In a typical emerging marketplace like Nigeria, trading in bonds is unpopular or rather uncommon most especially with retail and middle-class investors. The market is dominated by institutional investors such as financial institutions (banks and insurance), fund managers, Pension Fund Administrators (PFAs) and a few sophisticated high networth investors.

On the contrary, investors of all classes (existing and prospective) are hypnotized by prolific analysts’ coverage and journalists’ reports on activities in the equity market on a daily basis. The first thing that comes to mind when most people think of investing is the equity market. After all, equities are exciting. The happenings/events in the market are publicised in prints and electronic media and stories of investors building sustainable wealth in the equity market are very common lingos.

Bonds do not command the same attention as equities. Some say the language sounds complex and confusing to the average person. Moreso, bonds are much more boring - especially during wild bull markets, when they seem to offer insignificant returns compared to stocks. However, as we currently experiencing, all it takes is a bear market to remind investors of the virtues of a bond's safety and stability. In fact, for some sophisticated and informed investors, it makes sense to have at least part of their portfolio invested in bonds as a potent hedge against vagaries in the equity market. Beyond sophistication, sound portfolio management practice states that we should have a portion of our portfolio in equities, bonds and money market instruments.

Basics of Bonds:

Bonds are known as fixed income securities because you know the exact amount of cash you will get back if you hold the security until maturity. A company needs funds to expand into new markets, while governments need money for provision of infrastructure to funding of social programmes, etc. The problem large organisations usually face is that they typically need far more money than the average bank can provide or better still, it makes more economic sense to look elsewhere rather than banks. The solution is to raise money either by equity or issuance of bonds (or other debt instruments) through the capital market. Thousands of investors then each lend a portion of the capital needed. In the real sense, a bond is nothing more than a loan for which you are the lender. The organisation that sells a bond is known as the issuer. From a layman’s perspective, you can think of a bond as an IOU (i owe you) given by a borrower (the issuer) to a lender (the investor).

Obviously, nobody would loan his or her hard-earned money for nothing. The issuer of a bond must pay the investor some compensation for the privilege of using his or her money. This compensation comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon rate. The date on which the issuer has to repay the amount borrowed is called the maturity date. For instance, say you buy a bond with a face value of N1,000,000, a coupon of 8% payable annually, and a maturity of 10 years. This means you will receive a total of N80,000 (N1,000,000 multiplied by 8%) interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you will receive two payments of N40,000 each year for 10 years. At maturity (in this case 10 years), you will get your N1,000,000 back.

Differentiating Between Debt and Stocks

Basically, bonds are debts, whereas equities are stocks. By purchasing equity (equity), an investor becomes a part owner (shareholder) in a company. Ownership comes with voting rights and the right to share in future profits (if any). Conversely, by purchasing debt (bonds) an investor becomes a creditor (or bondholder) to the company (or government). The primary advantage of being a creditor is that you have a higher claim on assets than shareholders do: that is, in the case of bankruptcy, a bondholder will get paid before a shareholder. However, the bondholder does not share in the profits if a company does well - he or she is entitled only to the principal plus interest. By and large, there is generally less risk in owning bonds than in owning equities, but this comes at the cost of a relatively lower return and more certain returns.

Exploring Investment in Bonds:

What are Bonds?

There is an investing maxim that equities yield higher returns than bonds. However, this does not mean you should not invest in bonds. Bonds are appropriate any time you cannot tolerate the short-term volatility of the equity market. Risk-averse individuals can always turn to bond as a safe investment vehicle that guarantees preservation of wealth at all time. Let’s consider two situations where this may be true:

§  Retirement - The easiest illustration to think of is an individual living off a fixed income. A retiree simply cannot afford to lose his/her principal as income for it is required to pay the bills and provide for sustenance.

§  Shorter time horizons – Assume a scenario where a young executive is planning to enroll for an MBA programme in the next 12 months.

