In lesson 6, we discussed a scenario that had Jack, the Chief Financial Officer who was responsible for getting $500 million loan from the bank in order to build a new building for their real estate company. The bank created 500,000 bonds and issued all these to the investors to provide for Jack’s loan. As some of that might not be clear, we will look at the bond from the investors’ standpoint.
An investor named Jesse bought one of the 500,000 bonds the bank sold. The top portion of the bond contains the name of the real estate company that issued the bonds. That company is responsible for ensuring that Jesse receives his coupon payments and when the bond matures, he’ll receive $1,000.
The Par value, also known as the face value, is the dollar amount the bond was originally issued for, which is $1,000. If Jesse wants to buy this, he will have to buy it for $1,000 and that’s the amount of money he’ll receive when the bond matures.
The issue date of this bond is May 1, 2012, so it matures after 30 years on May 1, 2042. Jesse buys that bond from the real estate company for $1,000 on May 1, 2012. When it matures on May 1, 2042, the company needs to pay Jesse his $1,000 he had initially purchased. During these 30 years, Jesse has been collecting his interest on his $1,000 investment. When Jesse cuts out his first coupon and mails it to the company, he will receive a 25-dollar check as long as he mailed it within 6 months of the initial payment. He will continue to do this for 6 coupons, because he pays twice a year.
He now has 2 coupons for the first year, so that is $50. $50 from $1,000 Par value is 5%. When you add the coupons you receive for the entire year, you get the coupon rate of 5%. Jesse can buy this bond issued and hold it until maturity. Again, he’d get his 25-dollar check every 6 months, and in the end, he’d get his $1,000 back. Bonds work as simple as that. Since the coupon rate was 5% and was paid biannually, each coupon was for $25. At the end of each year, Jesse would receive $50 on the $1000 Par bond.
As you may notice, we have repeatedly explained many terms, and that’s to ensure that you’ll understand the lesson. Of course, it can’t be simply that easy. This is where you will really understand how bonds work. It gets a little more complex when you start talking about reselling the bond.
Let’s assume that Jesse didn’t want to hold on to the bond for 30 years, which he bought on May 1, 2012. The value of that bond changes constantly, as the market conditions change. 5 years later, interest rates may change from when Jesse initially purchased the bond – from 5% 5 years ago to 6% now. That is a lot better if you were to buy new bonds because you’d be given 6% instead of 5%. His bond value has gone down significantly to $871.
Now, let’s assume that he wanted to let go of the bond 15 years later. He would simply resell it. Again, the coupon rate when he bought it was 5%. After 15 years, the interest rate is still 6%. His bond value is higher when compared to what it was at the 5-year mark.
Let’s see what will happen if he wants to resell it in 29 years – a year before it matures. Again, the coupon rate when he bought it was at 5%. After 29 years, interest rate is still at 6%. His bond value is $990 now.
As we look at these three different scenarios, why is the value of his bond changing when the coupon and the interest didn’t change? Only the term changed with one year or 15 years or 25 years prior to the bond maturity.
If we bought that bond from Jesse on the 29th year, we will receive two coupons, two 25-dollar checks, and get back $1,000. Why would we be willing to pay a lot less for this bond knowing that we will acquire $1,000 back again in years? The longer we hold the bond and the closer the term is, the more the bond is going to reproach its Par value. The longer that bond has before it matures and those interest rate changes, the market value of that bond will drastically change. It is important to understand this if we are buying long term bonds.
If we buy high yielding bonds, we definitely want to buy long term bonds. Long term bonds are good if we’re buying bonds with high interest rates because when interest rate drops, the exact opposite occurs.
Assume the interest rate drops 1%, and those two raised 1%. Highlight this term – basis points. We’re talking about coupon of 5% here, and the interest rate goes down to 4%. That is called a hundred basis points. 1% change is 100 basis points. If you drop 2%, that’d be 200 basis points.
In the last scenario, the interest rate raised. Let’s say Jesse is holding the bond after 5 years, and he wants to sell it. His bond was 5%, and interest rates are lower right now at 4%. His bond value is $1,157. Let’s look at 15 years. It’s the same coupon and, and interest rates are still down to 4%. The bond value is only $1,112 which is low.
At about 29 years, it is close to the bond of maturity. The bond value is really close to the Par value of almost $1,010. What’s really unique about bonds is that if you buy a long term bond and you get to the really high interest rate and generally expect for it to continually drop, you can potentially turn around and sell the bond only a couple of years later for an enormous cranium. Why? That bond has a coupon rate of 5%, while interest rates are 4%. It compensates for the money lost. They have to pay that much in order to make the same amount of money.
If you don’t get it, rewind the video until you fully understand the concept, because this is how Warren Buffett invests. If you can remember this, you are good to go in the long run.
Again, keep this in mind: When interest rates go up, bond prices go down. When interest rates go down, bond prices go up. It’s really that simple.
In this lesson, we first learned about the primary components of a bond. We learned that the Par value or face value is the price the bond was originally issued for. It’s also the price that will be repaid to the holder of the bond when it matures.
The next component we learned about was the coupon. The coupon is the amount of money the bond holder will receive from the issuing company for every rate the bond specifies. For example, if a $1,000 par bond pays a $25 coupon biannually, the investor (or bond holder) can expect a 5% return on their money. This would be determined by summing the two coupon payments for the year and then dividing the annual coupons by the Par value.
The last component we learned about was the term of the bond. Just like a standard loan, borrowed money has a term in which the loan will be repaid. This duration is called the term.
After a bond is issued, the owner of the security (or bond) has the ability to sell the bond on a market. When the owner attempts to sell the bond, the price they offer to sell the investment is called the market price. Since the value of a bond is inversely proportional to current interest rates, the market price of a bond will increase as interest rates decrease, and vice versa.
More information on basic valuation techniques are taught in the following lesson.