FINRA Exam Tips and Career Advice 5 – What is a bond?

Tyler York
Achievable FINRA Exam Tips podcast

Unsexy but mighty, bonds represented $39T in net value WW in 2015, while stocks were worth approximately $26T. Basic Wisdom’s Brandon Rith walks you through how they’re handled in the wealth management profession.

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FINRA Exam Tips and Career Advice 5 – What is a bond?

Hi there, welcome to the achievable podcast. My name is Brandon. I hope you're having a wonderful day. Despite the fact that you're probably need even material study until your bloodshot in the eyes forgetting that you had relationships with people hopefully off to get a job that's going to change your life and set things in motion that will set you up for a great career all that stuff pretty heavy open for us, but try to keep things light as much as possible because yes this material that you are studying for the exam that you're preparing for is very difficult. Let's go and get the intro out of the way. I am Brandon from basic wisdom. Once again, I run a company that specializes in helping people pass finra in an essay exam specifically, I focus on tutoring and if you or your company needs any kind of help pairing either yourself or your

Please for any of these exams go to basic wisdom. Net and learn a little bit more about how I might be able to help you. I’ve also a partnered with achievable. We have put together an amazing product that if you’re preparing for the s i e exam, you should certainly check out it combines my expertise and the way that I teach this material that you need to know for the SAT exam with the amazing smart technology that achievable brings to the game. If you don’t know much about smart software, essentially, this is a program that analyzes everything you do every question that you answer right answer wrong and right Wendy’s system feels like you’re about to forget some of that information. It filters it right back to you. It’s very efficient way to learn and combined together. We have released achievable. Yes, I E program if you’re interested go to achievable. Me check that out, but that’s all we need to talk about in the intro and thank you for sticking around beyond that today’s topic of conversation.

Turn on the podcast is essentially what is a bond which a bond is a debt security we’re going to talk a lot about what this actually is one actually means but as you probably know this is a big part of almost every finra or nasaa exam, especially if we’re talking about the siec even the Series 6, you’ll see a lot of this in the series 65 and 66 as well. So this is an area that you need to be pretty proficient in to do well on these types of exams. And if you feel like you’re struggling with this topic, trust me, you are not the only one in fact during my tutoring sessions. This is probably top to top three things that people reach out to me for help on it’s not just the more advanced stuff. I mean I get people all the time reach out to me say hey this Bond seesaw thing. I have no idea what it is. Can you please break this down for me and help me understand it a little bit more and while we’re not going to talk through the bond seesaw today.

We are going to talk about the basics of what a bond is how it’s structured why it exists all that type of stuff. So I’m going to dive into the fundamentals in hopes of helping you better understand. What a bond is a bond is a very broad term and usually were referring to a longer-term version of a debt security now because we use the word debt in there as you probably have guessed a bond is a type of loan specifically and usually a longer-term loan is what we’re talking about. If you were to buy a brand new Bond from an issuer and by the way, the term issue where is really another General and vague term it just as any organization that decides to sell the security to the public in the real world any publicly traded company that you can think of is an issuer and for this podcast. I’m probably going to refer to Tesla

A lot. This is no endorsement of Tesla as a company. I’m not telling you to invest in them. I’m not telling you not to invest in them. But let’s at least use them as an example. If you were to buy a brand new Bond from Tesla, which is an issuer. You’re essentially acting as the bank for Tesla your lending money to Tesla at least to me. That is the most bizarre thing about a bond is that it puts us as people into a position of lending money that we usually are not terribly familiar with the average person borrows a lot more money than they lent. So think about it. I mean, how many times do you borrow money if you own a home and have a mortgage you’ve borrowed money to buy that home if you have a car loan you borrow money. If you use a credit card, your borrowing money borrowing money is a staple of being an American for the better or for the worse when we’re dealing with a bond. Yes. We’re talking about borrowing money, but

