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  • Understanding Bonds: A Practical Guide to Investors, Businesses, & Governments

    Understanding Bonds: A Practical Guide to Investors, Businesses, & Governments

    Bonds

    Meaning, Uses, & Practical Examples

    Bonds are one of the most powerful financial tools often underrated. It can be used by an individual seeking to earn stable income, a business wanting to raise capital, or a government needing funding for infrastructure. Bonds provide structured solutions with long-term benefits.

     

    What Is A Bond

    Bond is a fixed income instrument that is tradable in an organized financial market. It represents a loan made by an investor to a borrower (i.e. issuer) in return for a fixed interest payment  over a specified future date. The principal is repayable at the maturity date, depending on whether or not the bond is redeemable or irredeemable.

    Generally, bonds are issued by private individual, corporate, national, subnational, or supranational organizations for different purposes.

    Uses of Bonds

    Basically, bonds can be used for different purposes, including:

    • Funding Capital Expenditure
    • Capital Preservation
    • Hedging Against Risk Exposure
    • Earning Fixed Income
    • Funding Business Operations
    • Raising Capital for Investment Opportunities.

     

    The owner of the bond is called bondholder, creditor, or investor, while the issuer of the bond is called borrower. The bond price is highly sensitive to changes in interest rates. For instance, when the market interest rate increases, the bond price falls, and vice versa.

     

    How Bonds Are Used in Practice

    Let’s explore the practical ways in which bonds are used in real life by an individual, corporate, and government:

     

    How Individual Can Use Bonds

    Example: Retirement Planning

    Mr. Calafiori is a professional accountant retiring in 5 years’ time. He has decided to invest ₦5,000,000 in FGN savings bonds for the next 5 years at 14% interest per annum.

     

    From The Scenario Above:

    • Calafiori will earn annual interest of ₦700,000 (i.e. 14% x ₦5,000,000) for the next 5 years
    • Over the 5 years period, would have earned a total profit of ₦3.5 million
    • He has secure steady income while preserving his capital
    • This helps him to cover some of his living expenses as he transitions into retirement
    • At maturity, his initial investment of ₦5,000,000 will be repaid.

     

    How Companies Use Bonds

    Example: Project Expansion

    Eskoba Plc is a telecom company based in Ado-Ekiti, Ekiti State. The company’s board of directors agreed in the last meeting to expand their broadband infrastructure nationwide to enhance connectivity. The company does not want to issue additional shares to finance the investment due to dilution of ownership. Instead, it issues 9% ₦10,000,000,000 corporate bond. The bond will be redeemable at par in 5 years’ time.

     

    What Next:

    • Investors lend the company the finance required by purchasing the bond
    • Eskoba Plc will pay annual interest of ₦900 million (i.e. 9% x ₦10 billion) to the investors
    • At maturity i.e. after 5 years, the company will repay the principal amount

     

    From This Scenario:

    • The company get the required funding without losing control of the business
    • Investors earn predictable stream of income over the period of the investment.

     

    How Governments Use Bonds

    Example: Infrastructure Development

    The Federal Government of Nigeria (FGN) has concluded plans to build new roads and upgrade existing transportation infrastructure across the six geopolitical zones. The finance required of ₦550 billion to execute the project is not readily available. To raise the funds, FGN has decided to issue a 10-year sovereign bond at interest rate of 15%.

     

    What Next:

    • High-net-worth-individuals, retail, and Institutional investors subscribe to the bond.
    • FGN pays interest of ₦82.5 billion (i.e. ₦550 billion x 15%) every year to the investors (i.e. the bondholders) for the next 10 years.
    • FGN will repay the bondholders (investors) the principal of ₦550 billion after 10 years.

     

    From The Scenario Above:

    • The FGN is able to fund the intended project without having to raise taxes
    • Investors earn returns on their investment with relatively low risk.

     

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    In Summary

    Understanding bonds can enhance your financial decisions, irrespective of whether you are a professional planning for retirement, business owner wanting to invest idle funds to earn returns, or an investor interested in balancing portfolio mix. Bonds can be used as a wealth preservation strategy and funding capital expenditure, depending on the user.

