 Hello and welcome to the session. This is Professor Farhad in which we would look at the characteristics of Vance. This topic is covered on the CPA BEC section as well as the CFA exam. Farhadlectures.com is a supplemental tool if you're studying for your CPA exam or taking accounting courses. I do not replace your CPA prep course. I do not replace Specker, Roger, Wiley, Sargent or any other course you are using. However, I do cover the topics a little bit more in details and slower. I don't assume any prior knowledge. So my website, farhadlectures.com will help you substantially pick up the speed with your CPA course and help you learn the material because a typical review course will only review it with you. Now we're going to be talking about bonds from a finance perspective because this is an investment course. If you are looking to learn about bonds, about the journal entries for par, premium, discount, a retiring bond before maturity and other topics, please look into my intermediate accounting where I have extensive cover of the bonds topic. As always, I'm going to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,800 plus accounting, auditing, tax, finance, as well as Excel tutorials. If you like my lectures, please like them and share them. If they benefit you, it means they might benefit other people. Just simply share the wealth, connect with me on Instagram and on Facebook, farhadlectures.com. Once again, is where you need to go for those additional resources. So what is a bond? Well, a bond is a security that is issued. It means sold in connection with the borrowing arrangement. Simply put, the borrower, the company, we say issues or sales. So when we use the term issue or sales, it means the same thing. The issue of bond to the lender for some amount of cash. Simply put, you have the company and the company will need money from, call them lenders. The company will give them the bonds and the lenders will give them money. Now the company will go back and give them interest payments plus the bond. But this is basically what a lending arrangement is. So the bond is in fact is an IOU of the borrower. So they promise to pay. The issuer, which is the company, agrees to make specific payment to the bond holder on specified dates. Of course, why will you lend the money if you don't expect to receive payment? In a typical coupon, the issuer makes a semi-annual payment of interest for the life of the bond. So the way it works, we call those payment coupon. And I'm going to show you why in a moment. It's called the coupon. And typically, the interest is made semi-annually. So every six months, they will make an interest payment. It's called the coupon payment. They're called coupon because in the pre-computer days, most bonds had coupons that investors would literally clip off and present to claim for interest payments. So every six months, you clip off the coupon and I'll show you a picture of it and you will mail it to the company or go to the company treasury and get your interest payment. So when the bond mature, mature means at the end of the life of the bond. Because at the end of the day, you remember you lend them money. At the end of the day, I mean after five, 10, 15 years, whatever the term is, you want your money back. The issuer retires. It means they pay back the debt to the bond holder and they pay something called the par value or the face value. What is the face value or the par value? It's the number that's printed on the bond. Now, if you look at $100, what do you see written on it? You will see written on it 100. If you look at a $20 bill, you will see written on it 20. This is called the face value of the bill. It means what's written on it. And every bond will have a face value. Typically, each bond has a face value of $1,000. The coupon of the bond determines the interest payment. Of course, the coupon rate, the annual payment equal to the coupon rate times the bond par value. So how do we determine the payment? We'll take the par value or the face value multiplied by that coupon rate. So the coupon rate, maturity date and the par value of the bond are part of the bond indenture, which is the contract. The term indenture means the contract between the issuer and the borrower. And this is a picture of a US United States of America bond. The face value notice is $1,000. It's a coupon bond. Now, here we cannot see it. There must be an interest rate. And let's assume the interest rate is 6%. So simply put, we'll take the par value times, which is the coupon rate, 6% equal to $60. But look, this $60 will be paid in two payments every six months. So what's going to happen? You will clip the coupon. Notice here, there's a coupon that was clipped and there's another coupon that was clipped. So every six months you would clip this coupon. Actually here, I see it. It's $12.50. Wow. So every payment is $12.50. So what does that mean? It means this bond. I don't know how old is this. Actually it's right here. Treasury bond, 2.5%. Treasury bond, 2.5%, 2.5%. So notice the the rate. This is the coupon rate. This is called the, I did not notice this until now, this is called the coupon rate. So basically the payment is based on the coupon rate, which is you'll take the face value of the bond times the rate, which will give us the payment. So let's go ahead and just compute, go through the calculation. So this way, you know how to compute the payment on the bond. So if we have $1,000 times 0.025, that's going to give us $25. Remember, this $25 is a year. We divide it by two and this is where it comes, the $12.50. So $12.50. Remember, it's semi-annual payment. So this bond to be more realistic times 2.5%. We said this is $25 of which each payment is $12.5. And notice if you could, hopefully you can see it here. It says $12.50. A bond with a par value of $1,000 and a coupon rate of 8% might be sold for $1,000 more than $1,000 or less than $1,000. The issuer then buys the bond, the issuer then pays the bond holder 8% of $1,000. So the interest payment, whether this bond was sold for $1,100 or this bond was sold for $900. Now we'll talk later why would the bond sells for more or less. But the point is when they compute the interest, it's the face value, it's the face value or times the coupon rate. So it's the face value times 8% will give you $80. $80 will have 40 and 40. So every six months will have $40 and $40. So the $80 payment will come in two semi-annual payment. And remember, the issuer will pay $1,000 par value at the end of the life of the bond, which is the face value. So bond usually are issued with coupon rate high enough to induce investors to pay the value for the bond. So when they issue interest, when they, I'm sorry, when they issue the bond, they want to make sure that the bond is issued, the bond is issued at enough issued, it means offered, offered at enough interest rate to entice you. Otherwise, you will not buy it. You will not buy it. Okay. Sometimes we have what's called zero coupon bond are issued to make no coupon payment. So what is a zero coupon bond? Simply put, let's assume they say the face value of the bond is $1,000. So what they do is, what they do is they, they, they sell it to you at, for example, $300. And what's going to happen is this. And they would say, this bond has a face value of 1,000, but why don't you give us only $300? And what's going to happen, you don't get any interest payment, you wait until 15 years and over the 15 years, the interest is added or whatever, 15, 20, 30 years, then they will give you back the $1,000. So that's called a zero coupon bond. They don't tell you what the interest rate is. That's why it's called zero coupon, but they don't make any coupon payment. They'll just pay you the face value all at once. Okay. So in this case, investors receive the par value at maturity, but receive no interest payment. So the bond is set to have rate of zero, coupon rate of zero percent. So these bonds are issued at prices considerably below par value. As I told you, the par value is a thousand. They may give it to you at 300. And the investors return comes solely from the difference between the issue price and the payment par value at maturity. And we will return to these topics later on. Treasury bonds and notes, just like corporation can borrow money, also government will borrow money. So they borrow either using treasury bonds or treasury notes. Treasury notes are issued with the original maturity between one and 10 years, while treasury bonds, they have a longer term, 10 to 30 years. And this is, you know, both bonds and notes, you can purchase them directly from the treasury in the denomination of 100, but the denomination of a thousand are fairly more common. So simply put, you can either lend the government $100 if you choose to and they both make semi-annual payments. So this is basically what the U.S. Treasury bonds would look like. For example, here, let's take a look at this U.S. Treasury bond. This bond mature 2047. Notice, so this is definitely a bond. The coupon rate is three percent. It means it pays three percent. So if we're looking at a $1,000 bond, times three percent will give us $30 in a year. Remember that $30 is paid twice, 15 and 15. This is the bidding price. This is the ask price. And this is the change. Asks yield to maturity. We'll talk about this in the next session to know how to compute yield to maturity. So this is basically, this is basically the how you read treasury bonds and notes. Now, what happened when you buy bonds in between interest payment? Remember, we make two interest payment every six months. What happened if you buy the seventh month or the eighth month? So you are buying the bond in between interest payment. So if a coupon is purchased between interest payment, so let me show you between interest payment was that, what does that mean? Let's assume we're looking at 2022. So the first interest payment was made here, then you purchase the bond. You purchase the bond. Let me change the color here. You purchase the bond here. If you purchase the bond here, what's going to happen is you only get the interest from this point, from this point, from this point forward till 2022. So what's going to happen when you buy this bond? You have to pay the seller. You have to pay the seller this amount of interest. Now, we have to compute how we get to the interest payment. How do we get to the interest payment? For example, if 30 days has passed since the last coupon payment and there are 182 days in the semi-annual coupon period, which is half a year, the seller is entitled to a payment of a crude interest of image of the semi-annual coupon rate. So basically, we have to make an adjustment to pay the seller. The seller gets the payment upfront. Why? Because the buyer of the bond, it's going to hold the bond until the payment. So the sale or the invoice price of the bond, which is the amount of the buyer, would equal to the stated price plus the accrued interest. Usually, you don't add the interest at the price. You just, when you quote the bond, you quote the bond with the price, but you have to add the accrued interest. So the formula would look something like this. You will