We as the investors are in the position that the bank usually is. We are lending money to an organization in order for them to use that money and technically they can use that money for any purpose but they eventually have to pay that money back to us plus interest Tesla in the past has issued bonds to build car and Battery Factory’s they borrow lots of money large amounts of money usually in the hundreds of millions, if not billions of dollars and they do that in order to expand their business and just like a bank investors like you and me demand interest for the money that we lend you might be wondering why Tesla doesn’t just go to a bank to borrow money in the short answer to that is risk loans are only beneficial to the lender if the money is actually paid back if you think about it you loan money to a friend and then they for whatever reason just don’t pay you back. Not only is that going to strain and possibly

Ended that relationship with that friend, but you’re out that money whenever anyone or any organization decides the Lynn money. We always have to worry about that risk the risk of never being paid back and you better believe that Banks which are in the business of lending money. That’s something they think about it every single time. They give a loan to someone or an organization companies like Tesla borrow in the hundreds of millions. If not, the billions of dollars. These are not small companies doing small thing. So if a bank word alone, let’s say a billion dollars to one organization or one company. They’re taking on a ton of risk if that company where to go bankrupt the bank. Would it be repaid their that’s a billion dollars a principal for some banks. That’s a some smaller banks. That might be the end of the bank. Got to shut the doors got a fire all your workers. Got to just move on to the next thing for a larger bank. It’s going to present itself as a significant problem.

Imagine going to your boss and say hey I created this loan for this company. They seemed great. They’re going to make the next greatest and best thing. I loaned him a billion dollars of our money in that. They just declared bankruptcy. We’re out a billion dollars probably a pretty tough conversation half the reason why large issue, where’s my Tesla? Usually don’t go to Banks to borrow large amounts of money. It’s about risk if they were to find a bank willing to take on the risk of lending a billion dollars to one company knowing that if that company goes bankrupt that billion dollars is gone the amount of risk that one bank would be taking on would result in a significantly High interest rate. That’s the only reason why a bank would take on that much stress cuz if they feel like they’re being compensated enough for that risk. So again, if we have a large companies like Tesla going to One bank to borrow a billion dollars.

Probably not going to happen. Number one and number two. If it does it’s probably going to cost a lot an interest in order to get the bank to do that. Maybe there’s a better way to do that maybe instead of putting all the risk on One Bank. We spread the risk across thousands of different investors bonds exist to give organizations the opportunity to borrow money from multiple different sources and by doing that that reduces the risk for everyone across the board so that we don’t just have one entity taking on one large loan. That way we can spread the risk again across multiple. Usually thousands of different investors investors decide how much risk they take many investors buy bonds and smaller amounts, which could be as low as $100 if it’s a US Government Bond or usually $1,000 for other types of bonds and investors only risk what they invest which is why bonds are more easily sold the thousands of investors instead of just one or a few Banks. Think about it from your standpoint.

Would it be easier for you to borrow $100 from one of your friends or $1 from a hundred of your friends one central theme of this podcast today is going to be interest rates and you can think about interest rates just like you think about them right now. If you have a credit card balance your interest rates probably near 20% and that’s how much you’ll pay in interest if you maintain a balance on your credit card. Now, there’s that there’s your interest rate on a mortgage interest rate on a car loan etcetera bonds also have interest rates and the interest rate reflects the cost of borrowing money from an investor. And yes, the interest rate on a bond should be much lower than the interest rate that they would receive from say One bank or one institution. That would be may be willing to lend them large amount of money and taking on a lot of risk doing that. Hopefully that helps you understand why and bonds exist in the first place again.

Since to spread around risk and it’s easier to borrow from thousands of different investors rather than just one or if you so let’s transition back to the more fundamental aspects of a bond and how it’s actually sold to investors when a bond is created and sold. It is typically sold at will be call its par value. You want to think of its par value as face value or the principal amount of the loan has example if you borrowed $1,000 from the bank to open a small business the principal would be $1,000 same thing with bonds except for usually talking about large amounts of money. For instance Tesla in the past has borrowed money in the billions of dollars and they might borrow 1.5 billion dollars to build a new battery super Factory and if that’s the case the 1.5 billion dollars would be the principal amount or the par value of the overall loan the company from their breaks up the big loan and a small usual thousand-dollar chunks and those thousand large chunks of referred.

