Alright. We're going to start discussing one of the hardest topics in the course, bonds payable. Let's go ahead and start with some definitions and introduce you to the topic of bonds payable. So, when we see "payable," we are talking about a liability here. This means money that we owe, not to our suppliers, but to our creditors. Our creditors, we sell bonds to the creditors to raise money. This is different from a note payable. When we talk about notes payable, that's usually with one person, like a bank, where we sign a contract. They give us some money and we owe the bank money. However, with bonds payable, it's a group of debt securities issued to multiple lenders. It's not just one person that we owe money to; it's multiple people. But a lot of the concepts stay the same.
Let's look at an example here. We want to raise $1,000,000. We could have gone to a bank and could have gotten a loan for a certain amount from the bank, but that might not have been so easy. So instead, what we do is we sell 1,000 bonds worth $1,000 each. So if we sell those bonds to 1,000 different people and they each give us $1,000, we still raised $1,000,000. It just takes smaller investments from a bunch of different people.
Similar to a note payable, we're going to pay interest. The company will pay interest on the bonds. And there will be an interest rate that the bonds specify. For example, "We're going to pay 10% interest," or "We're going to pay 5%, 8%." Whatever it is, it's going to say it on the bond, how much interest we're going to pay. And it's usually going to be annual interest payments or semiannual. When we talk about semiannual, that's two times per year. So, it's either going to be once per year or twice per year that we pay the interest. And then, on what we call the maturity date, the company will repay the principal amount. That means, in this case, when we sold $1,000 bonds, on the maturity date, which is usually, say, 10 years in the future or something like that, we're going to pay everyone back that $1,000 that they lent us. So over time, they're going to be earning interest, and then finally, they'll get their principal back at the end. Very similar to a note payable, except in this case, there are multiple lenders.
Now this is just vocabulary. It isn't going to come up so much once we're studying how to do the journal entries, but you never know if you're going to get a quick multiple choice about some of this terminology. So it's good to know it. Let's go through it real quick. The first could be repayment characteristics of the bonds. The ones we're going to focus on throughout this lesson are term bonds. This is bonds with one maturity date. That means that we're going to pay back all the principal in a lump sum. And this is on the maturity date; we're going to pay back all the principal. Compare that to a serial bond. A serial bond has multiple maturity dates, and the principal is going to be paid back in installments. This would mean that maybe these $1,000 bonds, we pay them off $100 each year for 10 years and pay off the principal that way. The calculations are a little more complicated for serial bonds. So, we focus on term bonds in this class.
Bonds can also have characteristics related to collateral. The first type is secured bonds. These are bonds that have collateral. They're collateralized by certain assets. The best way to think of a secured bond is as a mortgage. When you think of someone buying a house and getting a mortgage on the house, if they don't make the payments on the mortgage, the bank is going to take the house away. So, you could imagine that a secured bond is going to have less risk because if you don't end up getting paid, you get the assets that are being collateralized. You get the collateral. So, there's less risk because you don't just lose the money that you lent out, you get some of it back. Compare that to a debenture bond. A debenture bond is only backed by the goodwill of the borrower. There's no collateral. They say, "Here's some money, borrow it, and I hope you pay me back eventually." And if you don't get paid back, well, that's too bad. So, there's more risk involved with a debenture bond. Let's make a note real quick that a bond could be a term bond and a secured bond at the same time. These are different characteristics of a bond: one is how they repay the bond, and one is related to whether there is any collateral on the bond.
Lastly, there are callable bonds and convertible bonds. Callable bonds mean that a bond can be called back, so we can call it early. We can say, "We no longer want to pay interest on these bonds; we're just going to buy them back now." And they can be called back at the call price. For example, let's say those bonds we were talking about were $1,000 bonds; maybe the call price might be $1,050. There's a little penalty that you pay for calling them back early since you don't want to pay the interest anymore. However, those people were expecting to get interest for a few more years, so you usually have to call them at a higher price. We don't dive too deeply into callable bonds in this class. You'll probably see that a lot more once you get into finance. And lastly, convertible bonds, which have a conversion clause. This means that you can take the bonds and convert them into shares of common stock in the company. So, that would mean you sell them a bond, which is originally a liability; you owe them interest and are paying this off. But the person who bought the bond could say, "Actually, I want to convert this," and instead of getting paid interest and being repaid the principal, they'll have common stock in the company.
So, those are most of the terminologies that you're going to deal with when you deal with bonds payable. Let's pause here, and then we'll talk about the interest rate and how that affects bond issue prices in the next video.