It is true that the equity market provides the opportunity for higher growth, which is why his/her retirement fund is mostly in equitys, but the executive cannot afford to take the chance of losing the money going towards his/her education. Because the money is needed for a specific purpose in the relatively near future, fixed-income securities are likely the best investment.

These two illustrations are specific, and they do not represent all investors. Investment professionals offering personal financial advisory services always advocate maintaining a diversified portfolio and changing the weightings of asset classes throughout one’s life. Portfolio allocation theory and investment professionals often advocate that, during one’s 20s and 30s majority of wealth should be in equities. However, for investors’ in the 40s and 50s age bracket, the percentage allocation should reduce from equities in favour of bonds until retirement, when a majority of one’s investments should be in the form of fixed income.

Features of Bonds

Bonds have a number of characteristics. All of these factors play a role in determining the value of a bond and the extent to which it fits in one’s portfolio.

1.     Face Value/Par Value

The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures. A newly issued bond usually sells at the par value. Corporate bonds in Nigeria usually have a par value of N100 (in contrast to $1,000 in the US), while virtually all government bonds are denominated at N1,000 par value. However, some few corporate bonds in Nigeria are also priced at N1,000 par value.

Confusions usually arise as to difference between par value and market value of the price of the bond. A bond's price fluctuates throughout its life in response to a number of variables (such as interest risk, inflation risk, liquidity risk, default risk, re-investment risk etc). When a bond trades at a price above the face value, it is said to be selling at a premium and when it sells below the face value, it is said to be selling at a discount.

2.     Coupon (The Interest Rate)

The coupon is the amount the bondholder will receive as interest payments. It is called a "coupon" because in the time past, there used to be physical coupons on the bond that you tear off and redeem for interest. However, this is not in vogue anymore. These days, records are kept electronically. As previously mentioned, most bonds pay interest every 6 months, but it is possible for them to pay monthly, quarterly or annually. The coupon is expressed as a percentage of the par value.

Illustration:

If a bond pays a coupon of 10% payable annually and its par value is N1,000, then it will pay N100 of interest a year. A rate that stays as a fixed percentage of the par value like this is a fixed-rate bond. Another possibility is an adjustable interest payment, known as a floating-rate bond. In this case the interest rate is tied to market rates through an index, such as the rate on Treasury Bills (TBs). One might think investors will pay more for bonds with a higher coupon than for a lower coupon. All things being equal, a lower coupon means that the price of the bond will fluctuate more.

3.     Maturity

The maturity date is the date in the future on which the investor's principal will be repaid. Maturities can range from as little as 1 day to as long as 30 years (though terms of 100 years are not common in Nigeria but are very popular with the US and other advanced economies in Europe and Asia). A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 15 years or more. Therefore, in general and under normal condition/expectation, the longer the time to maturity, the higher the interest rate. Also, all things being equal, a longer term bond will fluctuate more than a shorter term bond.

4.     Issuer

The issuer of a bond is a crucial factor to consider, as the issuer's stability is the main assurance of getting paid back. For instance, government is far more secure than any corporate body. Hence, its default risk (the probability of the debt not being redeemed) is extremely low - so low that government securities are known as risk-free assets. The reason behind this is that a government will always be able to bring in future revenue through taxation, at least. A company, on the other hand, must continue to make profits, which is far from guaranteed. This added risk means corporate bonds must offer a higher yield in order to lure investors - this is the risk/return tradeoff in action.

5.     Rating

The bond rating system also helps investors determine a corporate's credit risk. We can consider a bond rating as the report card for a company's credit rating. Blue-chip firms, which are safer investments, have a higher rating, while risky companies have a lower rating. One should note that if a company falls below a certain credit rating, its bond is downgraded. The rating scale ranges from investment quality grade down to junk status. Junk bonds are suitably named. They are the debt of companies in some sort of financial difficulties. Because they are so risky, they have to offer much higher yields than any other debt. This brings up an important point: not all bonds are inherently safer than equities. Certain types of bonds can be just as risky, if not riskier, than equities.