U.s. Par value of each individual Bond. So let’s assume that you buy a $1,000 bond from Tesla and lend them some money to build a new battery Factory you give $1,000 over to Tesla and in return they give you a bond and let’s talk a little bit more about the components of that Bond every bond has an interest rate attached to it that never changes over the life of the bond. The interest rate is expressed as a percentage of par now in plain terms that actually means that if we have a 5% bond that means it pays 5% I’ll depart value which is usually a thousand so 5% of 1000 would equate to an annual payment of $50 every single year. Remember the main reason why you would lend money to anyone or anything would be interest. Why would you lend money if you’re not getting paid to lend that money? So if you buy $1,000 5% Bond York

Paid 50 bucks a year every single year bonds typically make payments in semi annual chunks. So usually twice a year. So if you’re receiving $50 a year every year from your 5% $1,000 par bond, that means you’re receiving to $25 payments every year as long as you hold the bond every Bond will also have a time frame attached to it or what we were usually referred to as a maturity time. So, let’s assume that are $1,000 5% bond from Tesla is a 20-year Bond and effectively this means that this Bond will pay interest twice a year to $25 payments for 20 years. And then at the very end of that bond, which will be 20 years later at maturity. The bond will pay one final interest payments and the thousand dollars of principal back now the interest rate of a bond typically reflects, two things first the current market interest rates and second the risk of the

That the issuer needs to create a bond that investors want to purchase and of course like we talked about really the main reason why investors buy bonds is for the interest rate that they received if the interest rate is too low investors won’t lend their money. And that’s a problem for companies like Tesla if the interest rate is too high the issuer end up paying more than they necessarily need to and that just is a waste of money interest rates change over time. Sometimes a higher sometimes our lower. There are a lot of reasons why interest rates change and that’s going to be a whole there podcast when itself but all you need to know for right now is that on average interest rates change in the market, but we always assumed that there’s a going rate of interest at any point in time for instance right now. You could probably look up the going rate of interest for the average 20-year Bond. Let’s say on average that the going rate of interest for a 20-year Bond right now is 5% That will be the foundation for deciding what the

Interest rate of a specific Bond will be issuers need to take a look in the market and figure out what they going rate of interest is today and that again serves as their Foundation very similar to if you looked up the 30-year fixed mortgage rate today, if you were anticipating buying a house soon while the rate of interest today is 5% and you’re probably going to borrow money at a rate of close to 5% from there. The rate of interest on any given bond is typically determined by the risk of the bond things like the length of the loan the creditworthiness of the issuer and the characteristics of the bond ultimate Lee determine the risk of the bond and the more risk that the bond presents to investors the higher the interest rate that they’re going to demand to buy the bond the less risk the lower the interest rate deciding the interest rate that a bond comes with is not an easy process. And in fact is she was like Tesla will typically involve the services of an underwriter.

Are known as an investment Bank to help them with this process of kneeling down the perfect interest rate to sell the bond at now. Tesla is in the car business or I guess in the technology business and it isn’t necessarily known as a financial company. They don’t have the structure or the expertise necessary to create a marketable bond. So a lot of times companies like Tesla will hire other companies like Goldman Sachs Deutsche Bank Morgan Stanley. Those are all big Underwriters that help other companies and organizations sell their Securities to the public. So Tesla for instance could hire company like Morgan Stanley to help them structure their bond Morgan Stanley would help with things like and how long should the bond be? How long should Tesla have to repay the money that they borrow what features of the bond should be there? What feature should not be there? Is it a good time to sell a bond? Do we understand the bond market? Those are all things that companies like Morgan?

