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Principles of Finance: Unit 5, Baskin Robbins Bonds: 31 Flavors of Bonds and Bond Type 10 Views


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There are numerous flavors of bonds. In this video, we'll give you a chance to, um... lick 'em all.

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English Language

Transcript

00:00

principles of finance a la shmoop baskin-robbins bonds 31 flavors of bonds

00:07

and an L bond types vanilla rocky road tutti-frutti gluten-free well there are [ice cream flavors]

00:14

lots of flavors of bonds there are way more than 31 of them but we just like

00:18

ice cream so forgive us alright let's take our first lick right here no no

00:23

sprinkles yeah already evident all bonds don't necessarily have the same priority

00:28

when the electricity goes out on a hot day in the refrigeration unit that is [woman offering ice cream but the lights go out]

00:32

when a company goes bankrupt or stumbles on a tough economic times

00:36

senior bonds have priority over Junior bonds duh Bank debt owned generally has [pecking order in liquidation list]

00:42

priority over even senior bonds at the other end of the spectrum debentures

00:47

generally have lower priority well than any other type of bond

00:51

except for subordinated Dementors which have even lower priority than your basic

00:57

vanilla debenture what most investors operate on the assumption that the [writing on white board]

01:00

borrower will pay the interest as it comes due and then the principal at

01:05

maturity and bonds boringly payoff as expected yon passed the napkin

01:10

unfortunately in the real world borrowers do get into trouble from time

01:14

to time and are unable to repay the dough they promise to pay back well

01:17

their word was their bond and they broke it does this mean that you holding that [hands rip bond sheet in half]

01:22

IOU because you loaned them money are you out of luck well not necessarily

01:26

your chances of repayment even when things go bad well depends on how senior

01:31

your IOU is compared with all the other IOUs [long line of people]

01:35

standing in line ahead of you and it presumes that there's some value left in

01:39

the company after it goes belly-up even though it has gone legally bankrupt

01:43

unable to pay the interest on its debt think basically what California is gonna

01:47

be in about 10 years so let's cover a few of these issues right here senior

01:52

does not mean I bought it before you did so I stand first in line instead

01:57

seniority refers to the preeminence of claims of a given class of bonds

02:02

relative to all other bonds that the company has issued so let's get back to

02:06

the stack here from highest priority to Lois starting with Bank debt you know

02:11

any wild and crazy bankers you know we didn't think so there's a reason for [crazy banker gets punched in the face]

02:14

that they get paid for being boring make safe loans to safe bet people

02:20

collect the interest and principle lather rinse repeat as a result of their

02:25

craving for boredom and safety while bank debt generally stands at the top of

02:29

the stack and in practice often bank debt is back directly by something very

02:33

liquid like a company's accounts receivable what does that mean well at

02:37

even the whiff of bankruptcy banks can step in and seize legal claim to the

02:43

money that the company is owed ie accounts receivable credits and use

02:47

those proceeds to pay off any bank loans that had been made to the company that

02:52

were outstanding in return for this extreme seniority and safety to the bond

02:56

investor or bank while companies generally pay a relatively low interest

03:00

rate for renting such relatively very safe cashola all right next up senior

03:05

debt well senior debt is typically the safest and most secure type of real bond

03:10

in a corporate balance sheet if company ever ran into bankruptcy problems while

03:14

the first type of bond to be paid would be the senior obligation bonds and [hand dishes out money]

03:17

sometimes there are many series of senior bonds so you got a check which

03:21

one you're talking about there but note that senior bonds would come behind

03:25

primary vendor bills and of course IRS taxes and bank debt so they're pretty

03:31

senior than seeing your bonds there but they're not all that senior when you

03:35

know this happens all right well next up junior debt okay so not that junior but

03:43

you get it so just below senior debt otherwise pretty much the same thing all

03:47

right well then we have asset back debt ABS or asset backed bonds or securities

03:52

are backed by specific assets of a company that's why I've here called

03:57

asset back bonds for example airlines typically have

04:00

separate bonds secured only by the airplanes they own or lease if you had a [airplane landing in airport]