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  • Bonds: Meaning & Characteristics

    Bonds: Meaning & Characteristics

    Bonds: Meaning & Characteristics

    Bonds: Meaning & Characteristics

    Bonds are fixed income instrument that can be bought or sold in an organized financial market. It is a contractual agreement between the issuer and the bondholders that represent an acknowledgement of debt. Bond is one of the sources of long-term financing needs of an entity. It is a form of I owe you (IOU) or loan between the borrower (debtor) and lender (investor). Generally, public, and private organizations use bond as a means of financing their capital expenditures, including construction of roads, dams, bridges, buildings, refineries, etc. Bond can also be used by government to finance budget deficit.

    For example, when an entity needs money to finance a project, and the required financial resources is not readily available, the borrower may be compelled to approach investors to source for the needed funds by raising bonds. Bond can be redeemable or irredeemable, callable, or non-callable.

    Redeemable / Callable Bond

    The redeemable bond is also known as callable bond. It is a type of bond in which the issuer will pay both the annual fixed interest and the principal on or before the maturity date. It allows the issuer to settle the debt prior to maturity date. The callable bond offers some degree of flexibility. Because when the market interest rate falls below the bond interest rate, the issuer may want to call back the bond. This will then allow the issuer to raise another bond at a lower interest rate, thereby enabling it to save money and preclude the issuer from facing any financial challenges that may arise in the future in case the economic condition or its financial situation deteriorate.

    However, callable bond is generally issued at a price marginally above the par value to compensate the investors for taken higher risk. To this end, the callable bond is expected to pay a higher rate of return (interest rate) to the investors, relative to non-callable bond. This higher interest rate will invariably increase the overall costs of the potential investment or project.

     

    Irredeemable Bond

    This is also known as perpetual bond. It is the one in which the issuer will only make the annual interest payments for the foreseeable future, but the principal will not be repaid. There is relatively small market that exist for irredeemable bond due to its non-attractiveness. Because investors will not want to invest their limited scarce financial resources in a bond in which the principal will never be repaid. And that is why the perpetual bond is often referred to as a kind of equity, rather than being called a debt, since equity and irredeemable bond offer some level of return to infinity, or for an indefinite period.

    The price or market value of the irredeemable bond is the present value of the future expected cash flows discounted at the required rate of return.

     

    Non-Callable Bond

    The non-callable bond is a type of bond that is not redeemable or that cannot be recalled prior to its maturity date. If the issuer wants to call back the bond before the maturity date, the issuer must be ready to pay the underlying penalties to the investors. The issuer of con-callable bond is exposed to interest rate risk. This is because if market interest rate falls, the issuer will continue to pay the agreed higher interest rate until the redemption date. Therefore, it does not offer the issuer any form of flexibility and the ability to profit from positive market conditions during the life of the bond.

    Generally, most treasury securities and municipal bond instruments are non-callable.

    Characteristics of a Bond

    The main features of a bond include the:

    • Issuer
    • Maturity Date
    • Par Value
    • Coupon Payment / Rate
    • Price
    • Yield
    • Currency Denomination
    • Credit Rating

     

    Issuer

    These are entities that issue bonds, including private Individuals, Companies, National, State & Local Governments, and Supranational Organizations. The issuers sell bonds in the bond market for the purpose of achieving their financing needs. The bond markets are categorized into different sectors by the market participants by their issuers including:

    • National governments e.g., Nigeria, China, or United States
    • Subnational governments (state, or local governments), such as Lagos state in Nigeria, Ontario in Canada
    • Quasi-government entities (agencies controlled or owned by government) e.g., Central Bank of Nigeria, Nigeria Port Authority, Federal Reserve in United States
    • Supranational organizations e.g., International Monetary Funds (IMF), World Bank, World Trade Organization (WTO)
    • Companies e.g., banks, insurance (financial issuers) and others (non-financial issuers).

     

    Maturity Date

    The maturity date of a bond is the specified future date in which the issuer is obligated to redeem the bond after paying the outstanding principal amount to the bondholder. The maturity date is also known as the redemption date, or termination date. The maturity date of a bond can be classified into:

    • Short-term: This has a maturity of 1 to 3 years
    • Medium-term: This category of bonds has up to 10 years maturity
    • Long-term: This has over 10 years maturing period.     

     

    The maturing date of a bond can range from 1 year to over 30 years. The maturity date is usually printed on the bond certificate. A bond certificate is a legal document that shows the details of the bond instrument, including the name of the issuer, the face value, the coupon rate, and the maturity date. It is a receipt that show the evidence of ownership to the bondholder, including the terms of the bond.