Family are paid to provide expertise on and trust me. They don’t get paid a small amount of money. This is a game where hundreds of millions of dollars or sometimes made on single sales of one security. So it’s an important service to the issue and also an expensive service but ultimately investment Banks AKA Underwriters are the in between between Tesla and say the investing public and at the end of the day, they’re the reason why big companies like Tesla can borrow large amounts of money from the investing public and do that effectively and efficiently investors and the bond market ultimately decide if a bond is investment worthy. Therefore that’s another reason why knowing investor expectations are knowing the bond market why. So important if the market believes Tesla, what is a good credit where the company that will pay back its loan the interest rate of the bond could be fairly low maybe even lower than average but if the market believes the opposite Tesla may have to

Heather Bond at a higher rate of interest. This is a recurring theme throughout Finance at you’re going to realize if you haven’t already realize but with more risk comes for more potential for return. That’s the only reason why you as an investor would potentially decide to take on something. That’s a little bit more risky cuz you can make more money off of it. The financial well-being of Tesla is a big factor in determining the risk that an investor takes on by buying a bond from Tesla. Now Tesla could also entertain the idea of adding several different features to the bond all of which would influence not only the risk of the bond, but also the interest rate of the bond is well, we’re going to talk about several different features in the next few minutes or so some of which are benefits to investors and some of which are benefits to the issuer and we want to continually think about this from the perspective of risk. We’ll talk about that a lot as we go through these features the first feature and probably the most talked-about feature on any type of bond is a call feature.

If you’ve ever heard of the term callable bond call feature call provision if it involves work all in there and I’m in the word bond, then it’s all relating to the same thing a call feature allows an issue were to pay back borrowed funds earlier than expected. For example, let’s say Tesla issues that 20-year 5% bond that we were discussing earlier over the course of 20 years. Tesla would pay semi-annual interest twice a year then make a final principal payment to investors at the 20-year Mark also known as the maturity date now, it’s possible that when Tesla sold the bond, they also sold it with a call feature and let’s say that that Bond was callable in 15 years, which means a Tesla could decide to pay back those borrowed funds five years earlier than its actual maturity. If you have ever paid off alone earlier than expected. For example, let’s say that you paid your student loans off 5 years earlier than you needed to that would be the equivalent of you calling.

Your student loans you pay back that money for whatever reason or earlier than expected. And that means two things number one, you’re done making payments so you don’t have to make interest payments anymore. That’s a good thing for you. But for the lender not say the bank that you borrow that money from there no longer getting interest payment from you. So it’s kind of a detriment to the person that was loaning me that money because they may have expected to get five more years of Interest payment from you while you pay back the money earlier than expected that’s great in terms of being creditworthy. But again the lenders missing out on 5 years of Interest bonds are typically called for one of two reasons in our example with our 20-year Tesla Bonds callable in 15 years. If Tesla has extra money available in simply just doesn’t want to pay interest anymore. That’s a legitimate reason why an issue where would want to pay off a bond if you have the money in the bank, why would you continue to pay interest on borrowed funds just take that money pay off the loan?

And their you’re done paying interest wonderful II legitimate reason is refinancing which may be a term that you’re familiar with or not. But let’s go through an example to better understand this assuming that we have are Tesla 5% Bond if interest rates fell to 2% after 15 years of owning the bond Tesla would consider refinancing to do so, what they would do is they would call their 5% Bond me pay that money off get rid of the fibers and bond and then reissue a new Bond at the lower rate of 2% And essentially what happened there is that they’ve gotten rid of an older loan where they’re paying a higher rate of interest and now replaced it with a new loan with a lower rate of interest and they were able to do that because the current market interest rate went down since the time the bond was issued people do this all the time with mortgages. For instance. If you have a 5% mortgage and interest rates dropped a 2% you as a homeowner are going to consider paying off the old

Mortgage with that 5% interest rate and just take out a new loan at the 2% and that might save you thousands of dollars over the course of 5, 10 15 years. However long the time. Is it a lot of money that you can save as a homeowner now these issuers that refinance they can sometimes save millions of dollars especially for talking about a bond that’s in the hundreds of millions or even in the billions just do the math in your head. If it’s a hundred million dollar loan that’s outstanding a 5% interest rates means the issuers paying $5 a year in interest versus a 2% interest rate means 2 million dollars a year in interest.

