7. What are the components of a bond Video Lecture | Become an Expert: Value Investing - Business Basics

welcome to course one unit two lesson
two what are the components of a bond
there are four lesson objectives
the first lesson objective is
understanding what the par value is the
second is understanding what the coupon
rate is the third is understanding the
term and the fourth is understanding
market value so let's get started okay
in Lesson one we had a scenario where we
had a CFO named jack and jack was
responsible for getting a five hundred
million dollar loan from the bank in
order to build a new headquarters
building for his company and so the bank
created five hundred thousand bonds and
they issued all these bonds down to the
investors so some of that might not have
been crystal clear so what I'm going to
do is I'm going to look at the bonds
from the investor's standpoint so as we
look at these people over on the
right-hand side of the screen let's take
one person one of these individuals and
look at one of their bonds more in depth
okay so here's one of the five hundred
thousand bonds that the bank sold and it
went to this investor named Jesse and so
as we look at the bond that Jesse's
holding we're going to start right at
the top and work our way down so at the
top of the bond is simply the name of
the real-estate company that issued the
bond so this is the person who's
responsible for insuring that Jesse
receives his coupon payments and also
whenever the bond matures he's going to
receive his thousand dollars so let's
look at the par value or also known as
the face value this is simply the dollar
amount that the bond was originally
issued for which is $1,000 so in order
for Jesse to buy this you have to buy
the bond for $1,000 and then that's the
also the amount of money that Jesse's
going to receive
whenever the bond becomes mature and so
let's let's move down and look at the
term okay and as we look at the term we
can see that the date that this bond is
issued is 1 May 2012 and the date that
the bond becomes mature is 30 years
later on 1 May 20 42 and so when Jesse
buys that bond from the real estate
empires company
he buys that bond on 1 May 4th
thousand dollars then whenever the bond
becomes mature on that one mate 20:42
real estate empires is going to have to
pay Jesse his thousand dollars back that
he initially purchased the bond for so
in between all of that time in between
those thirty years
Jesse's collecting his interest on his
thousand dollar investment and so when
you look down at the bottom here I have
two coupons and back in the olden days
whenever you'd buy a bond you'd actually
get a whole booklet of these coupons
okay and as you can see there's a dotted
line so what Jesse would do for his
first coupon that if he would have
bought this back in the olden days not
right now because everything's
electronic now but if he would have had
his booklet what he would have done is
he would have cut out his first coupon
and he would have mailed this to the
real estate empire company and he would
have received the $25 check back just as
long as he would have mailed it in after
1 October 2012 which is six months after
the initial date of issue and so each
time that you see the date to the next
one you can see is 1 May 2013
Jesse you'd mail that in and he'd get
another $25 check from the real estate
company and so he would continue to do
this for 60 coupons because they're
being paid two times a year and so you
can see if we add up the two coupons for
the first year that be fifty dollars and
fifty dollars from the thousand dollar
par value is five percent so that's how
you get the coupon rate of five percent
is just adding up the coupons that
you've received for the entire year and
that becomes your percent so really it's
it's that simple if Jesse would buy this
bond that they was issued and he'd hold
it until maturity he would get his $25
check every six months and at the end he
to get his thousand dollars back and
that's all there is to understanding on
how a bond works
so of course it can't be simply that
easy and this is where really
understanding how bonds truly work it
gets a little bit more involved when you
start talking about the resale of the
bond let's assume Jesse didn't want to
hold on to the bond for all 30 years
that's where things get tricky because
the value of that bond is constantly
changing as market conditions change and
I briefly touched on this on lesson one
and I might have moved a little too fast
so what I'm going to do is just kind of
go a little bit slower here so you
understand how the market value of the
bond changes through time so let's
assume that Jesse bought this bond on
day one of the issue which was one May
2012 and now we're gonna warp ourself in
the time five years later
okay and what we're going to do is we're
going to move interest rates from when
Jesse initially purchased the bond so
when Jesse purchased the bond interest
rates were around five percent and
that's what he bought his bond for but
now five years later interest rates are
now up at six percent which is a lot
better if he would be buying new bonds
because he'd been getting six percent of
posted five percent and so what happens
