Introduction to Bonds and Bond Characteristics

Alright, we're gonna start discussing one of the hardest topics in the course, bonds payable. Let's go ahead and start with some definitions and introduce you to the topic of bonds payable. Alright so bonds payable when we see payable, right? We're talking about a liability here. So this is money that we owe to our suppliers are not our suppliers to our creditors here. Right? Our creditors, we sell bonds to the creditors to raise money. Okay. This is different from a note payable. When we talk about notes payable. Well that's usually with like one person with a bank that we uh sign a contract, they give us some money and we owe the bank money. Well with bonds payable, it's a group of debt securities issued to multiple lenders. So it's not just one person that we owe money to. It's multiple people. But a lot of the concepts stay the same. Okay, So look at an example here, we want to raise a million dollars. Well we could have gone to a bank and we could have gotten a loan for a million dollars from the bank but that might not have been so easy. So instead what we do is we sell 1000 bonds worth $1000 each. Right? So if we sell those bonds to 1000 different people and they each give us $1000 but we still raised a million dollars, right? It just takes smaller investments from a bunch of different people. Okay. So similar to a note payable, we're going to pay interest, the company will pay interest on the bonds and there will be an interest rate that the bonds say hey we're gonna pay 10% interest. Hey we're gonna pay 5% 8% whatever it is. It's gonna say it on the bond how much interest we're gonna pay. And it's usually gonna be annual interest payments or semiannual. When we talk about semiannual, that's two times per year. Twice per year when we have semiannual interest payments. Okay? So it's either gonna be once per year or twice per year that we pay the interest and then the company at the end. What we call the maturity date on the maturity date, the maturity date, the company will repay the principal amount. Okay. So that means in this case when we sold $1000 bonds. Well on the maturity date which is usually say 10 years in the future or something like that. We're gonna pay everyone back that $1000 that they lent us. Right, so over time they're gonna be earning interest and then finally they'll get their principal back at the very similar to a note payable except in this case there's multiple lenders. Okay So there's a few different terms. Now this is just vocabulary type stuff. This isn't gonna come up so much once we're studying how to do the journal entries but it's you never know if you're gonna get a quick multiple choice about some of this terminology. So it's good to know it. All right. Let's go through it real quick. So the first there could be repayment characteristics of the bonds, The ones we're gonna focus on throughout this lesson is gonna be term bonds. Okay, this is bonds with one maturity date. That means that we're going to pay back all the principal in a lump sum and this is gonna be on the maturity date. We're gonna pay back all the principal compare that to a serial bond. A serial bond has multiple maturity dates. And this is that the principle is going to be paid back in installments. Okay? So that would mean that, you know, maybe these $1000 bonds, maybe we pay them off $100 each year for 10 years and they paid off the principal that way. Well, the calculations are a little more complicated for serial bonds. So we focus on term bonds in this class. Okay, So that's with one maturity date and that's at the end, the very end we pay back all the principal. Okay, So bonds can also have characteristics related to a collateral. The first are secured bonds and these are bonds that have collateral right there collateralized by certain assets. And the best way to think of a secured bond is a mortgage. Right? When you think of someone get buying a house and they get a mortgage on the house. Well, if they don't make the payments on the mortgage, the bank is gonna take the house away. Right? So you can imagine that a a secured bond is gonna have less risk, right? Because if you don't end up getting paid, well, you get the assets that are being collateralized, you get the collateral. So there's less risk because you don't just lose the money that you lend out, you get some of it back. Okay, compare that to a Devonshire bond. A debenture bond is only backed by the good faith of the borrower. There's no collateral. They say here's some money borrow it and I hope you pay me back eventually if you don't get paid back. Well, that's too bad. So there's more risk involved with a Devonshire bond. I want to make a note real quick that a bond could be a term bond and a secured bond at the same time. Right? These are different characteristics of a bond. It one is how they repay the bond and one is related to. Is there any collateral on the bond? Okay, a couple more things here, is that these other characteristics I have is called double bonds. The first one callable bonds. This is that a bond can be called back. So this means that we can call it