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Principles of Finance Videos 166 videos

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Principles of Finance: Unit 5, Deconstructing a Bond: Yield 6 Views


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Description:

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.

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English Language

Transcript

00:00

Principles of finance ah la shmoop deconstructing a bond yield

00:07

Whoa Different kind of yield bond yields kind of closer

00:10

to the yield from a field you know like so

00:12

many corn heads for acre or whatever Okay great Enough

00:15

of that topic is yield here Bond yield What happens

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

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