take the annual payment divided by two, days since last coupon payment, divided by days separating coupon payments. So this is, this is how we compute it and we'll work an example. Suppose that the coupon rate is 8%, this means that the semi-annual payment is $40. So let's assume 30 days, let's assume 30 days has passed by since the last coupon payment. So we made the payment, then 30 days passed by, now the bond is being sold. If the quoted price is $90, if you read in the newspaper, it's not 90, $990. If the quoted price is $990, what you have to do, you'll have to say, okay, 30 days divided by 182 days in the period times $40. And what does that do? It's going to give the buyer, it's going to give the seller an extra $6.59. Why? Because again, what's going to happen is this. So this is the last payment and this is 30 days. So this is, this is the 30 days. So this 30 days is worth $6.59, because the seller held the bond for that long. So you have to pay them because when you buy it, you're going to hold it when it makes the next payment. Therefore, you will get your money, the $6.59, but you have to pay it. So the practice of quoting bond prices, net of accrued interest, explain why the price of maturing bond is listed at $1,000. So think about it, when it matures, you still get a coupon payment. So we don't say it's $1,000 plus a coupon payment, we just say $1,000. A purchaser of an 8% bond, one day before the bond mature would receive $1,040. Why? Because the following day, the other person will get the $1,040 anyway. So in fact, $40 of that total payment constitute the accrued interest for the preceding half a year period once again. So if you sold it right here, one day before the payment, well, they're going to get the full amount of interest. Then the following day, the buyer will get the principal plus the interest. Just like government, corporate also issue bond. Obviously, this is a really a large market as well. And just bonds are similar to the structure, similar to the government. They have a face value, they have a coupon rate. And for the sake of illustration, let's take a look at Northwestern University. This is basically university bond. This is their symbol. This is the coupon. This bond pays 4.643%. They mature in 2044. And this is the rating AAA. And we'll talk about the ratings later. The higher the rating, they mean the better is their credit credit standard companies. Also, they have credit standards. Just like individuals, they have a credit credit score based on your credit score. They will charge your interest rate. The lower your credit, the lower your credit rating, the higher the interest rate. Simply put, if you went to the bank and you want to get a loan and you have a lower credit rating, which is a lower credit score you will get. If you get the loan, they're going to charge you higher interest rate. So AAA is the top. Then you have AAAAA, depending whether you are using Moody's or S&P. Sometimes they have A1, A2, A3, so on and so forth. But the lower and we'll talk about the credit ratings later on. This is the high. How much high it was trading for the day? Low. What it last traded? The change from the prior day and the percentage yield. We'll talk about that in the next session. Simply put, very similar to how government bonds are traded and they pay interest semi-annually. Bonds, they come in a lot of flavors. So let's talk about bonds flavor. First is the cold provisions. Well, what's cold provisions? Well, some corporate bonds are issued with a cold provision allowing the issuer, notice here the issuer, it means the company, the issuer to repurchase the bond as a specified call price before maturity date. So what they do is they can buy the bond anytime they want to, anytime that they want to before the maturity date. For example, if a company issue a bond with a high coupon rate when the market interest rate are high and the interest rate later falls, the firm might like to retire it. How does that work? Let's assume the bond issue, the company issued a bond paying 10% now. That was the, or 10 years ago, that was the ongoing interest rate. Now, they can issue the same bond and they can only pay 6% because interest rate went down or their credit rating when they issued this, maybe their credit rating was triple B, now their credit rating is A. So what they do is now they can issue the same bond for 6%. If this is a callable bond, if this was a callable bond, then you have to give up that bond that's paying 10 and the company will take, they will pay you the money and they would reissue the new bond at 6 or sometimes what they do is they issue the bond, get the money, then pay you and retire the old bond at 6%, the 10% bond, not the 6%. The proceeds from the new bond issued are paid for the repurchase of the existing higher coupon bond. This is basically, this is the typical example of refunding or refinancing. Callable bonds typically come with a period of a call protection. So when the company sells, when the company sells a callable bond, usually they give you 5, 10 years, they say, we will not call it within 5 to 10 years. So you want some protection because what happened if interest rate drops and they buy back the bond from you, then basically you're stuck with that money and you have no other alternative. So this way these bonds are referred to as the third callable bonds because they want to give you some protection. Now, the option to call the bond is valuable to the firm because it's given them some feature, some sweetener, some additional advantage. So what's going to happen if that's the case