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okay here we're going to talk about bonds and before i go into bonds i want to uh the the one thing when i talk to students they they always thought about stock and they want to know about stock and so forth however i'm going to make the argument now and you know throughout the course that bombs are much more interesting in fact if you were to go back to uh work at solomon brothers back in the 80s uh if you if you did poorly that you know where they kind of sent you for your career to die was equities in dallas where you wanted to be bombs in new york right so bonds are very interesting bond markets are large right uh however bonds have are mainly dealt with by institutions right so students don't really see this you see stock and rob and all that sort of stuff uh and that's fine but but really there's there's an absolutely massive amount of money to be made in bonds and bonds are where i worked uh so i'm partial to bonds now first and foremost before we jump in here the text and i'm using the term bond very loosely so in general what we're just saying here is this is some sort of fixed income security or or this is a or or you know what the text means is a debt security right so this is a liability of the firm this is debt and we'll talk about most of what we'll talk about here would be fixed income now specifically a bond would imply some sort of collateral meaning i've pledged some collateral if i don't pay you you get my factory whereas most of the securities we'll get actually talk about are not bonds they don't have any collateral uh they would have no collateral so when apple uh issues a bond there's no collateral so technically it's a debenture right um also if it's between one and ten years it's a notes uh so there's so in other words instead of being very specific about saying okay this is a subordinated debenture we're just calling everything bond right even if it's a note or so forth we're just calling it a bond so first of all keep in mind that about bond right so what what is a bond a bond is nothing other than a promise to pay according to some schedule or according to some uh event this is why bonds will be you know really interesting because a lot of times people think derivatives are exciting but there's a lot of derivatives embedded in bonds but so the idea of a bond is just a promise to pay according to some set schedule or some uh event right so uh another way to look at bonds is how they differ from equity so uh and this will be very important later bonds are not ownership so you don't get uh a vote right you don't get to vote for the board of directors or anything so bonds are not ownership uh interesting aspect of bonds is the interest is tax deductible so the idea here is the more the company pays interest the more the taxes the lower their taxes are so that's a huge a huge aspect of bonds and you know and the the big thing here is bonds are have to be paid according that schedule if you don't pay according to that schedule that's bankruptcy right and if you don't pay according to the schedule then then the creditors the bond the owners of the bond can start to uh take assets of your firm right so the idea here is you know these are but you know i want you to think about this you know so those are important distinctions from equity but remember i want you to think about bonds just as a promise right good uh so when we talk about so i'm going to go over just just brief uh uh briefly the promise right uh and then we'll look at specific aspects of bonds and how to get the price and so forth in future videos but the the the promise that we're talking about here is is uh laid out in what is termed the bonds indenture e and t u r b the bonds invention so first and foremost this will tell the terms of the bond and here's the thing so in other words it'll say the bonds payments are semi-annually the coupon rate is six percent and it's a ten-year bond right so these these are like you know terms of the bond and we're going to talk about this later but the that tells you uh the bond payments so if i say it's uh it'll also tell you the face value the face value in this course will always be a thousand right so uh phase par value will treat us the same thing and it's always a thousand so so that lays out the schedule of promise like if i said uh six percent semi-annually for ten years that means the you know i will go over this a little bit later but it's going to pay uh the bond each bond will pay 30 every six months uh for the next 10 years right so that gives us uh the the uh that gives us um the schedule of payments right there's a lot of other aspects of that go into this promise right so uh whether a bond has a sinking fund will be in the promise the sinking fund is uh a certain amount of the bond is retired outstanding bond you know is retired every year this is this isn't terribly important um oh security will go into this so the if whatever collateral so if i don't pay this bond um you can take my you know tractor sort of thing uh and uh and of course lack of security will be listed in there um the the where the bond sits in the capital structure so an important thing to keep in mind is again looking at it as a capital stack is kind of you know what we have here is equity we have equity at the bottom and then this is all you know debt these are all uh promises this is all you know what we're talking about here bonds but within this this is now an important aspect here is equity there's no ranking in equity right uh there you know no one gets paid before another person right you can't you can't say i'm gonna pay these equity holders when we're talking about common stock common stock here um you can't pay these equity holders but not pay these comp you know these common stockholders may not pay these others so the idea here is but so there's no ordering of these common stockholders but in debt right there are right so we could have senior and junior debt holders and the senior get paid first and then junior later so um where you sit you know senior right or senior right so where you sit precisely in the capital structure um you know subordinated down right is is listed in the bond adventure but it's important to know that bonds are ordered these people get paid then these people are these people and then finally everyone here gets paid right but there's an ordering there is an ordering to dead anything else i want to say uh what you know i'm kind of delaying till i get to one of the big ones is protective covenants let me talk about those now so also in the indenture are things called protective covenants so what i said earlier this is where what i said earlier is important so uh bonds you have no vote right for the board of directors so bondholders have no representation right so so you know if i'm an equity holder and i want management to do something i can uh use you know go through the board right to in the board will tell management to do this but you have no mechanism like that you were not an owner of the firm if you're a debt holder so if you want