A bond is basically a loan an investor makes to the bonds' issuer. The investor generally receives regular interest payments on the loan until the bond matures or is called, at which point the bond issuer repays the investor’s principal. All bonds have special provisions and components (Face value, coupon rate, and maturity date).
The face value (also called par value) is the value of the bond as given on the certificate or instrument. This is the value the bond holder will receive at maturity unless the issuer defaults. If bonds are retired before maturity, bond holders may receive a slight premium over face value. Investors pay par when they buy the bond at its original face value.
The coupon rate is the annual rate of interest payable on the bond. For the owner of a bond, the higher the coupon rate, the higher the interest payments the owner receives. The rate is set at the time the bond is issued and generally does not change. Most bonds make interest payments semiannually, although some bonds are offered with monthly and quarterly payments.
The maturity is date the issuer pays back the face value of the bond. The bond terminates at maturity.
There are several types of bonds: government, municipal, corporate, etc.
Federal government bonds are issued bonds to pay for government projects. The yields are usually the lowest among bonds, but considered low in risk if held until maturity. Bonds are exempt from state and local taxes.
Municipal bonds are issued by states, cities, counties, and towns issue to finance or pay for public projects (roads, water projects, etc.). Interest payments from majority of municipal bonds are usually exempt from federal, state, and local taxes.
Corporate bonds are issued by corporations to finance expansion activities or cover expenses. These are usually less expensive financing options for most corporations. The yields and risk are generally higher than government and municipals. These are riskier than government and municipal bonds and they are fully taxable.
Lately a lot of state governments in Nigeria have been flocking to the Nigerian Stock Exchange (NSE) to raise funds through the sale of bonds. Late 2009, Lagos State issued a N50 billion bond which was oversubscribed. Imo State is currently in the process of issuing N18.5 billion worth of 7-year bonds with a 15.5 percent coupon to finance water and critical road projects as well as the construction of a new conference centre and financing government’s equity investment in Imo Wonder Lake.
These bonds are beginning to look like the fashionable investments for Nigerian investors. Most of these investors believe that bonds are by and large safe investments. To be precise, some of these investors consider bonds safer than equities in light of the capital losses experienced by NSE investors in the past 15 months.
As a result most investors including fund managers are switching from stocks to bonds. Although, bonds are among the safest investments in the world, they are not risk free. The only bonds that can be considered “risk free” are federal governments bonds, but other bonds carry the potential risk of default.
Some risks that investors should be aware of include:
The potential for default should not be taken calmly by investors. A bond is basically a promise to repay the debt holder. Corporations, cities, countries and states can go bankrupt. If the bond issuer becomes insolvent, they will break their promise to pay the bond holder. With the current worldwide economic downturn, states and federal governments all over the world are struggling to keep their heads above water. Even formerly wealthy States like California, USA, is drowning under a $26 billion deficit and threatening to issue IOUs . For example, in 1998 due to currency crisis (stemming from speculative attack on the country’s currency) and the decline in the price of petroleum to about $11 per barrel, Russia was forced to default on its sovereign debt, devalued the ruble, and declare a suspension of payments by commercial banks to all foreign creditors.
Additionally, the investors should be aware of the impact of inflation and interest rate on bonds. Due to their relative safety, bonds traditionally tend not to offer extremely high returns. As a result, bonds are vulnerable when inflation rises. If the rate of inflation exceeds the bond interest rate, the investor will be losing money since the bond is not keeping up with inflation.
Bond prices have an inverse relationship to interest rates. If one rises, the other falls. So If a bond is sold before it matures, the price investor receives will be based on the interest rate at the time of the sale.
Therefore, if interest rates have risen above the bond rate, the price of the security will fall. Investors can avoid these fluctuations by buying short-term bonds. These short-term bonds generate less income since shorter maturities generally have lower yields than bonds with longer terms.
Depending on the bond, it can either trade very frequently at a low commission or it may be very difficult to find a buyer or seller and involve large transaction costs. "Bond Liquidity" is the term used to describe how easy it is to sell a bond. The liquidity risk is the danger that when an investor wants to sell a bond before maturity there might not be available buyers especially for a bond which is considered to have high default risks.
Highly liquid bonds include federal government bonds, some state government bonds, or bonds issued by financially strong blue-chip corporations. Bonds become illiquid when the issuer becomes insolvent or viewed as financially unstable. When bonds are considered unsafe, they become more or less “junk bonds”, only those speculating that the issuer will turnaround are willing to buy those bonds, meaning they trade a lot less frequently.
Finally, in some bond market there’s always the risk of getting swindled. Unlike the stock market, where stock prices are known, the resale prices for some bond are not completely transparent, because of the hidden fees and other extraneous situations that might affect the sale if you decide to sell before the maturity.
Investors should understand that all bonds are not created equal. In the current environment, as an investor I will not buy bonds whose proceeds will not be utilized for specific revenue generating projects. Since these projects will provide the state government, the entity, or the bond issuer the income which will be used to make future interest payments. Additionally, as more state governments issue these bonds, it is pertinent that investors ascertain whether future governments that inherit these bond debts will accept (or honour) the commitments made by their predecessors.
Finally, if you are buying municipal bond establish that the issuing state can generate sufficient revenue internally from other sources to fulfill their interest payment commitments without relying on the federal government to bail them out. To illustrate, Lagos State has proven that they can survive and do exceptionally well without support from the Federal government. They proved it during the Obasanjo’s administration when the state survived even with the federal government holding about N10 billion of their funds.
Therefore, as an investor, I will buy Lagos State government bonds since they are potentially safe. In summation, investors who are rushing to purchase bonds because they believe they are safer than stocks should understand that bonds are not entirely free of risks and in most cases are less liquid than stocks.
Prepared by Chuckumah Biosah, InvestIQ, Technical Analysts to Proshare