when they issue those callable bonds, they have to empice you, they have to pay you a higher rate because you're giving them some features. So the firm's benefit is the bondholders burden, but the bondholder will demand a higher interest rate for these bonds. Another form of bonds, we're going to see a lot of them, convertible bonds. This convertible bonds gives the bondholder an option to exchange each bond for a specified number of shares of the firm. Okay, the conversion ratio gives the number of shares for which each bond may be exchanged. Suppose a convertible bond is issued at $1,000 and is converted into 40 stocks. Now let's think about it. You paid, let's assume you paid exactly for that bond, $1,000. If you paid $1,000, you could issue it into 40 stocks. It means each stock, it means you can buy, simply put, it's the same as saying, I will buy each stock for $25. That's what you are saying. If you take this bond immediately and you exchange it, you'll get 40 shares. 40 shares means you are paying $25 for the stock. Well, if the current stock is $20, would you do so? Would you buy this, would you convert your bond? And the answer is definitely not, because if I convert, it means technically I'm paying $25. Well, in reality, I can't pay only $20. Now, should the stock go up to $30? Of course you will convert. Why? Because you will take your $1,000 by 40 shares and your share basis will be $25, the stock price is trading at $30. Guess what? You make a profit of $5 per share times 40 shares, you make a $200 profit. So you will make a $200 profit. Okay? So the market conversion value is the current value of the shares for which the bond can be exchanged. So at $20 stock price, the bond conversion value is $800. You really don't want to do that. There's something called the conversion premium, is the access of the bond price over the conversion value. So if the bond were selling at $9.50, we would say the premium is $150. This is how you find the premium. Another type of bond is puttable bond. A puttable bond is where the callable bond gives the issuer the option to extend or retire the bond at the callable date. What does that mean? Well, it means you have the option. Put the bond, give the bondholder the option. If the bond rate exceeds the market yield, what's going to happen, the bondholder will choose to extend. So let's assume they're paying you currently 8% on that bond and the bond is puttable. Here comes maturity. Well, if the ongoing interest rate is 6%, you would say I am not going to give it up. Why? Because I am getting 8%. Why would I give up a bond paying 8%? Well, the current rate is 6%. So if the coupon rate exceeds, your coupon rate exceeds the ongoing rate, so you won't do it. Well, if the bond coupon rate is too low, so let's assume your coupon rate is 4% and the market rate is 6%, you would say no, give me my money and I will invest my money in a new bond. It will not be optimal to expand. So the bondholder instead reclaimed the principle which can be invested at the current yield. That's again, those are different options. Floating rate bonds, more types of bonds, floating in contrast to fixed. Remember, every time we talked about the coupon rate, I said the coupon rate is stated on the bond itself, which is it's fixed. Here we have a bond that the rate changes. What does it change? It's tied to some measure of current market rates. So floating rate bonds make interest payment that is tied to some measure of current market rates. So for example, the rate might be adjusted annually to the current T-bill rate plus 2%. So how much do you get? Well, what's the T-bill rate and add 2%. Now for international bond, they use LIBOR, the London Bank offering rate, London interbank, London interbank offering rate. In the US, we use the Fed rate, so basically, or the T-bill rate. So that's the rate. So if one year, T-bill rate at the adjustment date is 4% and the bond coupon rate over the next year would be 6%, which is the T-bill rate plus 2%. This arrangement means that the bond always pays approximately current market rate in a sense that it's the T-bill rate plus 2% in a sense that you are a little bit over the T-bill rate. Innovation in bonds market. Now we're going to look at some interesting or exotic bonds. One of them is called inverse floaters. Well, again, it floats, it means it changes, but it's inverse. So they are similar to the floating rate bond, except that the coupon on these bonds falls when the general level of interest rate rises. So if interest rate goes up, your coupon payment will go down. That's how it works. So the coupon rate on these bonds falls. So if they're paying you five and interest rate goes up, now they're going to pay you four. Investors in these bonds suffer doubly when the rate rise. Not only does the present value of each dollar of cash flow from the bond falls as the discount rate rises, but the level of these cash flow falls as well. Remember when interest rate goes up, your bond goes down. Your bond goes down in value. Hopefully you know this. When interest rate goes up, the bond goes down. So here we go. The interest rate goes up. Your bond goes down and your payment goes down as well. But let's reverse this. Let's assume interest rate goes down. Now your bond value go up and your payment go up. So you get a double benefit, but also you will also get double penalized if interest rate rises. We have asset-backed bonds. What's asset-backed bonds? It means the income, the interest that they pay you from a specified group of asset used to service the debt. So they say, okay, your income