FA40 – Understanding Bond Pricing - Discounts vs. Premiums in Accounting — Transcript

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1. 0:01Welcome to the part of the chapter that
2. 0:03discusses bonds. And bonds is a
3. 0:05notoriously difficult topic. So I
4. 0:08thought I'd introduce it with baby
5. 0:10steps. 948 958. Pretty gentle short
6. 0:14questions. And then you get into 96 97
7. 0:1798. They're a little harder. But what is
8. 0:20a bond fundamentally? It's a company
9. 0:23borrowing money, but they're not
10. 0:25borrowing from the bank. They're
11. 0:26borrowing from investors.
12. 0:29And in in borrowing from investors, it
13. 0:32means there's a market for their bond.
14. 0:35So in other words, I say, "Hey, I want
15. 0:37to borrow $1,000 from you. I promise to
16. 0:40pay you back with interest, and my
17. 0:42interest rate is 3%." And the investor
18. 0:44goes, "Ah, 3%'s not good." And nobody
19. 0:47buys it. And if that's the case, the
20. 0:50price of your bond comes down. And so
21. 0:51you end up trying to borrow a th00and,
22. 0:53you only get 900 bucks. Why is that?
23. 0:56Because your interest rate was too low.
24. 0:57the investors paid a discounted amount.
25. 1:01Or if I say, "Hey, I'm gonna offer 12%
26. 1:03interest." And the investors go, "Oh my
27. 1:05gosh, I love 12%." Then your price gets
28. 1:08bit up and your bonds issue at what's
29. 1:11called a premium. Because of these
30. 1:13market dynamics, it makes accounting for
31. 1:16bonds more challenging. But let's just
32. 1:18start with that fundamental concept. If
33. 1:20you offer low interest compared to
34. 1:23similar companies to yours in the
35. 1:25market, your bonds will issue at a
36. 1:27discount. Investors aren't going to buy
37. 1:29them. Uh they'll have to take a lower
38. 1:32price. If you offer very generous
39. 1:34interest, investors are going to pay
40. 1:36extra. They're going to pay a premium.
41. 1:38That's what this question gets at. So,
42. 1:41let's read it. Highflyers Inc. issues a
43. 1:43bond that pays 5% interest. The market
44. 1:46rate of interest for similar companies
45. 1:48is 6 and a half%. Okay, so we're
46. 1:51offering 5%. Similar companies to off us
47. 1:54are offering six and a half%. Will our
48. 1:56bonds issue at a discount or a premium?
49. 1:58Well, if we're only offering five and
50. 2:00you can get six and a half somewhere
51. 2:01else, you're not going to buy my bond
52. 2:03for full price. You're going to need to
53. 2:05have some discounted price to to want to
54. 2:08buy the bond. So, these bonds will issue
55. 2:09at a discount. Why? because there are
56. 2:12more attractive similar companies
57. 2:15offering six and a half, right? You can
58. 2:17get a better price somewhere else. Uh
59. 2:19there there's no need to buy my bonds.
60. 2:22Cool Beans Inc. issues a bond that pays
61. 2:255% interest. The market rate for similar
62. 2:27companies is 3.5%. Okay, so we're
63. 2:29offering five. Similar companies are
64. 2:31only offering three and a half. Well, in
65. 2:34this scenario, all of a sudden, we're
66. 2:37much more attractive than those other
67. 2:39companies. If we're more attractive than
68. 2:42our competitor companies or similar
69. 2:44companies to us, uh investors will be
70. 2:46willing to pay a premium for our bonds.
71. 2:49Again, because it's it's all relative.
72. 2:52It's compared to similar companies with
73. 2:55similar risk profiles. Assume that
74. 2:57Highflyers Inc. and Cool Beans issued
75. 3:00their 5% bonds on the same date at the
76. 3:02same time. Why would one issue at a
77. 3:04discount and the other at a premium? The
78. 3:07primary reason why two companies could
79. 3:10issue one at 5% and one's a discount,
80. 3:12one 5%, one's a premium, is because,
81. 3:15well, the company's risk profiles are
82. 3:17different. Remember, a bond is you're
83. 3:20loaning money to somebody. How likely is
84. 3:23it that they're going to pay you back?
85. 3:25If you told me I can loan money to MIT,
86. 3:29you know, the one of the most famous
87. 3:31universities in the world, very solid,
88. 3:33very stable, or Harvard, you know, that
89. 3:35type of place, or I can loan money to uh
90. 3:40Tony's discount education store, right?
91. 3:44Well, you would obviously say, "Oh, I'd
92. 3:46rather give my money to MIT than Tony's
93. 3:49discount education store. I think MIT is
94. 3:52going to be around to pay me back. You
95. 3:53know, if they sign the contract, MIT is
96. 3:55a much ba safer bet than Tony's discount
97. 3:58education store. So, why would one issue
98. 4:01at a discount, the other a premium? It
99. 4:02speaks to the quality of the company and
100. 4:05the outlook for the industry. So, those
101. 4:08are two big reasons why two companies
102. 4:11can both issue at 5% on the same day,
103. 4:14same time. One gets a premium, one gets
104. 4:16a discount. It's the quality of the
105. 4:17company and the quality of the industry.
106. 4:20Um, is it possible in the real world for
107. 4:23two companies to issue 5% bonds same
108. 4:25day, same time, and have one issue at a
109. 4:26discount, the other a premium? Why or
110. 4:28why not? Absolutely yes. Again, MIT
111. 4:32issues a bond uh offering 5% today and
112. 4:37uh Joe's crypto uh speculation investor
113. 4:42uh offers a 5% bond today. Hey, I mean
114. 4:45Joe's Crypto Speculation Investor might
115. 4:47be a good company. I wouldn't lend him
116. 4:49the money at this. Maybe I would lend
117. 4:52them the money, but I would lend MIT the
118. 4:54money first, right? So MIT would be much
119. 4:57more attractive to me because again, I'm
120. 4:59looking just for somebody to pay me
121. 5:00back.
122. 5:01I want the very stable company with a
123. 5:04very long track record. MIT is much more
124. 5:08attractive and would be much more
125. 5:09attractive to investors. Joe's would
126. 5:11have to offer a much higher rate of
127. 5:13interest to even be in the same ballpark
128. 5:16as MIT, which is why MIT would issue at
129. 5:19a premium and Joe's would likely issue
130. 5:20at a discount because you wouldn't want
131. 5:22to lend that money to Joe's crypto
132. 5:27investment scheme. Uh, okay, there you
133. 5:30go. We've solved a 94A. And I hope this
134. 5:33is just us dangling a toe in the waters
135. 5:37of bonds. As we go on, we step up in
136. 5:41difficulty each problem. Stay tuned for
137. 5:44our next video. Thanks for watching.
138. 5:46Bye-bye. The next video in our series is
139. 5:48right up here. And if you want a
140. 5:50supercut of all of the videos in this
141. 5:52series, that's the one down below.