Risks associated with short-term borrowing and the lull in the equities market are driving corporate organisations and state governments to the bond market, writes Eromosele Abiodun
The last four weeks have been a robust period for the bonds market as investors’ appetite for a less volatile investment opportunity hits an all time high. Analysts attribute this to the recent interest by some States Governors in issuing long-term bonds for developmental purposes.
UBA Capital, the investment banking and asset management division of United Bank for Africa (UBA) Plc, recently led other financial institutions to raise N18.5bn for Imo State government to help meet its developmental goals.
The Kwara State Government also is preparing to hit the capital market with its N30 billion bonds. These are coming on the heels of the success the Lagos State Government recorded with its N50 billion late last year.
Also, on September 10, 2008, the Federal Executive Council (FEC) approved the issuance of a 10 year $500 million Naira-denominated Bond in the International Capital Market (ICM). However, that fund raising exercise is still being kept on hold. The amount and the tenor, the government said, was carefully chosen in order to ensure that this first bond issuance by Nigeria in the ICM, achieves the primary objective of the issue, which is, to establish a sovereign benchmark in the ICM.
Market analysts believe credit must be given to the Nigerian Capital Market Institute (NCMI), a subsidiary of the Securities and Exchange Commission (SEC) for organising seminars to educate investors on the need to embrace fixed income securities.
Director, NCMI, Dr. Oluwatobi Oyefeso, in a chat with THISDAY said there was need to prepare the minds of investors on the mechanisms of the capital market.
“We have to let people know the risks associated with various classes of investments and the need for them to seek the professional investment advice and to support the market operators through quality workshops on investment securities, thereby encouraging the introduction of such financial instruments that would complement equities and deepen our market, “ he said.
Oyefeso said there was need for people to know more about the benefits to be derived in investing in of bonds, “having explored other areas to revamp the market, without recording much success, a flight into investments in the bond market will help revitalise the economy.”
Fixed income securities like bonds are instruments that have been neglected by investors over the years. The downturn in the stock market has however, helped to redirect investors’ attention to bonds. The article therefore seeks to expose the salient issues in the bond market – highlighting the steps to take to maximise returns in the credit market.
Meaning of Bond Market
The bond market also known as the debt market is where participants buy and sell debt securities, usually in the form of bonds.
A bond can also be described as a debt security, in which the authorised issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to repay the principal at a later date, termed maturity.
Thus a bond is a loan: the issuer is the borrower, the bond holder is the lender, and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Certificates of deposit (CDs) or commercial paper (CPs) are considered to be money market instruments and not bonds.
Bonds and stocks are both securities, but the major difference between the two is that stock-holders are the owners of the company (i.e., they have an equity stake), whereas bond-holders are lenders to the issuer. Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity).
As at 2006, the size of the international bond market was estimated $45 trillion, of which the size of the outstanding U.S. bond market debt was $25.2 trillion.
Investing in Bonds
Mr. Idowu Ogedengbe of UBA Global Markets, said that Bonds are bought and traded mostly by institutions like pension funds, insurance companies and banks. He said:” Most individuals who want to own bonds do so through bond funds. But, in the United States nearly 10 per cent of all bonds outstanding are held directly by households.
“Sometimes, bond markets rise (while yields fall) when stock markets fall. More relevantly, the volatility of bonds (especially short and medium-dated bonds) is lower than that of shares. Thus bonds are generally viewed as safer investments than stocks, but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks.
“Bonds' interest payments are often higher than the general level of dividend payments. Bonds are liquid, it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks and the comparative certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount), whereas the company's stock often ends up valueless. However, bonds can also be risky”.
Fixed rate bonds according to Ogedengbe, “are subject to interest rate risk, meaning that their market prices will decrease in value when the generally prevailing interest rates rise. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the market interest rate rises, the market price of bonds will fall, reflecting investors' ability to get a higher interest rate on their money elsewhere, perhaps by purchasing a newly issued bond that already features the newly higher interest rate. Note that this drop in the bond's market price does not affect the interest payments to the bondholder at all, so long-term investors who want a specific amount at the maturity date need not worry about price swings in their bonds and do not suffer from interest rate risk,”.
He explained: “Price changes in a bond will also immediately affect mutual funds that hold these bonds. If the value of the bonds held in a trading portfolio has fallen over the day, the value of the portfolio will also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers (irrespective of whether the value is immediately "marked to market" or not). If there is any chance a holder of individual bonds may need to sell his bonds and "cash out", interest rate risk could become a real problem.”
He said one of the ways to quantify the interest rate risk on a bond is in terms of its duration. “Efforts to control this risk are called immunisation or hedging. Bond prices can become volatile depending on the credit rating of the issuer - for instance, if the credit rating agencies like Standard & Poor's and Moody's upgrade or downgrade the credit rating of the issuer. A downgrade will cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.”
Bond Market Structure
Bond markets in most countries remain decentralised and lack common exchanges like stock, future and commodity markets. This has occurred, in part, because no two bond issues are exactly alike, and the number of different securities outstanding is far larger.