04:05

chain of chocolate pretzel stands with a unique formula for chocolate that you

04:09

knew Godiva would pay you a million bucks to own well you could likely

04:12

borrow say half that amount or so in the form of a bond backed only by your

04:17

Grandmama's secret formula all right next up the unwanted red haired

04:21

stepchild of the bond world debentures right well debentures are the lowest on

04:26

the prior stack of bonds should something go wrong

04:29

there backed only by the Full Faith and Credit and handshake of the company

04:33

meaning the company promises to pay back the bond unless it can't well why would [stacks of money]

04:38

a person ever loan money only based on the company's promise and handshake and

04:42

all that and nothing tangible if a company ever refused or couldn't pay any

04:47

form of a bond well it usually spells the end of the company's credit or trust

04:52

from wall street people and from all the company's vendors shareholders and board

04:56

a debenture not paying is more or less as cataclysmic to a company's financial [town center blows up]

05:01

health as any other form of fun and note that there are also subordinated

05:05

debentures which are basically the absolute lowest form of bond you can get

05:10

they get paid junior to the Full Faith and Credit bonds of the company and you

05:14

should smirk and I roll when you hear this Full Faith and Credit crap because

05:19

it just means that the company shakes hands with you and says yeah okay that's [hands shaking]

05:23

about it well why would someone buy a subordinated debenture bond instead of

05:28

all say a senior bond interest a senior bond might only pay four percent whereas

05:33

a subordinated debenture might pay on a seven eight nine percent something like

05:37

that or more and while we're at it why would you have faith that you'd ever get

05:41

paid back when you invest it in a subordinated debenture well because most

05:46

company management is incentivized via stock options which are common stock

05:52

released common stock is the underlying asset below a stock option well guess

05:56

what common stock in this priority stack comes below debentures and below

06:01

subordinated to ventures and below preferred stock well if the ventures

06:05

don't get paid in full the company management makes nothing from their

06:08

stock options and usually at the end of their career if they ever don't pay back

06:12

a bond obligation so there's a whole other incentive set there all right so

06:16

that's the stack of priority and bonds when things go badly but what happens

06:19

when things go well well in most cases when companies do extremely well their

06:24

performance means nothing to the bondholders the bondholders simply get

06:28

the interest promised to them then they get their principal back but there is

06:31

one feature many bonds have which allow the bond holder to participate in

06:36

magnificent winnings should a company end up doing you know [money falling onto table]

06:39

Google well that feature bond convertibility all right well because

06:43

debentures are low on the risk or priority stack

06:46

well they typically come with one other religious feature convertibility that is [jesus on the cross]

06:51

a thousand dollars of United Airlines bonds might be convertible into 50 [writing on white board]

06:55

shares of United Airlines stock well a thousand bucks yeah that's the par value

06:59

of the bond it gets divided by 50 shares of the option of the owner of the bond

07:04

50 into a thousand is 20 so that $20 is a key breakeven point for the

07:10

convertibility of the bond that is convertible bonds are just bonds with an

07:15

embedded call option in them to convert the bonds into equity aka shares of

07:20

stock in a given company so what does that mean well doing fancy math that

07:24

means that if the share price ever went meaningfully above 20 bucks the common

07:28

stock share price 20 bucks or more well then it might make sense for the bond

07:32

holders to convert their bonds into equities make a nice profit if the stock

07:36

went up a bunch you know from that 20 at the break-even point of 20 bucks well we

07:40

have what is called a parity position a key element to consider when you do the

07:45

math on convertible bonds values is die lucien and the rejigging of a balance

07:49

sheet that is when a bond exists just as a bond while the company shares

07:53

outstanding number remains unaffected by it the company owes the bond debt it

07:58

pays interest and eventually the principal but the shares outstanding

08:01

don't change however when that bond is converted into stock well the liability

08:07

of that debt goes away like magic but it comes at the price of having more common