early. We can say, hey, we no longer want to pay interest on these bonds. We're just gonna buy them back right now and they can call it back at the call price. So let's say that those bonds up above that we're talking about, we're $1000 bonds. Maybe the call price on the bond might be A $1,050, right? There's this little penalty that you pay for calling them back early, right? Since you don't want to pay the interest anymore? Well, those people are expecting to get interest for a few more years, you're calling them early, so you usually have to call them at a higher price. Okay? We don't dive too deeply into callable bonds in this class. You'll probably see that a lot more once you get into finance. Okay. And the last one here is convertible bonds and these are bonds that have a conversion clause meaning that you can take the bonds and you can convert them into shares of common stock in the company. So that would mean you sell them a bond which is originally a liability right? You owe them interest and your paying this off. But the person who bought the bond could say actually I want to convert this and they will, instead of getting paid interest and be repaid the principal. Well, they'll have common stock in the company instead. Okay, so they'll literally convert the bonds into common stock in the company. Okay, so those are most of the terminology that you're going to deal with when you deal with bonds payable. Let's pause here and then we'll talk about the interest rate and how that affects bond issue prices. Alright, let's check that out in the next video

Alright. So let's keep going here with the interest rates. Now, when we talk about bonds, there's gonna be two interest rates that we deal with, there's going to be the stated rate and this is the stated rate on the bond. So if you think about it, I'm a company selling bonds right now. I can say I want to pay 10% interest. I can say whatever interest rate, Right? I'm the one selling the bond. It's a matter of, will you buy it? So I'm gonna say, Hey, I'm paying 10% interest and that's the stated rate on the bond. I could also say, Hey, I'm making bonds and I'm gonna pay 8% interest. I'm gonna pay 10%. I'm gonna pay 12% whatever I want. That's gonna be the stated rate on the bond. Okay. And we also say coupon rate as another term for the stated rate. They mean the same thing. Okay. And when we start dealing with journal entries, this stated rate is going to be the cash interest that will be paid. Right. This makes sense. I say I'm gonna pay 10% interest. Well, that's the amount of cash I'm gonna be paying every every time I pay interest. So when we start dealing with interest expense. Well, the cash amount of interest is going to be based on that stated rate. Okay. And then alongside the stated rate, there's going to be the market rate of interest. So you can imagine my company is offering 10% right? We're saying, Hey, we're paying 10% on these bonds. Well there's gonna be other similar companies on the market that are also offering bonds and there's going to be the going market rate. Right? So the going market rate could be the average in the industry, right? Maybe the industry industry is paying 8% right now, or maybe the industry is paying 10%,. They're going to give you this information of what's going in the rest of the industry compared to what you're offering. Okay. And that's gonna make a big deal. That's going to be a big deal once we're dealing with how much we can sell these bonds for. Okay. So we're gonna go into a lot more detail about how these interest rates matter and how they affect the issue price of the bond. Okay. So this market rate is sometimes also called the effective rate. Okay. And this is the interest rate for similar bonds. Okay. So that's the big deal here. The interest rate for similar bonds to the ones we're trying to sell. All right. And this is going to be important when we're dealing with the interest expense. Part of the journal entry. Okay. Um we're gonna go into a lot more detail about how we do the journal entries for interest expense. So, don't get caught up on it right now, but just, it's, it's great to know that we're gonna be dealing with two interest rates. Okay, So let's go ahead and see why this matters because of how we issue bonds. Okay so bonds bond prices are gonna be quoted at a percentage, you're gonna see very often in this class that they're gonna tell you a percentage of the maturity value and that's how how much the price of the bond is going to be today. Okay. So just because up above were talking about $1000 bond, right? That $1000 bond, that's the $1000 that's going to be paid at maturity. So that $1000 is what's paid like 10 years from now. That doesn't necessarily mean that right now someone wants to pay $1,000 for it. The price of the bond today could be different than $1,000. Okay. And the way we're gonna see it is based on these percentages, the current selling price is based is going to be shown to you in these percentages. So if we talked about that $1000 bond and it's quoted at 100 if they say the $1000 bond is selling at 100 it doesn't mean it's selling for $100. It