If that was the case with a hundred million dollar Bond that’s Savings of three million dollars a year, which is absolutely something that companies should consider doing if they can do it. So it should be pretty obvious. They call the bonds are advantages to the issuer companies like Tesla and actually it is a risk to the investor. So let’s think about it from the investors perspective. If you owned that 20-year 5% Tesla bond that can be called in 15 years. You were receiving $50 a year in interest from that Bond and then it was called you were expecting to get five more years of that $50 interest every single year, I guess to $25 semiannual payments.

But once your bond is called what happens is that the issuer pays you back whatever interest they owe to that point and then they pay you your principal amount that Adventure traits of falling across the board and you’re going to take your money and put it into another similar type of bond out there in the market. You’re now going to get a 2% bond with a 2% interest rate most likely so you’re switching from receiving 50 bucks a year to 20 bucks a year and that’s opportunity that you’ve now missed out on not technically money out of your pocket. And I mean, you’re not seeing red on your statements, but you’re not making as much money as you were before we call this reinvestment risk, essentially. It’s the risk that you receive interest or money from a called Bond and you reinvest that back into the market at a lower rate. And again, it’s all about opportunity because a call feature is a risk for investors. You better believe that they will demand higher rates of return on those callable bond in terms that you’ll probably see and exam. It’s

I know that callable bonds should come with higher rates of Interest or higher yields than non-callable bonds. Just because you’re taking on more risk a bond could also be put Apple which is actually very similar to a callable bond put double bonds can be ended earlier than maturity. But the difference is that the investor decides when this occurs not the issuer. So if you bought a Tesla portable Bond and wanted to end the investment earlier than expected and get your money back. I’ll put up a bond would allow you to say hey, I want my $1,000 back. I wouldn’t be interested in doing up to this point. Just want to move on to something else. Thank you issue were thank you Tesla. It was a pleasure. But Sia now, why would an investor say someone like you decide to put a bond back to the issuer?

Well first you could just maybe want your money back whether you run into an emergency or going to surprise vacation or need to buy an engagement ring. Who cares what the reason is if you just need your money back. Hey portable Bond will allow you to do that on the spot. But the other reason that we’re about to talk on here is actually the most common reason why bonds are put back to the assure investors most likely use put options when interest rates rise. For example, let’s go back to that 20-year 5% Tesla bond that we’ve been discussing if interest rates in the market where the rise to 8% while you’ve got your 5% Tesla Bond and we haven’t talked about this in detail, but the interest rate of a bond that’s created when the bond is originally sold never changes. So if you buy a 5% bond from Tesla, it’s going to pay you fifty bucks a year every single year no matter what happens in the market.

Interest rates in the market might go up that might go down but that really affects new bonds are being issued to the public for the first time when you loan money to an organization you decide on the interest rate up front and that’s not going to change over the life of the bond. So again going back to our 5% Bond if you got a 5% Bond when interest rates have gone up to 8% if it’s portable get rid of the fibers that Bond put it back to the issue or you’ll get your principal back and any interest to your do up to that point and then take that money that you received back reinvest it back into the market by another similar to a bond that you’ll now get with an 8% interest rate or something close to that. Essentially. You could switch from a Bon Pain you fifty bucks a year to pay you eighty bucks a year if it has a put feature like that and that is why investors decide typically to put their bonds when interest rates rise put options on bonds are advantageous to investors. So these bonds can we saw

With lower rates of Interest or lease lower than average rates of interest and still are marketable to the investing public. So if an issue or wants to save some money on interest one thing they could do is create a portable Bond. There’s another Bond feature as well. That would also allow the issuer to save money on interest when a bond is convertible or when it hasn’t conversion feature. The investor has the ability of converting that interest paying Bond into shares of the same company stock. Tesla is an example of a company that has actually sold convertible bonds in the past and one of the main reasons why they sold a convertible Bond the way they did is to save money on interest convertible bonds are good for investors because they give them another way to make money off of their investment if the company’s stock is rising in the stock market, it could easily create a great opportunity to convert the bond into shares of stock. Normally when a convertible bond is originally sold.

