Principles of Finance: Unit 5, Bond Maturity and Zero Coupon Bonds

What are bond maturity and zero coupon bonds, and how are they related? Or are they NOT related, and this is just a very weird video?

CoursesFinance Concepts
Principles of Finance
FinanceFinancial Responsibility
Personal Finance
Finance and EconomicsPrinciples of Finance
LanguageEnglish Language
Life SkillsPersonal Finance
SubjectsFinance and Economics

Transcript

00:24

couple of things here first a bond is issued or sold it has a nominal rate ie

00:29

the amount it will pay in interest for renting the principal you know from

00:34

investors it has a duration or rather a time period that'll pass before the bond [Duration circled on a bond]

00:39

fully matures and the principal owed is returned and the bond might have other

00:42

features like put in call provisions which would entitle owners of the bond

00:46

to force the company or issue or to buy the bonds back usually at a discount or

00:50

call provisions which would allow the issuer of the bonds to buy them back

00:54

usually at a modest premium to the par value at which they were issued there's

00:57

also a PIK provision where they can pay in kind ie pay the interest of cash in [PIK provision definition on a whiteboard]

01:02

stock instead so think about the cash flows on a twenty-five thousand dollar

01:06

bond with a coupon of eight percent maturing in ten years well here's what

01:10

the cash flows look like mmm, what happened? well financially this is what

01:15

happens you get minus twenty five thousand and minus because the amount

01:18

was subtracted from your Wells Fargo checking account when it was deposited [Well Fargo logo with stack of cash]

01:22

into the coffers of the Comcast corporation when he bought the bond that

01:26

was part of their new bond offering to fund something that will save cable from

01:30

free Wi-Fi wimax well twice a year you get a plus one

01:34

thousand bucks that is an eight percent coupon pays two grand a year on a

01:38

twenty-five thousand dollar bond but again just to bludgeon you over the head

01:42

with this concept bonds normally pay twice a year so you'd get a grand twice

01:46

a year for ten years that's twenty payments of a grand and your last

01:50

payment would be for what... yes twenty six thousand dollars because you'd collect

01:56

your last coupon payment of that thousand dollars and then you get your [Payments of bonds listed]

01:59

principal back easy-peasy vanilla so that's standard maturity of a bond, but

02:04

there are other ways bonds mature as well so next type of maturity is a balloon

02:08

maturity and yes you can tell we're still working on [Clown making balloons and shmoop workers laugh]

02:13

In a balloon maturity the

02:14

principle is generally retired in nuggets maybe 5% is repaid after two [Balloon maturity explanation on whiteboard]

02:18

years and then another 12 and 1/2 percent of the bond that was issued

02:22

retired after three years and then 25% after seven years in Tibet so that the

02:27

principal shrinks in stages to nothing that is it's balloons of debt pop over [Debt balloons expand and pop]

02:32

time...but with big chunks paid off like a step function rather than the slow

02:37

gradual pay down of something like a typical home mortgage where a tiny bit

02:42

of principal is paid down each month until on the final month's payment most

02:46

of that payment is in fact principal think of it as serial liposuction of

02:50

debt all right next up zero coupon bonds, and yep your hunch is right zero coupon

02:56

bonds are bonds with no coupon... well they don't pay cash

03:00

interest along the way why would anybody want a bond that pays no coupon and no

03:05

interest well no in fact the bond does pay interest it just pays all of the

03:09

interest at the very end of the duration when the bond finally matures ie it has

03:16

outgrown shmoop writing stables here and the principal

03:19

plus all of the accrued interest payments are then paid all at once

03:22

well these type of bonds are sold at a discount to par with investors simply [Bond maturity breakdown]

03:27

collecting the par value so many years later in one lump sum...US government

03:32

short term paper trades this way and in the case of US government paper there's

03:36

no stated interest rate the bonds just traded a discount to par in an auction

03:45

okay so here's the sitch you have a bond being offered at $1,000 par value it's [Man discussing bond at $1,000 par value]

03:50

being sold today for 700 bucks which is a discount to par of $300 what's the

03:55

yield of this zero coupon bond

04:02

...okay trick question this one's impossible to answer why

04:07

because we didn't give you the duration without it you have no idea if you get

04:12

your thousand dollar principle and interest in one year or 10 years or a [Duration of bond changes from 1 year to 10 years]

04:16

hundred years or when the cows come home like when did they ever leave anyway all

04:20

right well so if you buy that zero coupon bond for $700 when it comes to

04:23

you in say six years you'll agglomerate the interest and the gradual increase in

04:27

principal when you calculate the value of the bond going forward while [Calculations of the bond through 6 years]

04:31

calculating the yields on zeros is a bit gnarly the basic idea here is just that [Surgeons performing operation]

04:36

you get nothing back until the end when you get it all back but by way of

04:42

example if you borrowed a thousand dollars for six years at 12% rate of

04:46

interest well you would get nothing along the way in roughly two thousand

04:50

dollars at the end in one lump sum payment remember that rule of 72 thing [Rule of 72 appears on the board]

04:54

here's the handy dandy way of calculating all that got it okay in this

04:57

case what are the risk characteristics of a bond like this, riskier or less

05:02

risky than a vanilla bond answer: riskier why well because the investors get

05:06

nothing along the way so all bets are on that investors get fully paid way at the [Rainbow appears]

05:12

end of the rainbow there's also a risk that the company doesn't sock away

05:15

enough money to pay off these zeros at the end or that they have a hard time

05:19

refinancing them at the very end if they haven't been disciplined enough to save [Woman worried about saving cash]

05:22

cash along the way or if their businesses you know gone to the crapper

05:26

there with no direct obligation to put away a few nuts each month for this [Squirrel eating nuts in the field]

05:29

eventual big fat payout it's easy for companies to get kind of sort of you

05:34

know forgetful about them well to stem some fears most corporations create

05:38

what's called a sinking fund an amount of money that they sink into a piggy

05:42

bank for the day that the debt money comes due not surprisingly zeros usually

05:47

pay higher yield or higher interest rates and carry these higher yields

05:51

because of this illiquidity feature like you don't get any cash

05:55

long time it's a bummer not to get at least a little cash along the way and [$1,000 bond with no interest for each year]

05:59

it's also a bummer to have to carry all that risk for an eventual payout way

06:02

down the line so that's why they have to pay you more in interest to rent your

06:06

money all right to the lesson well no matter how many comics you might own or [Series of comic books]

06:09

if you know farty jokes you might laugh at well you always have a shot at

06:13

maturity as long as you own a bond [Man discussing maturity in bonds]