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Principles of finance ah la shmoop deconstructing a bond yield

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Whoa Different kind of yield bond yields kind of closer

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to the yield from a field you know like so

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many corn heads for acre or whatever Okay great Enough

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of that topic is yield here Bond yield What happens

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if one day after owning a bond for three and

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a half years having a good relationship with it Lots

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of friendly romantic saturday night dinners you realize across the

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table that you've fallen out of love with it Well

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it simply didn't answer your needs And there was no

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pina colada song to bring you back together You know

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if you like peanut a lot getting god in the

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yield or something that apparently doesn't like getting caught in

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the rain either So you sell it Will it sell

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for the thousand dollars you paid for it Well no

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not necessarily It might sell for five hundred dollars It

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might sell for two thousand dollars or one hundred eighty

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eight Ninety five pricings up to you generally or rather

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up to the market Well if the market says the

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bonds worth eight hundred fifty bucks that's what it's worth

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The key idea here is that just like stock prices

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bond prices float You know along with hope there is

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a market for them and it moves all over the

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place all the time Well at the end of the

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day a bond is simple You buy it by losing

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cash out of your wallet and gaining a piece of

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paper representing a promise You then get a stream of

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cash flows in your pocket called interest payments And then

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you get your principal back at the very end assuming

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all goes well So the only issue is the pricing

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of the bonds When they are bought and sold and

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revolves around the rate of return investors get for parting

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with their hard earned cash for whatever period of time

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is involved Basically you're renting money and that rate of

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return carries the fancy name yield Bonds are both call

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a ble and put a ble meaning a company can

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call them at times Or you can put the bond

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forced the company to buy it back from you It's

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um set price and not all bond Sit around paying

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interest their entire lives to then finally come do after

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decades been paying off their principle because early call or

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early retirement of bond principle is such a common thing

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Most bonds would carry a call provisions are quoted in

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the form yield to call that is the yield is

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quoted assuming that the bond will in fact be called

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back by the issuer in the first period in which

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it is legally colorable mint let's say you're living in

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the worst bond market in american history toward the end

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of the jimmy carter presidency in the late nineteen seventies

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will prevailing rates for safe customers are nine percent for

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loans lasting a year or less and the yield curve

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is inverted meaning that if we look out ten years

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later the ten year treasury was yielding seven percent so

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investors were betting that rates would go down over time

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You are the local pizza parlor chain looking to expand

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financially not waste lining The venture world doesn't want to

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invest in you via equity i owning a part of

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you because pizza chains aren't really loved in the public

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markets and they don't see how you grow at a

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huge rate so all right fair enough but you want

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to buy five other pizza restaurants locally you need to

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act now like in the next thirty days or someone

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else will buy them So you get a nine percent

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plus risk plus other premiums of three percent to equal

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a twelve percent loan Yeah twelve percent interest on your

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loan will the cost of running your capital in this

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horrendous time a very expensive inflation stamping capital is twelve

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percent per year to rent your money you think this

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is crazy high expensive and you don't want to be

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saddled with such high rates for the fifteen year duration

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of alone at which point you would then have to

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pay off the principal So when you borrow the money

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in your contract you embedded clever call provisions which says

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that in four years you the pizza man may call

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the bond back like you'd phone the owner of the

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bond whoever owns it at that time you hit the

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f sharp key on your piano and you'd sing Hello

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it's me I'm paying you off That was adele Ready

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her for that cost us a million dollars Technically call

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provisioning is the right of the issuer The company raising

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Debt to buy back its own bonds usually at a

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modest premium to par the company has effectively a call

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option married to a bond the old fashioned marriage kind

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of way i e no divorce a big part of

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bond math involves factoring in these embedded call options which

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fester and in fact the otherwise beautiful simplicity of a

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stream of predictable cash flows will call provisions benefit the

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issuer so that it can be protected if interest rates

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fall meaningful e like they did from late seventies to

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the early eighties when jimmy carter was shown the door

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by voters and ronald reagan came in laden with testosterone

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So how did this work I know not that testosterone

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part Well you can imagine that in high interest rate

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environments like where t bills or yielding over six or

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seven percent call provisions are a big deal in a

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big part of the term sheet of new bond issues

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but in low interest rate environments like when the government

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papers yielding two percent there in the whole lot of

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focus on call protection because well interest rates can barely

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go any lower after processing paper costs and other elements

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Well anything below two percent is almost free money to

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begin with So with our pizza man we have an

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embedded call provisioned with a four year trigger That means

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that he is betting that rates will drop in four

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years when he then hopes inflation is under control in

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the fed has dropped interest rates such that the exorbitant

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price of renting money at that twelve percent for your

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figure drops down to something closer to six or seven

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percent at which time the pizza man will simply call

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the loan of the very expensive twelve percent paper he

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was renting for such high prices and refinance the loan

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with much more efficient six percent paper going forward like

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he'll cut his interest payments in half And if you

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could rent your same apartment building for half the price

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like why wouldn't you And for what it's worth the

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process of bonds being called isn't always straightforward Of course

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it isn't Often there is a lottery provisioned meaning that

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the issue of the bonds is only allowed to call

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back say and after four years and only twenty percent

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of the bonds they have outstanding then each year well

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they can call another say twenty percent such after for

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five years past that four year cliff off then the

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bond has been entirely retired or called back like refinance

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with cheaper paper or simply paid off because the company

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that issued the bonds was profitable old school right they

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generated own cash paid off bonds So how do you

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calculate the yield to call here when there are odds

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yo won't be called well you could make up statistical

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grids and discount back to account for the risk of

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being called But that clouds the real numbers a lot

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of times that since the future changes so much from

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what most people think it will be Well you get

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bad data when you practice is valuation technique more often

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than not bottom line yield is not always yield Didn't

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yoda say that you know unless it's a traffic sign

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in which case well you better I think that was 00:06:45.964 --> [endTime] been diesel who said that

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