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Introduction to bonds | Stocks and bonds | Finance & Capital Markets | Khan Academy - YouTube
Channel: Khan Academy
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Voiceover: In this video,
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I want to give you a general
idea of what a bond is
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and why a company might even issue them
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in the first place.
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And just at a very high level,
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a bond is essentially a way for someone
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to participate in lending to a company,
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so you're a partial lender,
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partial lender,
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to a company,
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and just to make that more concrete,
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let's imagine some type of company
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that has $10 million in assets,
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so these are its assets right there,
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assets,
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and it has $10 million in assets.
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Let's say just for the sake of simplicity,
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it has no liabilities,
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so all of that value,
all of that $10 million
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is what is owned by the owners,
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or by the equity, this owner's equity,
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so this is $10 million,
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$10 million in equity.
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And if we had, let's
say, a million shares.
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I'll write it down.
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If we have a million shares,
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and if we believe this $10 million number,
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that implies that each share
is worth $10 per share.
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Now let's say this company
is doing really well
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and it wants to expand.
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It wants to increase
its assets by $5 million
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so it can go out and buy
a $5 million factory,
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so it wants,
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let me draw it right here.
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It wants another $5 million in assets
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that it needs to build that factory,
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or essentially a $5 million factory.
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The question is,
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how does it finance it?
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Well, one way is they could
just issue more equity.
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If they're able to get a
price of $10 per share,
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they could issue another 500,000 shares,
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500,000 shares at $10 per share,
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and then that would essentially,
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it would produce $5 million.
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This is scenario one.
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They issue 500,000 shares at $10 a share.
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They now have 1.5 million shares,
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but these new owners
gave them, collectively,
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$5 million dollars,
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so this, the equity
would grow by $5 million.
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We now have 1.5 million shares,
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so this would now be 1.5 million shares,
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not one million,
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and that new money from
these new shareholders
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would go into the asset side,
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and then we would use that
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to actually buy the factory.
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What I just described is
essentially issuing equity,
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or financing via equity.
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Financing via equity,
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or by issuing stock.
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Now, the other way to do it
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is to borrow the money,
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to borrow the money,
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so let me redraw this company.
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I'll leave this up here just
so we can compare the two.
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Once again, we have $10 million of assets.
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That's our $10 million of assets.
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We have $10 million of
equity to start off with,
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$10 million of equity,
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and instead of issuing
stock to get the $5 million,
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we're going to borrow the money
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so we could, we're
essentially issuing debt,
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so we issue,
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we essentially could go to a bank and say,
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"Hey, bank. Can I borrow $5 million?"
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So we would have a $5 million liability,
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it would be debt.
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$5 million of debt,
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and the bank would give
us $5 million of cash
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that we can then go
use to buy our factory.
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So in either situation,
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in either situation,
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the asset side of our
balance sheet looks identical
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or the assets of the
company are identical.
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We had our $10 million of assets,
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and now we have a factory,
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but in this first situation,
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I was able to raise
that money by increasing
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the number of shareholders
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by increasing the number of people
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that I have to split the
profits of this company with.
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In this situation,
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I was able to raise the
money by borrowing it.
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The people that I'm
borrowing this money from,
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the people that I'm borrowing this money,
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this is borrowed money,
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borrowed money.
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They don't get a cut of the
profits of this company.
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What they do is they get paid interest
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on their money that they're lending to us
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before these guys get any profits at all.
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In fact, that interest
is considered an expense,
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so these guys get interest,
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get interest.
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And even if this company
does super, super well,
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and becomes very, very profitable,
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these guys only get their interest.
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Likewise, if the company does really bad
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and these guys suffer,
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as long as the company
doesn't go bankrupt,
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these guys are still going
to get their interest,
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so they're going to be a lot safer than,
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well, they don't get as much of the reward
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as the new equity holders would.
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They also don't get as much of the risk.
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Now, this is just straight up debt,
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and you could just get this from any bank
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if they were willing to.
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If they said, "You're
a good, safe company.
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"We're willing to lend you $5 million."
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But let's say that no bank wants to
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individually take on
that risk, so you say,
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"Hey, instead of borrowing
$5 million from one entity,
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"Why don't I borrow it
from 5,000 entities?"
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What I can do instead,
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instead of borrowing it from one entity,
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I could issue these certificates.
I could issue bonds.
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That's the topic of this video.
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I issue these certificates.
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They have a face value of $1,000.
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$1,000. This is my face value.
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Face value,
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or sometimes you'll hear
the notion of par value,
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of par value,
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and I'll say what interest
I'm going to pay on it,
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so let's say I say it
has a 10% annual coupon,
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annual coupon,
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and it's actually called,
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even though this is the interest,
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I'm essentially going to pay $100 a year.
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It's called a coupon because when they,
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when bonds were first issued,
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they would actually throw
these little coupons
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on the bond itself,
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and the owner of the
certificate could rip off
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or cut off one of these coupons,
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and then go to the person borrowing,
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or the entity borrowing the money,
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and get their actual interest payment.
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That's why it's actually called "coupons",
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but they don't actually
attach those coupons anymore.
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And it has some maturity date,
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the date that not only will
I pay your interest back,
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but I'll pay the entire principle,
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the entire face value,
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so let's say the maturity,
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maturity is in two years,
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is in two years.
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In this situation,
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in order to raise $5 million,
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i'm going to have to issue 5,000 of these
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because 5,000 times 1,000 is 5 million,
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so times 5,000.
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If you wanted to lend
$1,000 to this company
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so that they could expand,
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and if you think 10% is
a good interest rate,
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and it's a safe company,
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you would essentially
buy one of these bonds.
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Maybe you buy it for $1,000,
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and when you buy that bond for $1,000,
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you are essentially lending this company
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that $1,000, and if you
did that 5,000 times,
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or if that happened 5,000 times
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amongst a bunch of different people,
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this company would be able to raise
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its $5 million.
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Now just to be clear how
the actual payments work.
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The coupons tend to
get paid semi-annually,
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so let me draw a little timeline here,
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and this tends to be the case in the US
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and western Europe.
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If this is today.
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This is today.
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This is in 6 months.
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This is in 12 months, or 1 year.
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This is in 18 months,
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and this is in 24 months,
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and I'm only going up to 24 months
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because I said this bond
matures in 24 months.
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What is this,
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if you own, if you hold
this bond, this certificate,
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what do you get?
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Well, it's going to pay you 10% annually,
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so $100 a year.
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$100 per year.
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But they actually pay the
coupons semi-annually,
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so you get $100 a year,
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but you get half of it every 6 months,
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so you're going to get $50 after 6 months.
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You're going to get $50 after 12 months,
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or after another 6 months.
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You're going to get another $50 here.
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You're going to get a final $50 there,
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and they're also going
to have to pay you back
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the original amount of the loan.
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They're also going to have
to pay you the $1,000,
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so that last payment's
going to be the coupon of 50
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plus the $1,000,
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and so you will have
essentially been getting
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this 10% annual interest.
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Now, when the company does this,
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they'll probably have to
issue some type of new bond
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because all of a sudden,
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they have to pay all of these people
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this huge lump sum of money
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if they haven't been able to earn it
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from the factories yet,
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and we could talk about
that in a future video.
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