five percent coupon payments
but if the bank does sell the bonds off
to the investors which they want to do
because they'll ultimately don't want to
be responsible for that sizable on they
want to push that
responsibility off onto the investors
that after the bank would go ahead and
start selling those response off to the
investors
now investors have all the pawns
the relationship is now between jack in
the investors and so
jack's company is going to continue to
make the five percent
uh... coupon payments to those investors
and they're gonna make it every six
months
make another payment keep making this
payments clear up to the thirty years
so those investors who can pay five
percent that initial investment author
point for thirty years
and then
after thirty years
the ball in the constitution or and
that's important trim on the constant
reference for net
and jack's company now has to pay all
those investors
are whoever's hole in the bond whoever
holds the bond after the term comes up
they all received thousand dollar
payment for the part are you
every seat at the house in dollar
payment out to the point becomes chore
and that's it that's really all there is
too
okay so who is she responds
but it is really just to
divisions for this and one is
corporations and the others government
so the model that i just walked in three
was a was a corporation for corporation
the to raise money that's one of the
options that they have in order to
research funds is to can look back at
the bank issued bonds
uh... so you understand that model and
when you're talking to the government
beholden to you the exact same thing to
go through the same steps they'll don't
go to the bank to bank will look at
the uh...
the capability that the government
actually has to repay the bonds uh...
when you get into it the state and local
level
they don't have the luxury of the
federal level that they can just print
more money
because they don't have state dollars
that they don't have world colors
they're using federal dollars at the
state and local government have to
remain within the boundaries of watch
their balance sheets
and make sure that the revenues that
they bring in
or exceeding
via expenses that they have so
when they go to the bank to bank sent to
the same thing they're gonna assess
their ability that local government of
state government's ability to repay the
loan
in the interest rate that they would
make the bond for would-be corresponding
to there
to their ability to pay that off when
you get into the federal level
uh... warren buffett considers this is
your risk investment simply because the
federal government has the ability of a
luxury just print more money if they
need to
now that causes inflation and low
long-run but
uh... will talk about that later on
speaking to you of some of the working
its lessons in and second course of this
website bit
uh... all you really need to know is but
generally speaking the federal
government's upon is considered zero
risk because they can just print more
money in order to fulfill via coupon
payments so speaking about the risks
associated with bonds
uh... the thinking that i really think
about her these three things
of the first one is whether the company
of the government would have a failure
because if that company let's say we go
back to jack's company although he might
have got a really good interest rate
because maybe whenever he went in for
his initial
uh... screening everything looked like
the company pet for billy to pay back
their loans
that's a long long that's thirty years
logs of fifteen years later maybe
you got a new management may be a new
board of directors and the direction of
the company is taken has become a whole
lot riskier
and which we find is that
that company that risk associated with
the company and that made either
inability to continue making a coupon
payments
search showing up in the market and
people start trading that bond
much lower because there's no
anticipation that the coupon payments
are going to be sustained
the next first that's associated with
bonds is that
when interest rates change
the bond of
value the market value that bonds also
been a change
let's assume that you just went out and
you bought five percent federal pond
and two years later interest rates went
down to four percent
to hear you are holding that five
percent bonds in two years later the
best people can get when they go out and
buy bonds four percent
so there's a there's an enormous
advantage that you have holding up on
that is paying a higher interest rate
than what
people can go out get at four percent
incident valued your bond market goes up
significantly
based off of that change in the last
thing that uh...
is a risk associated with the parts
inflation if you would go out and you
buy a five percent bonds
and inflation throughout the term about
on is four percent
all more money you're going to make
relatively speaking as one percent
so
when you're figuring out the value of a
pond
uh... you absolutely have to subtract
out the inflation
that occurs to me that duration that you
got the bond that something very
important understand we'll talk about
all those factors much more in the
second course that this is just a
general overview okay so i briefly
talked about
uh... company that would start
performing poorly
and let's assume that you have you're
holding a bond for a company that
actually does fail goes through
bankruptcy
online in two thousand two thousand nine
time frame this was
uh... real for general motors they went
through the bankruptcy
and uh...
