– By Chukwudi Odili
What are Bonds?
Bonds or Debt Securities are medium to long-dated interest-bearing financial instruments issued in the capital market. Bonds are gilt-edged (very safe) securities because they are assured, by the certainty and consistency in the payment of interests. The ease of disposal is guaranteed because the Central Bank of Nigeria (CBN) is always prepared to pay back.
Compared to equities, bonds have wider diversities of issuers and users, such as: corporate entities, federal and state governments as well as local authorities.
The Federal Government borrows money from the capital market through the issuance of a type of bond called development loan stock for funding of specific projects. The Debt Management Office issues the security on behalf of the government. Apart from targeting the stock market, the bond issuance is at times targeted at Institutional investors and high net-worth individuals. Structured bonds could be issued through global offering aimed at raising foreign exchange.
State and Local Governments could also go the way of companies to issue securities in the primary market. However, State Governments are yet to develop a strong and responsible culture of using the capital market. The situation is even worse for local Governments which are not yet autonomous to deal in financial transactions. In advanced jurisdictions, municipal (local government) bonds are a veritable source of financing projects of long gestation.
Certain special features are essentially designed to enhance bond’s attractiveness to potential subscribers. Some of these features include:
- The interest-rate structure, which may be floating or fixed;
- The repayment value element, specifying whether it should be discounted or not;
- Other options as to whether it is secured or non-secured;
Arguments for and against Investing in Bonds
Arguments For
Bonds are safer investment vehicles than shares. