Notes

A bond is a loan given to a technology firm by an investor, who expects the money to be paid back with interest. Learn how to determine a bond's issuance price by studying demand, risk, and market conditions.
What Are Bonds?
Bob has owned a technology firm for ten years. The business has done very well, and now he wants to expand and invest in more research and development to offer more product lines.

When a company wants to expand and grow, they have three options to finance the expansion: sell stock, seek a loan from a financial institution, and sell bonds. Bob's firm has several outstanding loans, and he's already spoken with an investment banker about selling stock. Now, he's interested in issuing bonds. He makes another appointment with the investment banker to discuss selling bonds.

The investment banker explains to him that a bond is similar to an IOU, where investors loan the technology firm money with the expectation of annual interest payments and repayment at maturity. He also says that the initial price of the bond issue would be determined by three factors: demand, risk, and market conditions. For the rest of this lesson, we'll examine how these factors affect the initial price of the bond.

Demand
Demand represents how interested investors are in the company. If Bob's firm is on the cutting edge of technology and in the process of developing the most technologically-advanced widgets, then investors may be interested. However, if Bob's firm has an idea to bring back the analog TV era, then there may be little interest in his company.

Let's say Bob's firm is in the process of developing the world's most advanced widget, and investors are lining up to purchase the bonds. With the help of the investment banker, Bob decides he will issue $100,000 bonds with $9,000 as the annual payment payable to the investor for five years. At the end of the fifth year, Bob's firm will pay the $100,000 back.

In this instance, $100,000 represents the principal, $9,000 are the annual coupon payments, and five years are considered the maturity date. Based on demand and other factors which we'll discuss later, the bonds can sell at discount or a premium.

If the bonds sell at a discount, the investors will purchase the bonds at a price less than the principal. For example, they may purchase the bonds at $98,000. In year one through five, they'll receive $9,000 each year, and at the end of the fifth year, they'll receive the profit of $2,000 ($100,000 - $98,000). For purchasing the bond, they receive $47,000 ($2,000 in profit + (5 years * $9,000)) in total.

Now, what if the bonds are in great demand, and investors are willing to pay $125,000 for the bonds? Keep in mind that they'll only receive $100,000 of principal at maturity. These bonds are being sold at a premium, which means bonds are sold at a price greater than the principal. Why would an investor lose money on the principal? Good question; remember the interest payments? Typically, the coupon payments will be higher when bonds are sold at a premium.

For example, let's say the firm will issue $100,000 bonds with $15,000 annual coupon payments and five years to maturity. While we know the investor will lose $25,000 from the principal ($100,000 - $125,000), they will make $75,000 ($15,000 * 5) in coupon payments for a net profit of $50,000 ($75,000 - $25,000). Now, let's look at another factor of the price, which is risk.

Risk
Risk is the chance of financial loss. Investors know there's a possibility of losing money when they invest. However, investors have different risk tolerances. Some are willing to lose a lot of money, we call these investors 'risk tolerant.' While others are considered 'risk averse,' meaning they do not want to lose very much money, if any.

In order to assess a bond's risk level, bond ratings are assigned based on the company's financial health. Bond ratings are similar to school grades, an A is excellent, B is good, C represents average and a D needs improvement. An A-rated bond would be considered a good, low risk investment, and a D-rated bond would be considered high risk. A bond that carries a rating lower than BB by Standard & Poor's or lower than Ba by Moody's is called a junk bond.

Remember, there's a correlation between risk and return, the higher the risk the higher the return. Therefore, investors who purchase a D-rated bond would have a much higher annual coupon payment than those who purchased an A-rated bond. They also would most likely purchase the bond at a discount. The next factor that affects price is market interest rates.

Market Conditions
Market conditions refer to the financial state of our economy. There are many factors that affect our economy, and the analysis is extremely complicated. However, in the investment world, we can classify market conditions as bull or bear. A bull market signifies a buying market, where investors are interested in purchasing bonds and few are willing to sell. Therefore, if we apply the concept of supply and demand, we know that when supply is low and demand is high, the price increases. Conversely, in a bear market investors are willing to sell rather than buy.

Lesson Summary
A bond is similar to an IOU, where investors loan the technology firm money with the expectation of annual interest payments and repayment at maturity. There are several factors that affect a bond's price: demand, risk and market conditions.

Demand represents the investor's interest in the buying the bond. Based on demand, bonds can sell at a discount, where the purchase price is less than the repayment principal, or bonds can sell at a premium, where the purchase price is more than the repayment principal. Investors are willing to lose money on the principal to receive a large annual coupon payment when buying a bond at premium.

The next factor that affects bond prices is risk. Risk is the chance of financial loss. Based on an investor's 'risk tolerance,' they may choose a lower rated bond, which can be considered so risky they are called junk bonds. However, high risk means high return and investors will look to purchase the bond at a discount.

The last factor is market conditions. In a bull market, investors are willing to buy, which may increase the price of the bond; however, in a bear market, investors are more interested in selling, which can have an opposite effect on the initial price of the bond.

Key Terms
Bond: similar to an IOU; investors loan money with the expectation of annual interest payments and repayment at maturity
Demand: how interested investors are in the company
Discount: investors will purchase the bonds at a price less than the principal
Premium: bonds are sold at a price greater than the principal
Risk: the chance of financial loss
Junk bonds: D-rated bonds and are considered high risk
Market conditions: the financial state of our economy
Bull market: a buying market, where investors are interested in purchasing bonds and few are willing to sell
Bear market: a selling market
Regarding risk, investors can either be risk tolerant or risk averse.
bond issue
Learning Outcomes
Learn the particulars of this lesson in preparation to prove your ability to:

Identify the three factors that would determine the initial price of the bond issue
Explain the how discounts and premiums impact the selling of bonds
Contrast a bull market with a bear market