Structure of Bonds

So how do bonds work? And remember I'm going to show you the structure of bonds. And now I'm going more towards entities borrowing than personal people borrowing on personal behalf. We have done the loans at the personal level, so you can call them bonds as well. But the distinction between what we are talking now is, we are talking about institutions that we give money to by buying their bonds. And we'll start off with institutions that are everywhere in the world, and they're called governments. So, and by the way, state governments also issue bonds, and they're called municipal bonds in the US.

So we are going to entities, and as we go to entities, in many instances, especially in the US, these entities do such thing publicly. So I think that's mostly good news. Why? Because if the bonds are available publicly, they're priced, then markets come into play. And one of the biggest functions of markets or trading is to provide information to everybody. Anyway, so I'm going to go to the structures. So there are two sources of payment from a bond. So if you buy a bond issued, say, by the government, they pay you in two ways. Remember, you pay them by buying the bond, but they pay you back in two ways. And the two ways, the first is called coupon.

So what is a coupon? Coupon is a payment that's paid by the borrower, and it's paid periodically, meaning, every year, every six months typically. And we'll talk about that. So the first kind of payment is a coupon. And who determines the coupon? The coupon is determined by the issuer of the bond, or the borrower. I know there's a lot of words in there. But the person who's borrowing the money says look, I'll pay you coupons, every six months or so. And finally, I will also pay you something called face value. In other words that's the contract that I'll pay you typically smaller amounts every six months and then kind of a balloon payment at the end of face value.

And we'll see what it all means in a second. The reason I'm highlighting this is because you'll see the nature of the beast right away in terms of what does that mean? The other thing that's extremely important about a bond is it's called a bond partly because it has a lifetime, it has a maturity. It doesn't go on forever, though there are very rare exceptions of that. I think I already talked about a perpetuity in England called a console. So they have limited lifetime maturity, and that's another distinction from what we'll study later, which are called shares and stocks that companies issued to create a value as well.

Okay, as I said before, finally, the structure of bonds can be such that, depending on the issuer and the nature of the bond, the risks can be very, very, very different across different kinds of bonds. In fact, I don't know if you've heard about this, but the riskiest bonds are called junk bonds. It's kind of funny they're called junk bonds, because they're are kinda junky, but not in the sense of trashy, but in the sense of very high risk, high return. And one of the things about humans is, we like the upside, but we dislike the risk, which I tease is that's hypocritical, right, because volatility doesn't care about upside or downside.

Risk is double-sided, and humans want only the upside. And there's in life very few such things. So let me draw the timeline for you, and I think let's get a little bit practical now. I do a lot of examples but not without showing you the structure, right? So here's the timeline. So what happens typically? 1, 2, 3, and let's make it 10 periods. We'll define what a period is, but for the time being assume it is one year, or whatever. So what happens? There's a C, there's a C, there's a C. This is called the coupon. Again, remember, we use C for many different things. In the context of bonds, it's a coupon.

And in the final year, you also get something called face value, right? Again, please, remember, all these are determined by the, Borrower.

So what does the lender determine? The lender looks at who is issuing the bond, first thing. Second, looks at the cash flows promised by the bond, typically in two forms, not necessarily always, but typically in two forms, coupon and face value. And then says, okay I'll give you X amount of money today, and that X is called price of a bond. And take a guess what that is. That is equal to the PV of the Cs and the face value. As you know it's time value of money all over again. And what we are going to do now is we're going to start doing problems and applications.

And if you know time value of money very well, you'll, in some ways, find this segment as very easy to do. There are two reasons for this. I'm pitching it at a level where you understand fundamental bonds and the borrowing done by all kinds of institutions, particularly the government, because they are one of the biggest players. And the simplicity is because of the nature of the beast, ie, coupons are known and face value is known. But as we get more and more risky, it becomes quite complicated, and I'm gonna stop at that point. And then we'll take a break and talk about stocks later.

But you could go and do very sophisticated analysis with bonds that have all kinds of risks in it. We won't do that in this course, but we'll take you close enough that you'll understand a lot more than you can actually execute. Having said that, you can execute and actually calculate a lot of stuff yourself as well.