08:11

shares being printed and outstanding otherwise in the variously known as

08:16

dilution we have a company with 2.5 billion dollars of debt with 500 million [writing on white board]

08:23

dollars that is convertible into stock at $50 a share and a 10 to 1 conversion

08:28

ratio well the company reports a good quarter and the common goes from 50 to

08:32

60 and before any conversion there are a hundred million shares outstanding every

08:36

bond holder now has the right to convert their debt into stock and well they had [woman driving red car]

08:41

the right before but why would you do that lose money so they don't and all of

08:45

them rationally convert all of the five hundred million dollars worth of bonds [writing on white board]

08:48

now convert into common stock how many additional dilutive

08:52

shares are now created well to get the magic answer we divide 500 million

08:57

dollars by the conversion price of 50 bucks a share and you add 210 million

09:01

shares to the pie so think about that you've just I looted yourself ten

09:05

percent via that bond convertibility feature well now to earn $2 a share with

09:10

a company after tax has to earn two hundred twenty million dollars because

09:14

of the dilution instead of two hundred million and there's a ripple effect when

09:18

you have more shares outstanding it just means you have to have more revenues

09:21

higher margins usually or more profits to actually be where you were before the

09:26

dilution happened well on the flip side the 500 million dollars that carried

09:30

that interest cost of five percent or twenty five million a year it goes away

09:34

the company doesn't have to pay that 25 million a year anymore there's just more

09:37

shares outstanding and the bondholders now become equity holders so maybe that

09:41

evens things out but lots of moving parts here so we got to think through

09:45

the math companies often give away the store by being too liberal in selling

09:50

this bond convertibility feature when they do an offering and that dilutes [businessman selling bonds]

09:53

them and bites him in the end that can be a problem right okay almost done here

09:57

moving on to guaranteed bonds wealth guaranteed bonds are a rare pebble on

10:01

the bond beach but they do happen on occasion and they come when one company [writing on white board]

10:04

offers to guarantee the bonds of another like let's say General Foods wanted the

10:09

right to distribute the Bubby's sauce but in order for the sauce company to

10:13

produce enough sauce at a scale that General Foods would care about like a [bottles on a conveyor belt]

10:17

million bottles an hour the sauce company would need to build and own its

10:21

own bottling plant which might cost 50 million bucks well on its own to get a

10:25

loan for that plant General Foods could allow the sauce company to offer a bond

10:29

guaranteed by General Foods if the sauce company ever defaulted on

10:34

that bond well General Foods as the creditor would simply take over

10:38

ownership of the whole sauce company having ended up quote buying it unquote

10:42

for a very cheap price in the form of their simply having loaned the money to [old woman in kitchen]

10:47

the company why wouldn't the sauce company get a loan elsewhere or just all

10:50

on their own well likely because they couldn't or likely strategic reasons

10:54

that is it was hoping to get bought by General Foods but at a high price

10:58

someday not from taking over their defaulted bonds and they simply wanted [man thinking of a river of money]

11:02

to be closer to it strategically and in using the

11:05

enormous balance sheet of General Foods promoted from Colonel Foods a long time

11:09

ago the sauce company would have been able to likely get interest rates much

11:12

lower than had they had their own credit alone and they alone had to negotiate

11:18

with lenders right all right so let's review the stack here quickly at the top

11:21

comes the IRS then there are vendors like Joe the Plumber did some work

11:25

fixing toilets and well he gets paid above everybody else [man plunging toilet]

11:27

then there's the bank debt secured by accounts receivable and any other liquid

11:31

asset of the company then we have the normal bond stack senior bonds and

11:34

junior bonds and they can range in priority on the stack all the way down

11:38

to debentures and then even we have subordinated ventures way at the bottom

11:42

there you know and the shadow of the bond world and then there's preferred

11:45

and then common at the bottom yeah so yeah that's it that's the you know scoop

11:49

on bond types [kid holding three scoop ice cream cone]

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