ShmoopTube

Where Monty Python meets your 10th grade teacher.

Search Thousands of Shmoop Videos

Principles of Finance: Unit 5, How Bonds are Called - or Put 14 Views


Share It!


Description:

When you call a bond, you (a company) are basically buying a bond back. When you put a bond, you (a bondholder) are selling it back to the company.

Language:
English Language

Transcript

00:00

Principles of finance a la shmoop how bonds are called or put...[Person picks up suitcase and replaces with new suitcase]

00:08

Want to win the lottery without dropping the dough on like a zillion

00:12

tickets buy a call provision you know most call provisions have a lottery

00:17

provision... okay so this is not about going

00:21

to 7-eleven and paying 2 bucks to the state's tax collection system because [Man carrying bags full of lottery tickets]

00:25

like nobody ever wins those things do they rather a lottery in this sense

00:29

refers to random numbers being assigned to individual series of bonds which make

00:36

those bonds callable by the issuer at some point between when the bonds were [Money transfers from phone to bonds]

00:41

issued and when the cash is collected by the company and when the bonds are fully

00:45

paid off the big idea here is that calling a bond means that the original

00:50

issuer is buying it back like hello bond 8675 309 I'm calling you I want you [Man calling for bond back]

00:57

back please come back all right that is they return the cash to the

01:01

investor who originally bought the bond plus interest and usually a small

01:05

premium paid above the par value of the bond to reward the investor for of a

01:10

hassle and you know that the bond then is considered paid off and done okay so [Bond stamped paid]

01:15

let's say 20% of the outstanding bonds of whatever.com can be called after

01:19

three years and then another 20% can be called after six years and so on until

01:25

the whole thing's retired well the company had a banner year finding itself [Fireworks in the sky]

01:28

with a ton of cash on its books at the end and having already acquired all of

01:32

the corporate jets it wanted well the company decided to spend its remaining

01:36

cash available by calling its outstanding bonds back home to the [Alien spacecraft picking up people from the city]

01:40

mothership all right so what's that process like calling back your bonds

01:44

well if the company wants to call them they spin the wheel of fortune and

01:47

called lucky winners and losers remember there's lottery tickets or lottery [Person calling on a mobile]

01:51

numbers associated with each bond paying each chosen bondholders something like a

01:56

hundred and three cents on the dollar like a three percent premium here

02:00

whatever it said in the paperwork when the bond was originally issued that the

02:04

call premium would be should the bonds be called early well they do that they

02:09

pay a thousand thirty bucks and retire the debt okay [Person hands over a check]

02:13

if bond rates are high today and you're a bond fund portfolio manager well

02:18

you're gonna want some protection, like if you buy someone's bonds which yield

02:22

say 8% today but then what if the bonds are callable next month at par, or a

02:28

hundred cents on the dollar and you're paying a hundred three cents on the

02:32

dollar to buy those bonds that supposedly will be yielding eight

02:35

percent forever and ever but then they get called in a month or a year or less [Person picks up telephone]

02:39

than that well then you have what's called call risk so imagine a scenario

02:43

where you've just paid a thousand thirty dollars for $1,000 par bond that in

02:47

theory pays you 80 dollars a year in interest for the next ten years and you

02:51

feel good about its risk default meaning that you trust that the bonds will you [Man giving presentation on call risk]

02:56

know fully pay off fully down line but then since the bond has no call [Telephone rings]

03:01

protection and interest rates suddenly plummet and the company can refinance

03:05

the bonds elsewhere cheaper well, just one month later before even having paid

03:09

semiannual interest the bonds you just paid a thousand thirty for each are

03:15

called and well legally and you're kind of screwed you must surrender them for a [Person calling on a mobile]

03:19

thousand dollars each you just lost three percent in a month nice job! To

03:24

avoid such a calamity you'll want call protection like the

03:27

company issuer of the bond agrees that it won't call these bonds for at least

03:31

four years so time can pass and you can collect at least some interest along the

03:35

way and if they do get called well then the company will pay a hundred three [Sticky note lands on 1 dollar bill]

03:39

cents on the dollar or a hundred ten cents on the dollar or hundred twenty cents

03:42

on the dollar to buy them back or something like that

03:44

it's called protection so you don't end up losing money on your bonds and note [Money on fire]

03:48

that if the company issuing ever wants to buy them back even if there's no call

03:52

provision it can it's called tendering yeah the company tenderly gently asks if

03:59

people would kindly like to sell it back their used debt they tenderly do this [Man with company briefcase for a head waving]

04:04

that's why it's called tendering the company just tiptoes into the open

04:07

market and tenderly offers whatever the market price is for those bonds like a

04:13

hundred two dollars and seventy three cents or something like that like at a

04:16

2.7% premium and if there are any suckers out there who want

04:19

to sell the company there are perfectly nice eight percent coupon bonds for

04:23

ninety six cents on the dollar well then fine it'll go ahead and buy them back

04:26

thank you very much wow this sounds apocalyptic but most bond investors are [Apocalyptic city up in smoke]