However, the New York Stock Exchange (NYSE) is the largest centralised bond market, representing mostly corporate bonds. The NYSE migrated from the Automated Bond System (ABS) to the NYSE Bonds trading system in April 2007 and expects the number of traded issues to increase from 1000 to 6000.
Type of Bond Markets
Managing Director and Chief Executive Officer, Emerging Capital Limited, Mr. Chidi Agbapu, classifies the broader bond market into five specific bond markets. These, he said, are - Corporate, Government & agency, Municipal, Mortgage-backed, asset-backed, and collateralised debt obligation and Funding.
“There several kinds of bonds but I will try and explain a few of them. Fixed rate bonds have a coupon that remains constant throughout the life of the bond, while Floating Rate Notes (FRNs) have a coupon that is linked to an index. Common indices include: money market indices, such as London Inter-bank Offered Rate (LIBOR) or Euribor, and CPI (the Consumer Price Index). Coupon examples: three month USD LIBOR + 0.20 per cent, or 12 month CPI + 1.50 per cent. FRN coupons reset periodically, typically everyone or three months. In theory, any Index could be used as the basis for the coupon of an FRN, so long as the issuer and the buyer can agree to terms. Zero coupon bonds don't pay any interest. They are issued at a substantial discount to par value. The bond holder receives the full principal amount on the redemption date,” Agbapu said.
There is also what they call Inflation linked bonds, these are bonds in, which the principal amount and the interest payments are indexed to inflation, he explained. The interest rate is normally lower than for fixed rate bonds with a comparable maturity (this position briefly reversed itself for short-term UK bonds in December 2008). However, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation linked Gilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government. Other indexed bonds, for example equity-linked notes and bonds indexed on a business indicator (income, added value) or on a country's Gross Domestic Product (GDP). Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are Mortgage-Backed Securities (MBS's), Collateralised Mortgage Obligations (CMOs) and Collateralised Debt Obligations (CDOs).
Subordinated bonds, he said, are those that have a lower priority than other bonds of the issuer in case of liquidation.
“In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then governmtent taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in trenches. The senior tranches get paid back first, the subordinated tranches later,” he said.
Perpetual bonds, he explained, are also often called perpetuities. He said: “They have no maturity date. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today, although the amounts are now insignificant. Some ultra long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond, which matures in 2361 (i.e. 24th century) are virtually perpetuities from a financial point of view, with the current value of principal near zero.”
Bearer bond, he said, is an official certificate issued without a named holder.
“In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets. Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner,” he explained. He described Municipal bond as a bond issued by a state, territory, city, local government, or their agencies.
He said: “Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.
“Book-entry bond is a bond that does not have a paper certificate. As physically processing paper bonds and interest coupons became more expensive, issuers (and banks that used to collect coupon interest for depositors) have tried to discourage their use. Some book-entry bond issues do not offer the option of a paper certificate, even to investors who prefer them. Lottery bond is a bond issued by a state, usually a European state. Interest is paid like a traditional fixed rate bond, but the issuer will redeem randomly selected individual bonds within the issue according to a schedule. Some of these redemptions will be for a higher value than the face value of the bond. War bond is a bond issued by a country to fund a war.”
Bond Market Participants
According to Agbapu, “Bond market participants are similar to participants in most financial markets and are essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often both. Participants include: Institutional investors, Governments, Traders and Individuals. Because of the specificity of individual bond issues, and the lack of liquidity in many smaller issues, the majority of outstanding bonds are held by institutions like pension funds, banks and mutual funds. In the United States, approximately 10 per cent of the market is currently held by private individuals.”
Bond Market Volatility
Managing Director of DHTL Capital Limited, Mr. Tunde Adeyemi, advised market participants who own bonds to collect their coupon and hold it to maturity because market volatility is irrelevant. Principal and interest, he noted, are received according to a pre-determined schedule.
“But participants who buy and sell bonds before maturity are exposed to many risks, most importantly changes in interest rates. When interest rates increase the value of existing bonds fall, since new issues pay a higher yield. Likewise when interest rates decrease the value of existing bonds rise since new issues pay a lower yield. This is the fundamental concept of bond market volatility: changes in bond prices are averse to changes in interest rates. Fluctuating interest rates are part of a country's monetary policy and bond market volatility is a response to expected monetary policy and economic changes,” he explained.
Economists' views of economic indicators versus actual released data contribute to market volatility, he added.
“A tight consensus is generally reflected in bond prices and there is little price movement in the market after the release of "in-line" data. If the economic release differs from the consensus view the market usually undergoes rapid price movement as participants interpret the data. Uncertainty (as measured by a wide consensus) generally brings more volatility before and after an economic release. “Economic releases vary in importance and impact depending on where the economy is in the business cycle. Investment companies allow individual investors the ability to participate in the bond markets through bond funds, closed-end funds and unit-investment trusts. Exchange-traded funds (ETFs) are another alternative to trading or investing directly in a bond issue. These securities allow individual investors the ability to overcome large initial and incremental trading sizes,” he said.
Bonds, he said, are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets.
“The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. However, government bonds are instead typically auctioned,” he said.