Conversion feature doesn’t have much value. Let’s go back to our example our 20-year 5% Tesla Bond and said this time let’s say it’s convertible into 10 shares of Tesla stock. If you bought that Bond originally for $1,000 phone, you bought $1,000 Tesla Bond, they can be converted into 10 shares of stock. Let’s assume that the stock price was $90 in the market 10 shares of stock worth $90 a piece would mean the conversion feature is worth $900. And if you just bought this bond for a thousand turning into $900 of stock Lee doesn’t make a ton of sense conversion features usually need time to build value and a lot of times. We’re just waiting for the stock price to rise and if it does rise enough, then it could be worth something. For example with the same Bond. Let’s say the stock price Rises to $150.

Well, we have a bond is convertible into 10 shares worth $150 in the market right now will now that conversion feature is worth $1,500. And if you bought the bond originally for a thousand and now been converted into $1,500 with a stock that probably makes a lot of sense to convert the bond over to stock now. There’s a lot more that goes into that decision. You’re moving your money from an interest paying investment where you getting interest every six months from this Tesla Bond into Tesla stock, which historically has never paid a dividend or never paid income. So you’re essentially moving from one income paying investment Bond pays interest every six months to of stock. That doesn’t pay you income but can make a significant amount of money if it goes up in price if you can sell the stock for a much higher price than what you bought the bond originally for you can create a lot of what we call capital gains because of this potential to make money on the stock convertible bonds.

Course beneficial to investors and therefore they can be sold with lower interest rates than say a non convertible Bond calls puts in conversion features are all optional features on bonds and they’re not the only future that you could see in a bond you’ll certainly learn more and more about other features that are available out there. But in terms of the most tested features, those are probably your top three, it’s important to know each one what it means to be callable what it means to be portable what it means to have a conversion feature. It’s also important to understand how that factors into the risk of the bond which ultimately will factor into the interest rate of the bond and how much the issuer has to pay to borrow money from its investors be issued or in combination with the underwriter will decide what features the bonds that they sell has again. Those features will ultimately decide the cost of their borrowing money. Once the bond structure is finalized. The issue are essentially will hand over the bonds to the underwriter the underwriter will then sell.

What bonds to the public again Tesla hiring Morgan Stanley to sell their bonds if the bond is marketable then investors will purchase the bond effectively lending money to the issuer. Once the bonds are sold to the market be under writer gets their Cuts in the majority of the money goes back to the issue or being Tesla and our example, and from there the issuer can use that money to build a new automobile Factory hire new workers to expand their business for whatever purpose in overtime. They will pay back those borrowed funds usually through semi-annual interest payment through with bondholders. And then at the very end of one final principal payment where everyone receives are par value back at maturity. Once the bond is sold in the market. Then the bond trades amongst investors. The bond market is a whole other conversation and a whole different podcast and comes with a lot of characteristics and things you need to know for the different exams. You’re preparing for hopefully this podcast help you understand how bonds are strong.

And how they fundamentally work which is the first step to understanding what a debt security actually is and how it works there. A lot of different versions of bonds out there everything from corporate bonds to Municipal and US government bonds. They have different characteristics different features and it can get pretty complicated in terms of how these trade and the yd of what yield is on a bond we will discuss those in future podcasts. But once you have a solid foundation for what a bond actually is all those other items become much more easy to remember and much more easy to relate to the material. Thanks so much for listening to the podcast today. I really appreciate it. If you have any feedback feel free to reach out to me. You can reach out to me directly through basic wisdom. Net and whether you’re looking for tutoring Services General guidance on how to approach these exams or just to say a quick. Hi, you can go to the are my website click the contact button at the top right and you can get in touch with me and Eve.

Get my personal cell phone number right there on the website and finally as a last reminder if you’re looking for an SIE program that is modern smart and will help you master the material that you need to know for the SI exam go to achievable. Me and you can check out a product that comes with all writing materials that I put together on my behalf in behalf of my company basic wisdom in conjunction with achievable and their Smart Learning System. It is the best program out there, and I know I’m biased, but I’d highly recommend you check it out. You can gain access to a free trial and get access to our first chapter of material without actually paying a dime check out the material and let us know what you think. Thanks so much for listening again. Good luck with your studies and I’ll see you next time.

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