when something like this happens the
work distribution for the equity it
remains that company whenever they go
bankrupt
in order of presidents is that the
bondholders receive their money first
then the preferred shareholders than the
common shareholders
now in the first
uh... unit but we were talking about
were common shares so you the last in
order there to receive
distributions of what was written in the
company if it would fail
so that's one of the things that truly
great about paul
insist that level risk has a lot lower
than dealing with common shares because
of something that happens
you're the first person to receive
payment if their space there is any
money left said something else you to
consider on a lot of times when you're
talking bankruptcy there's not really
too much left
so this is something else to think about
so why would you invest in a bar
in a lot of people they
baber we don't see the value in it
because they see maybe a little coupon
rate of maybe five percent
want to do is on a show you wife
investing in bonds
is absolutely just as important as
investing in stocks
and this is so fundamental to warren
buffett's investment approach in this is
something that really want to pay close
attention to it
when i got here is the dow jones
industrial average uh... through our
last market crash in two thousand eight
you can see the timeline about there
and what ideas and looked up what the
thirty year federal laundry was back in
beginning at two thousand set
nap on rate was around five percent
no one else i did and if you can't eat
gone through the first unit you
understand what the price earnings ratio
isn't it
if you don't i recommend you go back in
definitely watch the that first unit
before you jump your second in texas
will make a whole lot more sense
that during that same time and and two
thousand seven beginning in two thousand
seven the average price earnings ratio
on the dow jones was twenty seven
as you remember if we take the
reciprocal overpriced earnings ratio
that
that gives us a the preaching a rain
uh... rough estimate of what our return
will be
and so
taking the reciprocal which just means
one divided by a price-earnings ratios
would be one divided by twenty seven
are returned as three point seven
percent
so
looking at the bond a federal quan which
we've already established system
you know misses your risk investment
and it's making five percent
and if you would do it invests in the
dow jones industrial average
and your pisa twenty-seven and you can
only expect the three point seven
percent return
it's pretty obvious which investment
you're is the better choice mandates
that the bond is because you can't make
a five percent oppose the three point
seven percent
and so
when you look at this chart you can see
how
stocks will prolly training like
wildfire back in two thousand seven and
everyone in their kid was involved in
the stock market
the yet the bond is where warren buffett
and really smart uh...
value investors would have been because
they know that they're gonna get a
better return on that
and so what that does and they were
predicting anything
they're not predicting anything here
that all altered to resist and simply
reacting to put to better value
and at this point was the bond
now as we look over to the right side
let's go to two thousand nine can look
at how the numbers change
so now in two thousand nine thirty-year
federal pauline
is now at two twenty three percent
because the federal government china
stimulate the economy to drop the
interest rates
and now we look at the average price
earnings ratio for stocks ten to fifteen
so when we take the reciprocal of
fifteen
which is one divided by fifteen
our return
is six point seven percent
almost double where it was two years
earlier
so now let's look at that return soon
bonds are now up to twenty three percent
and stocks are at six point seven
percent
on average across the board
which ones that are investment will of
course the stocks of the better faster
and of course that's what we were both
in
old billionaires were doing was a
whereby a police talk soon thereafter
cheap prices never unit minimizing and
they were buying companies that had very
little that
and so
what they knew it was there
that they were always on the right side
of the equation they're always investing
and bonds when they should have been
there investing in stocks and they
should have been because
they were simply making that comparison
and that is so vitally important to
understand
so let's have some fun here let's assume
that we bought a thirty-year federal
blog
back in two thousand seven because we
saw it was a five percent
and the price list at the thousand
dollars per points let's just by one
point four thousand dollars back then
so that we hold onto that bond
okay and
now in two thousand nine interest rates
dropped on the two twenty three percent
and when there is interest rates
dropping your holdings
remember we bought the five percent
bonds were holding that five percent
ball
and now it's two years later
and the best that anybody can go out and
find a street when he three percent
but what are you holding on to your
holding on to the five percent bond who
doesn't want by five percent bond when
interest rate to that level
so that your bond becomes more valuable
on the market
because you want to five percent bond
when everyone else can we get two twenty
three percent
and so the value-added changed
approximately upto one thousand four
hundred eighty dollars
and then when you add in two years of
coupon payments
that actually goes up to five hundred
eighteen dollars you've made in a two
year period
so that's about twenty five percent
return precluding that bond
in just two years
so that's why uh... investing in bonds
is so important and just it's equally
important to warren buffett's investing
approaches as much as stocks that
unfortunately a lot of people don't talk
about that nate really don't understand
how he's doing that but this is what
he's doing so why invest in bonds then
what i just said you know understanding
pause just as important as understanding
stocks which are gonna find is that a
lot of times let's talk to really high
the bond
prices are really load of great value
and vice versa years see the exact
opposite whenever
uh... the bond prices when interest
rates really well and no one st stops
that's when you really want be involved
stocks so that includes the first lesson
unit to we've learned what is upon
we learned uses bonds we've learned
about four hundred wise bombastic said
and i really hope that this uh... might
be the will to faster discussing with
things i wanted to get everything out on
the table so that you can understand
where i'm going with this picture at sea
and let's assume