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Principles of finance a la shmoop bond maturity and zero coupon bonds well [Briefcase with bond maturity and zero coupon bonds on the front]

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unlike the writers at shmoop bonds eventually mature what does that mean

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well yes in fact bonds get hair on their private parts and become distinctively [Bond grows hair]

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attractive to other bonds and well there's a rebellion against their issuer

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that's only natural okay so bond maturity let's frame a

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couple of things here first a bond is issued or sold it has a nominal rate ie

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the amount it will pay in interest for renting the principal you know from

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investors it has a duration or rather a time period that'll pass before the bond [Duration circled on a bond]

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fully matures and the principal owed is returned and the bond might have other

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features like put in call provisions which would entitle owners of the bond

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to force the company or issue or to buy the bonds back usually at a discount or

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call provisions which would allow the issuer of the bonds to buy them back

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usually at a modest premium to the par value at which they were issued there's

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also a PIK provision where they can pay in kind ie pay the interest of cash in [PIK provision definition on a whiteboard]

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stock instead so think about the cash flows on a twenty-five thousand dollar

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bond with a coupon of eight percent maturing in ten years well here's what

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the cash flows look like mmm, what happened? well financially this is what

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happens you get minus twenty five thousand and minus because the amount

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was subtracted from your Wells Fargo checking account when it was deposited [Well Fargo logo with stack of cash]

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into the coffers of the Comcast corporation when he bought the bond that

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was part of their new bond offering to fund something that will save cable from

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free Wi-Fi wimax well twice a year you get a plus one

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thousand bucks that is an eight percent coupon pays two grand a year on a

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twenty-five thousand dollar bond but again just to bludgeon you over the head

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with this concept bonds normally pay twice a year so you'd get a grand twice

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a year for ten years that's twenty payments of a grand and your last

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payment would be for what... yes twenty six thousand dollars because you'd collect

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your last coupon payment of that thousand dollars and then you get your [Payments of bonds listed]

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principal back easy-peasy vanilla so that's standard maturity of a bond, but

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there are other ways bonds mature as well so next type of maturity is a balloon

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maturity and yes you can tell we're still working on [Clown making balloons and shmoop workers laugh]

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In a balloon maturity the

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principle is generally retired in nuggets maybe 5% is repaid after two [Balloon maturity explanation on whiteboard]

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years and then another 12 and 1/2 percent of the bond that was issued

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retired after three years and then 25% after seven years in Tibet so that the

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principal shrinks in stages to nothing that is it's balloons of debt pop over [Debt balloons expand and pop]

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time...but with big chunks paid off like a step function rather than the slow

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gradual pay down of something like a typical home mortgage where a tiny bit

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of principal is paid down each month until on the final month's payment most

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of that payment is in fact principal think of it as serial liposuction of

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debt all right next up zero coupon bonds, and yep your hunch is right zero coupon

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bonds are bonds with no coupon... well they don't pay cash

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interest along the way why would anybody want a bond that pays no coupon and no

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interest well no in fact the bond does pay interest it just pays all of the

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interest at the very end of the duration when the bond finally matures ie it has

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outgrown shmoop writing stables here and the principal

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plus all of the accrued interest payments are then paid all at once

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well these type of bonds are sold at a discount to par with investors simply [Bond maturity breakdown]

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collecting the par value so many years later in one lump sum...US government

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short term paper trades this way and in the case of US government paper there's

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no stated interest rate the bonds just traded a discount to par in an auction

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okay so here's the sitch you have a bond being offered at $1,000 par value it's [Man discussing bond at $1,000 par value]

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being sold today for 700 bucks which is a discount to par of $300 what's the

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yield of this zero coupon bond

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...okay trick question this one's impossible to answer why

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because we didn't give you the duration without it you have no idea if you get

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your thousand dollar principle and interest in one year or 10 years or a [Duration of bond changes from 1 year to 10 years]

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hundred years or when the cows come home like when did they ever leave anyway all

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right well so if you buy that zero coupon bond for $700 when it comes to

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you in say six years you'll agglomerate the interest and the gradual increase in

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principal when you calculate the value of the bond going forward while [Calculations of the bond through 6 years]

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calculating the yields on zeros is a bit gnarly the basic idea here is just that [Surgeons performing operation]

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you get nothing back until the end when you get it all back but by way of

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example if you borrowed a thousand dollars for six years at 12% rate of

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interest well you would get nothing along the way in roughly two thousand

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dollars at the end in one lump sum payment remember that rule of 72 thing [Rule of 72 appears on the board]

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here's the handy dandy way of calculating all that got it okay in this

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case what are the risk characteristics of a bond like this, riskier or less

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risky than a vanilla bond answer: riskier why well because the investors get

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nothing along the way so all bets are on that investors get fully paid way at the [Rainbow appears]

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end of the rainbow there's also a risk that the company doesn't sock away

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enough money to pay off these zeros at the end or that they have a hard time

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refinancing them at the very end if they haven't been disciplined enough to save [Woman worried about saving cash]

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cash along the way or if their businesses you know gone to the crapper

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there with no direct obligation to put away a few nuts each month for this [Squirrel eating nuts in the field]

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eventual big fat payout it's easy for companies to get kind of sort of you

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know forgetful about them well to stem some fears most corporations create

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what's called a sinking fund an amount of money that they sink into a piggy

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bank for the day that the debt money comes due not surprisingly zeros usually

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pay higher yield or higher interest rates and carry these higher yields

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because of this illiquidity feature like you don't get any cash

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long time it's a bummer not to get at least a little cash along the way and [$1,000 bond with no interest for each year]

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it's also a bummer to have to carry all that risk for an eventual payout way

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down the line so that's why they have to pay you more in interest to rent your

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money all right to the lesson well no matter how many comics you might own or [Series of comic books]

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if you know farty jokes you might laugh at well you always have a shot at

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maturity as long as you own a bond [Man discussing maturity in bonds]

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