Bonds: What They Are And How they Matter to You as Investor
By Acceler8now.com Bond Investing Team, August, 2007
A bond is an instrument evidencing borrowing from the public, by the Government or a corporate body. That government could be the Federal, State or Local Government. Bonds are issued by any of these bodies to borrow money to meet its funding needs. Investors purchase the bonds, thereby providing the needed funding to that government or company and, in return, receive the bond instrument, which is a legal evidence of the indebtedness of the borrowing party. A bond is therefore a securitised debt. The two parties are the borrower (government or company), also called the issuer and the lender (investors), also called the buyer. A bond, even when issued by a company, is clearly different from a share since the investor enjoys the status of a lender (creditor), unlike in shareholding where he is a co-owner of the company. Bonds represent debt while shares are equity.
Understanding the Features
Following from the last statement, a bond will have a maturity date, which is the repayment date when the borrower will pay back the borrowed sum - the bond principal - to the lender (whoever purchases the bond). Until that repayment date, interest will be paid to the holders of the bond at a rate that is stated on the bond. This rate is called the coupon or coupon rate. Usually interest is paid at half-yearly intervals, though the frequency could be at any other interval specified on the bond. So, a bond has a fixed interest rate, fixed interest payment interval, a specified maturity date and of course the principal sum (face value) repayable at maturity. Given those three features, the income (interest) you earn from a bond is known and fixed. That gives bonds their 'fixed income securities' tag, which is another distinquishing feature from shares where the income you earn will depend on the earnings of the company and whether the directors have recommended any dividend. Note too that while bondholders receive interest (a price for the money lent), shareholders recieve dividend (a distribution of profit by owners). Interest to bondholders is a non-discretionary, obligatory charge against the borrower, unlike dividend to shareholders, which is not guaranteed and depends on company performance and the discretion of the board of directors.
A bond has a fixed term, which is the period from issue to its maturity. A bond issued in year 2007 with a term of 20 years will mature for repayment in year 2027. When the government or companies borrow for terms not exceeding one year, these are usually by other instruments called money market instruments. Treasury bills, bankers' acceptances and commercial papers fall within this category.
Specifically, the following are the key features of a bond:
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Face Value (Called Par Value)
This is the principal sum, repayable to the holder at maturity. Most bonds here are issued at a par value of N1000. A minimum subscription of N10,000 is usually required. So, with as low as N10,000, you can invest.
- Issue Price
This is the price at which the bond is to be bought by investors at the time it is first issued. This will, most times, be the same as the face value, though it could differ if the bond is sold at a premium or discount.
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Market Price
Bonds are traded in the market, on the Nigerian Stock Exchange, in our own case. This means the original purchaser can resale on the floor of the exchange, also called the secondary market. That resale price fluctuates, though not as widely as with stocks. The market price is the current price at which the bond can be bought or sold, different from the par value. You buy at this market price, which could be higher or lower than the par value, but if you hold to maturity you will recieve the par value. A bond can therefore be bought at a premium (above par) or a discount (below par).
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Bond Maturity Date
The date that a bond is due for repayment. The face value of the bond will be paid back on that date by the issuer. The maturity date determines the term of the bond, that is, the 'span' of the bond, also called maturity. The maturity is usually a certain number of years. In broad terms, we can classify into short-term, mediun-term and long-term bonds.
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Coupon
This is the interest rate stated on the bond. Interest is paid at specified intervals, more commonly half-yearly. Interest payment is based on the par (face) value. Such rate is therefore fixed. It is however possible to have a floating rate bond, where the interest floats with a benchmark, say the Treasury bill rate, meaning that when the T-Bill rate changes, the bond interest rate also changes. In that case, the rates are formally adjusted at intervals.
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Bond Issuer
This is the party that issues the bond, the borrower. The quality of the bond is largely a function of its risk profile which has so much to do with the issuer. The FGN bonds, for instance, are considered risk-free, given the corporate soveignty of the State that backs it. It will be erroneous, however, to think that risk will be absolutely zero, even in the long term or that every government bond is risk-free. Corporate bonds, on a general note are considered riskier but, there again, much depends on the standing of the issuing company.
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Bond Yield
Yield refers to the return expected from the bond. However, given the various features of a bond, it's yield is a little complicated to define because it has different variants. Principal among these are the coupon yield, current yield, yield-to-maturity. Read more on bond yield here.
Why Bonds?
Bonds represent another class of financial assets that you can invest in. One reason is that they offer better-than-savings-rate returns. If issued by the Federal Government, their default risk is extremely low, which cannot be said of bank deposits. So, you enjoy possibly higher returns and a far better risk profile. In our market today, it's actually Federal Government bonds that are traded. Bond prices do not gyrate like stock prices, meaning a more stable store of value and an easier-to-manage investment. If the marked price movements that more or less define the stock market are too dizzying for you to cope with, bonds could calm your nerves a bit, though for taking less trouble, your profit potential is significantly downgraded. You possibly make up for this with the certainty of your returns, at least to the extend that there is a non-negotiable obligation to pay you. It must be realised that when a company is incapable of paying (principal and/or interest), there is a different problem, but the obligation subsists.
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