is on his bond his bond value has gone
down significantly to eight hundred and
seventy one dollars okay
now let's look at the 15-year if let's
assume Jesse one just he bought his
blonde he held it for 15 years and he
wanted to sell it 15 years later and we
looked down there and we see the coupon
rate that he bought it for was five
percent that's not going to change but
we look at the interest rates and it's
still at six percent but you look at his
bond value and it's higher than it was
at the five-year mark so that's kind of
weird so let's go ahead and look at if
he was going to sell this bond at twenty
nine years meaning there's only one year
left on the bond before it becomes
mature and let's look at what would
happen if those interest rates stayed
exactly the same so his coupon is never
going to change that's the 5% and
interest rates are at 6%
okay we're going to assume that interest
rates didn't change they're still at 6%
but look at his blog value it's $990 now
so as we look at these three different
scenarios why is his value on his bond
changing when the coupon didn't change
an interesting change and only the term
changed from you know one year being
left on the bond to 15 years being left
on the bond and 25 years being left on
the blonde what you're going to find is
if you're going to buy that bond at the
29 year Mart and there was only one year
left you're going to receive two coupons
you're going to receive two $25 checks
and then you're going to get a thousand
dollars back so why would I be willing
to pay a lot less for this bond knowing
that I'm going to make my thousand
dollars back at the end of the year so
the value what you're going to find is
that the longer that you hold the bond
the closer that it approaches the 30
year mark or whatever the term is on the
bond that the bond is going to approach
the value its par value or its face
value but the longer that the bond has
before it becomes mature in those
interest rates change that bond value
that market value on the bond is
drastically going to change okay and
that's really important to understand if
you're buying long term bonds and as we
talk about strategy when we get into how
the markets move in things like that
you're going to find that if you're
buying high yielding bonds you're
definitely going to want to buy a long
term bond just as long as you're buying
a good company in an a stable company
the long term bonds are good if you're
buying bonds at a really high interest
rate because when the interest rates
drop you get the exact opposite effect
which I'm going to demonstrate now okay
so let's assume that interest rates
dropped 1% opposed to raised 1% now I
want to highlight a term here that you
might hear when you start getting
involved in bonds more and you're going
to hear the term basis points so we're
talking about a coupon of 5 percent here
and interest rates go down to 4%
that's called a hundred basis points one
percent change is 100 basis points so if
it dropped two percent that'd be 200
basis points so that's just some
terminology
kind of take with you so if you hear
that you understand what people were
talking about so in the last scenario we
had the interest rates raised but now
what we're going to do is we're gonna
look at Jessie holding the bond for five
years and then he's looking to sell it
so his bond the coupon rate when he
bought it was five percent but interest
rates are lower right now four percent
and his bond value is one thousand one
hundred and fifty seven dollars okay
let's look at the 15-year one same same
coupon interest rates are down one
percent but it's blonde value is now
only one thousand one hundred twelve
dollars which is lower and then as you
look at the 29-year one it's really
close to the bonds maturity so the bond
value is going to be really close to the
par value which is almost a thousand
dollars one thousand ten dollars so
what's really unique about bonds is that
if you buy a long-term bond and you get
it at a really high interest rate and
you generally expect the interest rates
to continue to drop you could
potentially turn around and sell the
bond only a couple years later for an
enormous premium because if a person
buys that five percent bond and interest
rates are four percent in order for them
to compensate all that money that they
would lose over the long haul they have
to pay that much of a premium in order
to make the same amount of money so
that's some important stuff too to
really comprehend and if you didn't get
it I would recommend to rewind the tape
listen to this a couple times until you
fully understand this concept because
this is vital to understanding how
warren buffett invests so here's the
thick of it if you can remember this
you're going to be good to go when
interest rates go up bond prices go down
and when interest rates go down the bond
prices are going to go up it's really
that simple and that's what you really
got to understand and take away from
this lesson so in this lesson we covered
the terminology for par value we talked
about what the coupon rate was we talked
about the term and then we talked about
how market value changes with interest
rates and so I look forward to seeing in
the next lesson