Understanding how to invest in bonds

Oct 23, 2018
One of the fastest and most reliable ways of building financial wealth and planning for retirement in this challenging economy is investing your little earnings rather than saving in banks with little or no return on savings.
 
Investment provides you with the opportunity to put your money in a vehicle with the potential of earning high rates of return thereby fast-tracking the rate of increasing your financial worth.
 
However, investments are not totally risk-free, but with the right information, you can make informed-decision on how to grow your money even while engaging in other ventures.
 
While there are several forms of investments, bonds – fixed income securities – are one of the safest of the three main generic asset classes including stocks and cash equivalents to invest in because of its low default risk.
 
What is a Bond?
 
A bond is a contract where a lender (investor) loans out his excess money to a borrower having little or no funds to finance new projects or refinance existing debts, the borrower agrees to pay the lender interest payments and repay the principal after a stipulated period.
 
The borrower could be a government entity – Federal or State Government – or a corporate organisation wishing to raise capital to finance its operations.
 
Before a bond is issued, both parties will agree on the maturity date (time which the loaned fund will be returned) and amount (percentage of the principal to be paid) the bondholder will earn for loaning his funds to the issuer, this is often referred to as coupon.
 
For example, Company AB seeks to raise capital to build a new warehouse. The company issues a 20-year bond of N100,000 of several portions at 7 percent annual coupon rate, implying that for the next 20 years when the bond will mature, an investor with N1,000 face value of a portion of the bond will earn N70 annually as coupon. At the maturity date, the investor gets his N1,000 principal (face value) and his last N70 coupon.
 
Federal Government of Nigeria Bonds
 
The Federal Government of Nigeria (FGN) through the Debt Management Office (DMO) often issue a number of debt instruments including the monthly FGN Savings Bonds which have tenor of 5 years, 10 years and 20 years.
 
Other FGN Bonds include Green Bond, Sovereign Sukuk Bond, Eurobonds and Diaspora Bond.
 
Green bonds are fixed income, liquid financial instruments issued in partnership with the Federal Ministry of Environment to raise funds towards financing climate mitigation, adaptation and other environment-friendly projects.
 
Sukuk Bond, also known as Islamic Bond, is a financial instrument structured to generate returns without interest payments, it is targeted at funding road infrastructure across the country, while Eurobonds are special debt instruments issued in a currency different from the currency of the country or the market in which the bond is issued.
 
Benefits of FGN Savings Bonds
 
The FGN Savings Bonds allow low-income earners to save and earn more interest than the regular bank savings. For this category of bonds, investors lend to the federal government to fund its budget deficit and earns a percentage of his investment annually, semi-annually or quarterly until the bond matures and the investor gets his initial payment.
 
FGN Bonds are traded publicly on the Nigerian Stock Exchange (NSE) and Financial Markets Dealers Quotations (FMDQ) Over-the-Counter Securities Exchange. Interests on the bonds are not taxed, the bonds can easily be traded or used as collaterals, and repayment is guaranteed at maturity.
 
Bonds Trading
 
The bonds are first issued to the public in the primary market such as the example given for Company AB. The bondholder (investor A) gets a certificate having the face/par value, annual interest rate payable and maturity date written on it.
 
However, the investor may wish to sell the bond before the maturity period (20 years) to another investor, transactions between two investors after issuance can be performed in the secondary market at a market price which is determined by the force of demand and supply, inflation, interest rate of the bond and credit quality.
 
In the secondary market, bonds could trade at a premium or at a discount. When investor A decides to sell his portion of Company AB’s at a market price above N1,000, for example N1,100, then the bond is trading at a premium (above par value), but if he sells at a lower price, for example N950, then the bond is trading at a discount (below par value), even though the face value (original price) of N1,000 of that portion of bond does not change regardless of changes in the market price.
 
This indicates that investor A could either gain N100 (market price – cost price) in the first case or incur a loss of N50 in the other case.
 
But if investor B (a new investor) decides to buy the N1,000 par value bond from investor A after 5 years at N950 in the secondary market and resells after 10 years, which is before the 20-year maturity date, at N1,050. Then, investor B will make a profit of N100 (N1,050 – N950) and not N50.
 
Now as a potential investor, you may want to consider any of the FGN Savings Bonds to join the list of investment-included Nigerians. To do this, you will need contact any licensed Primary Dealer and Market Makers (PDMM) listed on DMO’s website. It could be a bank, investment firm or broker, you will fill forms to create a brokerage account. The form gathers basic investment information including your bank account details.
 
If you want your bond to be listed on the NSE or FMDQ, you will need a CSCS account, this would give you a leverage if you want to sell before maturity date.
 
It is also important to understand your investment timeframe, choose a bond that will mature when you will need the money if you do not intend to sell before it matures. A 20-year bond will be suitable for anyone who plans to retire in 20 years’ time, the longer the duration, the higher the interest rate.
 
Investing in FGN Bonds
 
FGN Bonds are offered every month at N1,000 per unit subject to a minimum subscription of N5,000 with increases thereafter in multiples of N1,000 up to a maximum of N50 million.  They are backed by the full faith and credit of the Federal Government with quarterly coupon payments to bondholders, indicating it is almost unlikely for the government to default payments.
 
The FGN Bonds offerings are conducted in an auction-based system, often for a period of a week after DMO’s announcement. At the auction, investors quote interest rates for bonds they intend to buy. After the close of biddings, bids with interest rates below the marginal (average) rate are accepted while those above are rejected, implying that interest rate for the bond changes based on the auction result.
 
Successful bidders are notified after the auction while for unsuccessful ones, probably because of high interest rate above marginal rate, a refund is made to the account with investors’ brokers, such unsuccessful bidders may decide to wait till the next primary auction or buy from any investor that won the bidding and willing to sell or from brokers.
 
The amount paid (market price) for FGN Bonds is dependent on the interest rate and yield. That is, N1,000 bond at 10 percent interest rate will return N100 as coupon. If the marginal rate is 15 percent, then the price payable is calculated by dividing the coupon by the marginal rate (expected yield), which in this case is N666.67 for a bond with N1,000 face value.
 
Apparently, when yield is higher than the coupon, the bond is sold at a discount, but when the coupon is higher than the yield, the bond is sold at a premium.
 
Also, the above expression indicates that there is an indirect relationship between the market price of a bond and its yield. That is, when the price rises, the yield drops and vice versa.
 
If your choice is to buy at a discount, sell at a premium or most importantly make profit should you decide to sell before maturity, it is advisable to seek your broker’s advice, not only for the choice of bond to invest in, but also for proper guidance on your other investment decisions.
 
 

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