What are Bonds?

Welcome, today we are doing module three which I view as just a continuation of what we were talking about. Actually, with a huge overlap that something we spent a lot of time on. Remember application one was on loans. This whole module is on something called bonds. Now when I was discussing this with my colleagues as to how to do finance for everyone, many wondered that I should use things like bonds and stocks. Turns out, the cool thing about finance is that the importance of fundamentals to everything.

Now bonds and stocks are words that if you're 16 doing this course you may not relate to, but if I pitch it the right way, it will make a lot of sense, regardless of age, regardless of experience. And I would encourage you among all things to not only do the problem, but to read the popular press. Whichever language you find, you find things like this everywhere. Okay, so it's bonds. So let's first start off clarifying lingo, and I'll go very slow in this whole course, simply because there's a lot of lingo, a lot of complexity, but I want to not avoid all complexity.

I'm gonna hold your hand a little bit more than otherwise because I think it's important for you to basically figure out how cool finance is. So as the name suggest, what a bond is something that binds two people or two institutions. And basically it's a contract between a borrower and a lender. And one of the coolest things about it is, the borrower is the person who needs the money for whatever reason, doesn't have enough of it and the lender is the person who happens to have more than they need at that point in time and is willing to trade over time. Remember, time value of money. It'll be inherent to everything we talk about.

So a bond is a contract between a borrower and a lender. The word contract is very important because we'll see it later. And as you do more and more finance, you'll understand what this is all about.

It's an explicit IOU. So contract or IOU is what I owe you, a promise to pay money in the future in return for money borrowed today. That's another way to think about a bond. And the word bond can be classified even simpler, we have seen it before. So when you go take a loan for whatever purpose we took loans for, for buying an iPhone, I believe, or going to school or buying a car, whenever you take a loan, what it ends up being it is a bond. So we are going to talk about different kinds of loans in this module, but the essentially nature of beast is identical and becomes more and more interesting, that's all.

A loan is in the eye of the beholder. So go back to Excel whenever we figure out future value, present value and so on. If you plug in a positive number, out comes a negative number. So the issue of eye of the beholder is extremely important. So if you have a positive sign on a timeline, that means a person is getting money. If there is negative sign on the timeline, the person is spending money. But because there are two parties in every financial contract, you will be responsible to figure out whether the money's flowing out or flowing in.

Bonds are extremely important because loans are the primary way, in spite of all the buzz about stock markets and so on, loans are the primary way in which people who need money get money and then people who have extra money give money to others. And one of the reasons perhaps is that bonds tend to be less risky than stocks so that could be one of the reasons. But on the other hand there's another reason, which is bonds can span all kinds of risk, right. So for example, if you take a very safe loan for a safe activity, the interest rate will be low. On the other hand, we will talk about loans based on credit cards, which are unfortunate, right?

Because a person using a credit card to finance themselves in the US is a person who doesn't have enough money to even buy daily things. I think that's unfortunate and the interest rates on those are very high partly because the default rate, the chances that the person won't pay back are higher, but partly maybe artificially. So I'm not going to get into that issue but I'm going to just talk about different types of bonds and how risk going up means return goes up. So the complexity covered by bonds is very, very rich, so we could talk about bonds forever, right.

So financing an iPhone, you need a loan if you don't have money and if you want to finance a home, you need loans and those are called mortgages. And if you notice, it's closely related to all of the stuff and the crisis we went through, especially in the US with housing prices falling and so on.

Activities of governments are financed by what is called fiscal policy and what does that mean? Governments issue bonds in large quantities to finance their activities. Again, hopefully, for stuff that we collectively need and believe in, right? So one of the passions that I have is that government should fund education all over the world. And one of the concerns in higher education is, that maybe perhaps pressures of different kinds of expenses have led governments to not support higher education as much as before. And this is extremely important because I believe education probably is next only to health in terms of empowering and enabling people.

Finally, turns out that indirectly, but very powerfully, financier bonds are used to create value and that's where I will get into stocks. Because stocks are issued by companies, by entities, and when they borrow, they borrow to create hopefully what we call positive value creation, by ideas that are better and better and better, and we'll talk about those. Those are called corporate bonds. One small caveat, that corporate bonds are bonds that are traded in the marketplace. On the other hand, many companies, all of them borrow, but they borrow directly and privately from banks and those loans don't trade.

What's interesting is that there's something called securitization that I'll talk about later which happened in the mortgage business where loans issued but private banks are then combined and created into tradable securities. Okay, it has huge potential, but of course, a lot of risks as well as we've seen in recent times, especially if not executed with care.