is coming from this source. That's what it is. For example, solar city issued bond with payment backed by revenue generated by the rooftop solar panel that has installed throughout the countries. Okay, we're going to sell you these bonds, but here's what's going to happen. Your income from these bonds is basically backed by the amount of revenue. Sometimes it's called income bond or revenue bond. So your payment is coming from those revenue. We also have what's called the David Bowie bond, have been issued with payment tied to the royalties on some of his albums. So that's another type of asset-backed. Again, sometimes it's called revenue or income-backed bond. More innovation, it's something called pay-in-kind bond where the issuer, they will tell you, do you want to be paid the interest in cash or you were going to pay you the interest in additional bonds? They don't tell you, they will either give you cash or additional bonds. Why would they do that? Well, if they want the cash, if they want to keep the cash, they will not give you the cash, they will pay you an additional bonds. If the issuer is short on cash, it will likely choose to pay with new bonds. So basically, they would say, you owe us more money. That's what they say. Simply put, they don't have the cash. So what's going to happen? They will add it to their liability, they will add it to their bond. There's something called also catastrophe bonds. Well, these bonds are a way to transfer catastrophic risk from the insurance company to the capital market. Simply put, you have a bond, but it's bagged by catastrophic risk. So investors in these bonds receive compensation in a form of higher coupon payment for taking on the risk. So what happens is you buy the bond and what they say is this, if something happened based on certain conditions, you are responsible for that catastrophe. So you are basically, in a sense, you are ensuring, your investment is ensuring that risk. So obviously, because you are taking more risk, you will get a higher coupon payment. So for example, Oriental Lent Company, which manages Tokyo Disneyland, has issued bond with a final payment that depends on whether there has been an earthquake near the park. That's the risk that you are taking of the earthquake near the park. Maybe Disneyland doesn't make a lot of money. You lose some of that principle. But what happens is when you buy that bond, that bond will pay a premium, premium in terms of the interest rate. The coupon rate will be higher. Index bond, another form of bond. Index bond make payments that are tied to the general price index or the price of a particular commodity. So for example, in the U.S., the United States Treasury started issuing what's called inflation index bonds. They are called Treasury Inflation Protection Securities or TIPS. And those are very common because if people don't like inflation, they will buy those bonds because they are protected from inflation. By tying the par value of the bond to the general level, coupon payment as well as the final repayment on these bonds increase in direct proportion of the consumer price index. So what's being protected? The bond itself being protected and the payment of these bonds being protected at the same time. So this is what's being protected. Both of these things. Therefore, the interest rate on these bonds is a risk-free real rate. Why? Because inflation cannot eat up any of your income because you are protected against inflation. So it's a risk-free real rate. So you are getting the real rate. So the best way to illustrate this is to actually show you. So to illustrate how TIPS work, consider a newly issued bond with a three-year maturity of a $1,000 and a coupon rate of 4%. 4% means they're going to pay you $40 per year. So at the end of the first year, the inflation is 2%. What's going to happen to that bond? It's going to increase by 1.02. Now the face value is 1,020 and your coupon payment, it won't be $40. It will be $40 times 1.02 which is $40.80. So you will get $40.80 and your face value now is 1,020. In year two, the inflation is 3%. Well, what we do now is we'll take 1,020 times 1.03. Your face value becomes 1,050 and your payment, it was $40.80, it's going to be multiplied by 1.03. Now your payment is $42.02. That's your final payment. The last year, the inflation is 1%. Same concept. You will take 1.01 times the prior year. Now the face value is $1,061.11 and your coupon payment is $1.01, $42.44. Therefore, you'll get, at the end, the total payment of $1,103.55. So what is your nominal return for the first year? Well, the first year, you got $40.20 in interest and you have $20 appreciation. Your nominal return, you earned $6.08. Now, did you really earn $6.08? You did not earn $6.08. Your real rate is 4%. Why? Because the real rate, if you remember the formula, 1 plus the nominal rate divided by 1 plus the inflation. Well, if we do that, you'll get the real rate of 4%. And this is how these tips, okay, treasury inflation protection securities work. So this is how tips work. They will give you 4%. They promise 4, they will give you 4. So anything happened to inflation, it doesn't eat up your return because you will be compensated for that. In the next session, we would look at more bonds. Specifically, we would look at pricing the bond. And if you like this recording, please like it and share it. Again, if it benefited you, it means it might benefit other people. As always, I'm going to remind you to visit my website, farhatlectures.com, especially if you're studying for your CPA exam. Good luck, study hard, and stay safe.