Principles of Finance: Unit 5, Deconstructing a Bond: Yield

In this video, we'll deconstruct a bond in terms of yield. Because when you're renting money, you'd kinda like that investment to, uh... yield something.

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

Transcript

00:19

if one day after owning a bond for three and

00:22

a half years having a good relationship with it Lots

00:24

of friendly romantic saturday night dinners you realize across the

00:28

table that you've fallen out of love with it Well

00:31

it simply didn't answer your needs And there was no

00:34

pina colada song to bring you back together You know

00:37

if you like peanut a lot getting god in the

00:41

yield or something that apparently doesn't like getting caught in

00:43

the rain either So you sell it Will it sell

00:45

for the thousand dollars you paid for it Well no

00:48

not necessarily It might sell for five hundred dollars It

00:51

might sell for two thousand dollars or one hundred eighty

00:53

eight Ninety five pricings up to you generally or rather

00:56

up to the market Well if the market says the

00:58

bonds worth eight hundred fifty bucks that's what it's worth

01:01

The key idea here is that just like stock prices

01:04

bond prices float You know along with hope there is

01:07

a market for them and it moves all over the

01:09

place all the time Well at the end of the

01:11

day a bond is simple You buy it by losing

01:14

cash out of your wallet and gaining a piece of

01:16

paper representing a promise You then get a stream of

01:20

cash flows in your pocket called interest payments And then

01:23

you get your principal back at the very end assuming

01:26

all goes well So the only issue is the pricing

01:29

of the bonds When they are bought and sold and

01:31

revolves around the rate of return investors get for parting

01:35

with their hard earned cash for whatever period of time

01:38

is involved Basically you're renting money and that rate of

01:41

return carries the fancy name yield Bonds are both call

01:45

a ble and put a ble meaning a company can

01:48

call them at times Or you can put the bond

01:51

forced the company to buy it back from you It's

01:53

um set price and not all bond Sit around paying

01:56

interest their entire lives to then finally come do after

01:59

decades been paying off their principle because early call or

02:03

early retirement of bond principle is such a common thing

02:06

Most bonds would carry a call provisions are quoted in

02:09

the form yield to call that is the yield is

02:12

quoted assuming that the bond will in fact be called

02:15

back by the issuer in the first period in which

02:18

it is legally colorable mint let's say you're living in

02:24

the worst bond market in american history toward the end

02:27

of the jimmy carter presidency in the late nineteen seventies

02:31

will prevailing rates for safe customers are nine percent for

02:35

loans lasting a year or less and the yield curve

02:37

is inverted meaning that if we look out ten years

02:40

later the ten year treasury was yielding seven percent so

02:44

investors were betting that rates would go down over time

02:48

You are the local pizza parlor chain looking to expand

02:51

financially not waste lining The venture world doesn't want to

02:54

invest in you via equity i owning a part of

02:57

you because pizza chains aren't really loved in the public

03:00

markets and they don't see how you grow at a

03:02

huge rate so all right fair enough but you want

03:05

to buy five other pizza restaurants locally you need to

03:07

act now like in the next thirty days or someone

03:10

else will buy them So you get a nine percent

03:13

plus risk plus other premiums of three percent to equal

03:16

a twelve percent loan Yeah twelve percent interest on your

03:20

loan will the cost of running your capital in this

03:22

horrendous time a very expensive inflation stamping capital is twelve

03:27

percent per year to rent your money you think this

03:29

is crazy high expensive and you don't want to be

03:31

saddled with such high rates for the fifteen year duration

03:34

of alone at which point you would then have to

03:36

pay off the principal So when you borrow the money

03:39

in your contract you embedded clever call provisions which says

03:43

that in four years you the pizza man may call

03:46

the bond back like you'd phone the owner of the

03:48

bond whoever owns it at that time you hit the

03:50

f sharp key on your piano and you'd sing Hello

03:54

it's me I'm paying you off That was adele Ready

03:59

her for that cost us a million dollars Technically call

04:01

provisioning is the right of the issuer The company raising

04:04

Debt to buy back its own bonds usually at a

04:07

modest premium to par the company has effectively a call

04:11

option married to a bond the old fashioned marriage kind

04:14

of way i e no divorce a big part of

04:16

bond math involves factoring in these embedded call options which

04:20

fester and in fact the otherwise beautiful simplicity of a

04:24

stream of predictable cash flows will call provisions benefit the

04:28

issuer so that it can be protected if interest rates

04:30

fall meaningful e like they did from late seventies to

04:33

the early eighties when jimmy carter was shown the door

04:36

by voters and ronald reagan came in laden with testosterone

04:40

So how did this work I know not that testosterone

04:42

part Well you can imagine that in high interest rate

04:45

environments like where t bills or yielding over six or

04:48

seven percent call provisions are a big deal in a

04:51

big part of the term sheet of new bond issues

04:53

but in low interest rate environments like when the government

04:57

papers yielding two percent there in the whole lot of

04:59

focus on call protection because well interest rates can barely

05:02

go any lower after processing paper costs and other elements

05:06

Well anything below two percent is almost free money to

05:08

begin with So with our pizza man we have an

05:10

embedded call provisioned with a four year trigger That means

05:13

that he is betting that rates will drop in four

05:15

years when he then hopes inflation is under control in

05:18

the fed has dropped interest rates such that the exorbitant

05:21

price of renting money at that twelve percent for your

05:23

figure drops down to something closer to six or seven

05:27

percent at which time the pizza man will simply call

05:29

the loan of the very expensive twelve percent paper he

05:32

was renting for such high prices and refinance the loan

05:35

with much more efficient six percent paper going forward like

05:39

he'll cut his interest payments in half And if you

05:41

could rent your same apartment building for half the price

05:44

like why wouldn't you And for what it's worth the

05:46

process of bonds being called isn't always straightforward Of course

05:49

it isn't Often there is a lottery provisioned meaning that

05:52

the issue of the bonds is only allowed to call

05:54

back say and after four years and only twenty percent

05:57

of the bonds they have outstanding then each year well

06:00

they can call another say twenty percent such after for

06:02

five years past that four year cliff off then the

06:05

bond has been entirely retired or called back like refinance

06:10

with cheaper paper or simply paid off because the company

06:13

that issued the bonds was profitable old school right they

06:16

generated own cash paid off bonds So how do you

06:18

calculate the yield to call here when there are odds

06:21

yo won't be called well you could make up statistical

06:24

grids and discount back to account for the risk of

06:26

being called But that clouds the real numbers a lot

06:29

of times that since the future changes so much from

06:31

what most people think it will be Well you get

06:33

bad data when you practice is valuation technique more often

06:37

than not bottom line yield is not always yield Didn't

06:40

yoda say that you know unless it's a traffic sign

06:43

in which case well you better I think that was 00:06:45.964 --> [endTime] been diesel who said that