Want to Invest in Bonds? Here Are the Variables that Count Most
By Acceler8now.com Bond Investing Team, August, 2007
Bonds play an important role in the investment matrix of investors in the developed economies where the bond markets are verile, with a wide spectrum of market offering for investors to choose from. However, whether active market or not, the impact bonds can bring into your investment portfolio are generally the same. Experts recommend the inclusion of bonds in a portfolio for purposes of diversification - a strategy to advance the long-term performance of your investment. Particularly in certain circumstances, bonds are thought to be uniquely helpful as an investment option: a conservative investor that is highly risk-averse will possibly find peace in bonds, especially with government bonds; someone in or nearing retirement whose opportunity for generating income inflows have diminished, meaning that playing exclusively in more risky markets may be imprudent, will possibly settle more for bonds; when you need to hold money for a specific purpose in the near future, a bond may work better since wide share price fluctuations can throw your calculations off balance, while low savings interest will undermine returns.
Decide Your Objective
If you are thinking of getting started, your first step should be to decide exactly what role bonds should play in your investment plan. What's your objective? As has been stated, different investors may have divergent needs and your specific interest will affect, for instance, your choice of bond maturity. When you're clear on what you hope to achieve, decisions on what matches the need will be easier. Granted that many important features of bonds that may matter to an investor may not be present in our market with its limited scope (largely only FGN bonds are traded), its good to know what counts about bonds. Besides, there is a global investment market and nothing stops your buying US bonds, for instance. To choose, these are variables to consider:
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Credit Quality
Even the most aggressive investor will be concerned about the quality of the investment or put differently, the level of risk. When corporate bonds are involved, the risk consideration is accentuated. To invest in less-developed emerging markets, the risk profile is higher. While some investors deliberately go for junk bonds or emerging markets opportunities because of their higher yield, they are also aware of the higher risk of default. You should evaluate the credit rating of the institution - the issuer. If it's one that is rated by the international or other rating agencies, that gives you a good basis. Otherwise, you have to rely on the available information, especially in the prospectus, to evaluate the credit standing of the issuer. When you invest in the Federal Government of Nigeria bonds, however, the sovereign strength of the State backs the instrument which is in fact "charged upon the general assets Nigeria". Risk is therefore quite low, meaning high credit quality, but possibly, lower yield than you'd get from corporate bonds, some of which will also be of top quality.
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Maturity of the bond
Bonds have a maturity, which is the date at which the par value is paid to the holder by the issue. Only very rare, exceptional cases of perpetual bonds are known. Based on maturities, bonds are generally classified as short-term, medium-term (or intermediate) and long-term. The maturity of the bond therefore tells when your investment will be available to you, though the option of resale in the secondary market is always avaliable. A staggered maturity structure for bonds you buy may provide more flexibility to your bond portfolio. Called a laddered portfolio, you aim to have bonds that mature at various intervals, say every year, thereby putting you in funds you may need or re-invest. Longer term bonds are, understandably, more risky, since the predictability of outcome is affected - how do you judge the risk of default in 25 years, when the issuer may not even exist. They consequently should have higher yield to maturity, just as they experience more price fluctuations than shorter-term ones.
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Redemption
Some bonds allow the issuer to redeem them before the stated maturity. The issuer may possibly want an option to exit from the bond, should interest rates fall significantly. That it can do by including a call provision in the bond, which allows it to call it when market conditions dictate so. As an investor, you have to be sure if there is such provision, as this alters calculations about yield. What will be more relevant to you in evaluating the investment will then be 'yield-to-call' and not 'yield-to-maturity'. Usually, such provision, which weakens the investors position, should reflect in a higher yield profile.
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Interest Rate
Possibly the first feature the investor looks at: the rate determines the amount of the periodic income that you receive on the investment. Most bonds carry fixed interest rates but floating rate bonds, which move with the market by being tied to an index or benchmark, are also available. Some are zero-coupon, purchased at a discount, with no interest payments over the term of the bond - in effect, you receive your principal and interest at maturity. You need to know what a particular bond offers. The rate should also be such as reflects the perculiar features of the bond, the rating of the issuer and the inherent risks of the investment.
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Payment Intervals
Most bonds pay semi-annually, but this is not sacrosanct. Considering that some investors go for bonds for the regular income stream feature, it's important to know the frequency of payments and to be sure that it works for you. Otherwise, if you have better options, you obviously have to go for them. In our local market presently, only the FGN bonds are traded and these pay interest at six-months' intervals.
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Price
What's the right price to pay, especially when you buy from the secondary market? Variious factors are at work, meaning that the bond could current sell at a premium or discount, that is, above or below its par value. Interest rate trends, term to maturity and market forces are major variables impacting on price. Is the price right, given the yield to maturity? Remember that the bond is not necessarily selling at the face value when you want to buy, so check the price and do your computations before giving out your purchase instructions.
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 Yield
The ultimate check. The yield to maturity has to be right as investment return and relative to other bond options, to justify your buying. The yield to maturity (YTM) is the total yield over the term of the bond, taking account of all interest payments (and assuming their reinvestment at the YTM rate) and any gain or loss on the bond. While calculating bond yield may be tricky, electronic calculators are available to do so and some can be found online. Knowing the yield is important if you are to compare different bond options with different maturities and interest rates.
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Tax Consideration
A bond may offer some tax advantage: like the FGN bond series being tax exempt, meaning that your earnings are not taxed. Figure this into your calculations to know which bond option provides you the best value.
Bond Analysis
The
bottomline is that buying bonds is an investment requiring sufficient investment analysis. The key issues to bother about and figure into your analysis have been highlighted. If you are investing locally in Nigeria, the job is largely cut out as you do not have the luxury (or confusion) of having a wide array of bond issues to wade through for a selction. Even at that, you still have to decide on whether you are buying a primary offer or from the secondary market, what tenor of bonds to buy and evaluate the yield on the different options.
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