means it's selling for 100% of the $1000 price. So it's selling for $1000 in this case. Okay. Because it's 100% of the face value. But let's look at some different ones. What if they say the $1000 bond is quoted at 103. So this is a very common terminology, you're gonna see throughout this chapter, the $1000 bond is quoted at 103. Well, that means it's selling for 100 3% of its $1000 value. So it would be selling for we would say $1000 times 1.3. Right? We would do times 1.3. So let's do that calculation real quick. Let's pull out our calculator 1000 times 1.3. Well, that's 1000 30. Right? We could have done that in our head. So 1000 30 is the current selling price. And we're gonna go into more detail why the current selling price could be different than the face value. But in this case it's selling for more than $1000 face value. What about in the next example, $1000 bond quoted at 92.375. You can totally see something like this. Okay. And that would be that the $1000 bond is selling for 92% 92.375% of its face value. Which is the $1000. So that would be time 0.9237375, meaning it's selling for $923.75 right? $923.75 would be the current selling price of the bond. Okay. In the future this this bond that you paid, that we received $923.75 for well the liability is still for 1000 in the future. Right? When we have to finally pay off this bond, we're gonna pay them $1000. They just it wasn't worth as much today. And we're going to see why it has to do with the interest rates that they would pay this lower price. But the big deal here is to see that they're going to be quoted in these percentages. Okay? So that's how we find the current selling price is by dealing with these percentages that they give us and they're going to have to be given they're going to give you these percentages and you're just gonna have to calculate the current selling price. Okay, so a couple more vocabulary we're gonna be dealing with first, is this face value? That's what we've been using so far. Right? The $1000 bond, the face value of the bond was the $1000 right? That was the $1000 that we've been dealing with in these examples. Now the discount price, what do you think is a discount price gonna be above face value or below face value? Well, you should think from the terminology right discount. Well, a discount is gonna be below the face value. Right? So if you would imagine This this one right here, when we talked about 92.375, that one was a discount right? A price below face value and this occurs when the stated rate is less than the market rate. Okay. And let's think about that real quick. Why would this make sense? So right now, the stated rate of the bond, remember the stated rate is what we're offering. Our company says, hey, we're offering 8% interest right now. Come buy our bonds that are offering 8% interest, Right? So let's say our bonds are offering 8% interest. Come buy our bonds and then the market saying, hey, check us out, we're selling bonds that are 10% interest. Right? Well, doesn't that make sense that yours wouldn't be as enticing to an investor, right? The market is offering 10% interest and you're only offering 8% think of it from the investor's perspective, would they rather earn 10% interest or would they rather earn 8% interest? They want to earn the more interest? Right? So since you're only offering 8%, they're not gonna be willing to pay you as much as they would be willing to pay someone offering the market rate. Okay. And this is the opposite as the premium price. And we're gonna go into a lot more details about all of this in in the upcoming videos. Okay. So premium price. Well, premium, right? You're paying a premium and this is a price above face value. So if we're looking at our example up above this 103, right? That one was issued at a premium because they paid more than the $1000 face value for this bond and we can write this in here for the first one was at face value. Right? Because that one was sold at 100% of its value. It was sold at the face value. It's sold at face value. Okay. So this would be the opposite situation with the premium price from the discount price. So think about the premium price. Now, this is a situation where we're saying, Hey, check us out. We're offering 12% interest. Look at our bonds. Come buy our bonds that will pay you 12% interest and the market is offering 10% interest. Now, what do you think the investor is gonna do? The investor's gonna want our bonds? Right. We're offering 12% interest and everyone else is offering 10%. So, our bonds are a lot more enticing to the investor. They're gonna be willing to pay a premium for our bonds because our interest is higher than the market interest rate. Okay, So when the stated rate is greater than the market rate, that's when we get a premium price situation. All right. So let's pause here and we're gonna go into more details about discounts, premiums, calculating interest, expense, all this fun stuff in the upcoming videos. All right. Remember this is one of the trickiest chapters. All right. So, I want you guys to pay close attention and let's go through all the details. Let's do that in the next video.