management to do anything you have to put it in the promise you have to put it in the indenture and that's what protective covenants are so i'd often give an example of you know why i want a firm if i can sell a bunch of debt you know and then i think the firm's going poorly so what i can do is i can take all the proceeds i sell 100 million in debt i can just um give out 100 million as a dividend and then you know uh close the firm right so it what would stop management from doing that if they if they saw you know business prospects or that and it's actually the protective covenants in the indenture so the in the invention there's a bunch of stuff where where the bondholders were saying management you have to do this or you can't do this right so again this comes from the fact that the bondholders don't have a you know vote so they have to put it in this promise they they have to put it in the contract right again i say this is a promise you know the indenture is it's a formal legal contract right and the nice thing is you can bring these up look on the sec for bond adventures with a million and you can read them but in terms of protective covenants what they'll say is you can't increase the dividend you know above a certain amount so you can't increase the dividend by more than five percent per year or something like that that would be a protective covenant uh [Music] another protective company is you have to uh uh now so there's some things like you can't do and then there's something you can do so this is obviously a can a can of protective covenant would be all you have to do uh is uh fight auditing financial statements right so you have to um you have to file audited financial statements on a timely schedule interestingly enough usually in the bond adventure if if everything you want to become sort of what are often termed vulture capitalism but it's uh you know somewhat uh yeah um which is not a terrible terrible thing to do uh what you can do so if the firm violates that that that part that protective covenant you can ask for all of your money back right so in other words let's say the 100 million bonds are outstanding they don't file audited financial statements in a timely manner you can say well give me my hundred million you know hey uh so and usually what there is there's a trustee who manages all the who represents all the bondholders so the trustee would say that right you as just an individual bond holder if you have a small piece of it couldn't say that but but the trustee would would manage this but um now so that would be sort of the the enforcement or what happens if you don't abide by that protective covenant is i can demand all my money back and if you if you're a firm that can't uh file audited uh financial statements you're probably not doing very well so that may bankrupt the firm the firm may say well i don't have the money and then they're bankrupt and you take the assets so that's a uh kind of a uh not i don't say a common that is a way some people have have acquired firms as i i buy a bunch of their bonds i wait for them to break the protective covenant i ask for all the money back when they can't give it to me then they go into bankruptcy and i own the assets of course an important thing to keep in mind here is you don't have to enforce it so i think dell missed its financial statements quite a bit but the bondholders never told they didn't want dell to go bankrupt so they said okay we'll do better okay we'll do better so that's another important thing to remember about these protective covenants is it's not that you have to do it it's not you you're late it automatically triggers it's just if you're late then the bondholders can decide what to do and they can you know they can they can say give me my money back or they can say no right so uh it doesn't you know it doesn't put the bombers in sort of a street jacket uh other protective covenants uh you can't issue debt senior to me would be it would be another protective covenant uh if i have um if you know my collateral is a is a tractor you can't issue any other debt with with uh with the uh with uh that tractor's collateral so limitations on what you can do with collateral there could be there could be um things how the how the company should manage the firm right uh you can't uh you have to maintain cash above this level you have to maintain working capital above this level uh you can write again this bonds it's just this is a legal document it's you know um if you want me to buy your debt you know put that stipulation you have to keep you know uh working capital above this level and that goes into there and then that's a requirement that the management has to to abide by right so um but the idea here is the underlying so on the exam i don't really care if you remember like memorize protective covenants i want you to know the reason why they have to be in there right because management works for shareholders right so uh and and you as a bomb holder have no vote management doesn't necessarily work for you so anything that you want in any way that you want to protect yourself has to be in that bond indenture has to be in that contract and you know right management works for shareholders shareholders want the firm to be risky and this is a you know one thing i really um maybe i should mention this earlier but keep in mind when we're talking we're comparing debt and equity holders equity they have different risk preferences so think if you're a debt holder and google when it was a small firm right do you really uh if google does really well right you know let's say the debt pays five percent you still get five percent right uh no matter how well the firm does you still get your five percent whereas if you're an equity holder if the firm does really well you get more money right so keep in mind equity holders want more risk right because if the firm succeeds they get the additional uh cash to get the additional income debt holders do not want risk right so because if the firm does very well they don't get an additional dime but if the firm does poorly and again any risk goes up you increase risk on the upside you increase risk on the downside so if the firm does very poorly i don't get paid so keep in mind the structure of the contract the structure of debt just that kind of simple debt that we're talking about here just you pay me five percent uh this makes the this this means the the debt holders prefer firm to be safe right whereas the people who management answers to the shareholders right they want the firmware to be risky so right so what the the so the idea of the protective covenants is to sit there and say okay well let's write a bunch of stuff in to make sure when i say like keep cash on make sure the firm is safe right so this this is uh you know this is the important part of the convention all right so i think i'll leave it at that um in in future videos i'll look at how to get the price of a bond given the bond and denture um and and then the present interest rate on the bond we'll talk a little bit about bond ratings and so forth have a great day