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

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

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

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

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

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

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

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

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

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generally have lower priority well than any other type of bond

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

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

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

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maturity and bonds boringly payoff as expected yon passed the napkin

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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investor or bank while companies generally pay a relatively low interest

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

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

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

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

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

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

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

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

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

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

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

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

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asset back bonds for example airlines typically have

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

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

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

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

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

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

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the prior stack of bonds should something go wrong

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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company management is incentivized via stock options which are common stock

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

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

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subordinated to ventures and below preferred stock well if the ventures

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

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

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

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

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

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performance means nothing to the bondholders the bondholders simply get

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

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

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

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Google well that feature bond convertibility all right well because

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debentures are low on the risk or priority stack

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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pays interest and eventually the principal but the shares outstanding

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

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

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shares being printed and outstanding otherwise in the variously known as

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

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

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

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

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

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

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

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now convert into common stock how many additional dilutive

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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guaranteed by General Foods if the sauce company ever defaulted on

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

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

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

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

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

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

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

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to be closer to it strategically and in using the

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

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

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

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

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

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

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

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

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

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

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

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

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

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