    Bonds: Meaning & Characteristics

    Par Value

    The par value of a bond represents the nominal value that the issuer agrees to repay the lender (bondholders) on the redemption date. The par value is also known as face value, nominal value, maturity value or redemption value. The par value is expressly stated on the face of the bond certificate. However, by way of standard convention, the par value of a bond is mostly quoted at N1,000 or $1,000 per unit.

    Generally, and in practice, bond prices are quoted as a percentage of its face value. Say for instance, a bond with nominal value of N1,000 is quoted at 97%. This means that the bond price is N970 calculated as 97% of N1,000. Again, let us assume that you bought FGN Savings bond at N1,000 per unit at an annual interest rate of 15 per cent. This means that you will earn an annual return on your investment of N150 per unit of the bond (i.e., N1,000 x 15%).

    Bonds can be priced at 100%, less than 100%, or above 100% of the face value, depending on whether the bond is quoted at par, discount, or premium. When the bond is priced at the nominal value of N1,000 or 100%, then the bond is trading at par. If the bond price is quoted below the par value, the bond is said to be trading at a discount. But if the bond price is quoted above the par value of 100%, then the bond is trading at a premium.

     

    Coupon Payment / Rate

    The coupon payment represents the annual amount of interest payable to the bondholders by the issuer. The coupon rate is the annual interest rate that the issuer agrees to pay the bondholders until the maturity date. A bond’s coupon payment can be estimated by multiplying the coupon rate with the nominal value of the bond. For instance, if a bond has a coupon rate of 4% on the par value of N1,000, then the annual interest payment will be N40 (i.e., 4% x N1,000). The coupon rate of a bond can be calculated as the ratio of annual coupon payments to the par value of the bond, multiply by 100% i.e., coupon payments divided by the nominal value.

    Coupon payment may be paid quarterly, semi-annual, or on an annual basis.

     

    Price

    The price of a bond is the present value of the expected future cash flows (interest and principal repayment) discounted at the required rate of return (yield), or cost of the bond. It should be noted that the price of a bond is sensitive to a change in interest rate. This means that:

    • When the coupon rate is equal to the required rate of return, the bond is priced at par
    • If the coupon rate is less than the required rate of return, it means the bond is priced at a discount
    • But when the coupon rate is greater than the required rate of return, the bond is priced at a premium.

     

    Yield

    This is the rate of return expected by the bondholders from their investments. It is the rate of return received from investing in the bond instrument. There are basically two types of bond yield, including current yield and yield to maturity. Normally, bond of the same risk class is expected to have the same rate of return.

     

    Currency Denomination

    This is the currency at which a bond is issued. Bonds can be issued in any currency e.g., Nigerian Naira, US Dollar, Euro etc. But majority of the bonds are issued in either US dollars or euros. The currency of issue may affect bond’s attractiveness. If the currency is not liquid, freely traded, or if the currency is susceptible to gyrations against major currencies in the market, the currency may not appeal to many investors. In this case, it is usually advisable for issuers in the countries with volatile currency to issue bonds in major currencies such as US dollar, instead of their domestic currency. However, a bond that is designed principally to attract local investors can be issued in the local currency.

     

    Credit Rating

    Bonds are usually rated by credit rating agencies (CRA) and the higher the credit rating, the lower will be the coupon rate required to pay by the issuer and vice versa. The credit rating enhances the creditworthiness of a bond. It represents a financial indicator to potential lender. The global and well-known credit rating agencies include:

    • Standard & Poor’s (S&P)
    • Moody’s
    • Fitch

     

    The highest rating for an entity’s bond is AAA or Aaa, and such bond is regarded as top-quality and have the lowest degree of risk. This class of rating is not common and as such, not awarded very often. An entity’s credit rating can improve or worsen based on its financial conditions.

    Basically, there are Investment grade and non-investment grade bonds. The investment grade bonds are bonds that are usually considered by the rating agency to be more than likely to meet payment obligations. On the flip side, the non-investment grade bonds are generally rated below the investment grade, and they are of low quality. They are often considered as high yield rated or junk bonds.

    In Nigeria, an intending or operating credit rating agency must be duly licensed by the Nigeria Securities and Exchange Commission (SEC).

     

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