04:30

a relatively dismal dark crowd to start with so the nomenclature fits; bond

04:35

buyers just want to get paid back their interest and their principle and then go

04:40

home and pray an errant airplane does not hit their house. Fittingly most bonds [Airplane in the sky, plummets and explodes]

04:45

carry a yield to worst tag instead of a yield to call that is at worst like if

04:52

my bond is called in the first tranche of potential lottery calls what will be

04:57

the lowest or worst yield I'll get from this point forward on my investment

05:02

Here's another twister when bonds are called

05:05

early they usually carry that premium we mentioned specifically if a bond is

05:10

callable at 1:02 any time well what does that mean well bonds trade in

05:14

denominations of $1,000 right so what is 102 here right we said it's 2% premium

05:19

so that would be the bond is callable for a thousand 20 let's say we've paid a

05:25

thousand dollars for a bond yielding 8% and we hold it exactly 4 years

05:29

collecting 80 dollars a year in interest each year and after 3.8 years we get a

05:34

nasty little email saying thank you very much for your investment that we paid [E-mail from investment to bond buyer]

05:38

you 8% a year in rent for money now we're gonna buy back that bond after 4

05:42

years not letting it go to its full decade long duration sorry pal and for

05:46

the privilege of buying it back we'll pay you a thousand $20 or a 2% call

05:50

premium to retire those now very expensive-looking 8% bonds when we know

05:54

we could refinance with someone else and rent money today at only 5%

06:01

So, if we went back to the beginning of our investment well the yield to worst was [A stack of 100 dollar bills]

06:05

in fact 80 plus 80 plus 80 plus 80 plus 20 plus a thousand or 1340 returned over

06:12

4 years that's cumulative total the yield ended up being a bit more than 8%

06:17

but you can imagine situations where the nominal rate was a very high relative to [Nominal rates value increase on a graph]

06:22

market conditions number and investors paid 1,200 bucks for a bond callable

06:27

four years later at a thousand twenty well they could have ended up tying up

06:31

their money for four years renting it to other people and actually losing money

06:35

it would be like renting your apartment not cashing the check for four years and [Apartment 4 rent sign on a block of apartments]

06:39

then realizing that all the checks that you would have cashed bounced yeah that

06:43

would not be good all right well we just outlined what a call provision looks

06:46

like the right for the company to buy back the bond or call it home to the

06:51

mother ship so then what on earth is a put well is

06:54

it the right of a company to force you to buy a bond...No, but that would make for [Man with company briefcase for head holding a baseball bat]

06:59

a really great reality TV show the put option is given to the holder of the

07:03

bond the holder has the right to put the bond back to the company usually at a [Bond holder puts bond to the company]

07:09

preset price and usually at a discount to the principle price right so it's

07:14

kind of the inverse of a call so the bonds of whatever dot-com might have had

07:17

to have had this extra feature in order for cautious buyers of their bonds to be [Person slowly picks up a bond]

07:22

enticed to buy them why is a put appealing to cautious buyers, well

07:27

because the buyers then legally have the right to get their money back after what

07:32

is essentially a small bond restocking fee...A put provision might have said

07:37

something like puttable anytime after four years at 96 so that means [bond yields transfer to company]

07:43

that owners of the bond could force the company after four years to buy back

07:47

their bond for ninety six cents on the dollar or nine hundred sixty bucks for

07:51

that thousand dollar par value bond well why would a company offer such a great

07:55

deal to investors in its bonds well it would offer it if it had to and

08:00

pretty much only if it had to to entice them to buy that is in order to get the [Lots of people walking fast]

08:04

deal done to attract enough buyers to actually get the bond offering to you

08:08

know happen well they'd have to offer a put the belief in this case by the

08:12

buyers is that the company will still be solvent or at least solvent enough so

08:16

that in four years if everyone who owns these bonds wants to sell them back to

08:20

the company at ninety six cents on the dollar nine hundred sixty bucks four

08:24

thousand dollar principal bond that the company will have the dough or access to [Stacks of money in a vault]

08:27

it via other debt it would issue in place you know to buy back those bonds

08:32

that the investors in them have put back to the mothership....Here's

08:36

hoping but hey well even if the odds aren't a hundred percent that you make a

08:39

nice return on your bond investment well they're a whole lot better than the

08:43

upcoming mega zillion Powerball ...[Road advert for the powerball]

Up Next

GED Social Studies 1.1 Civics and Government
39794 Views

GED Social Studies 1.1 Civics and Government

Related Videos

Fake News
11938 Views

How do you tell fake news from real news?

Finance: What is Bankruptcy?
260 Views

What is bankruptcy? Deadbeats who can't pay their bills declare bankruptcy. Either they borrowed too much money, or the business fell apart. They t...

Finance: What is a Dividend?
1777 Views

What's a dividend? At will, the board of directors can pay a dividend on common stock. Usually, that payout is some percentage less than 100 of ear...

Finance: How Are Risks and Rewards Related?
589 Views

How are risk and reward related? Take more risk, expect more reward. A lottery ticket might be worth a billion dollars, but if the odds are one in...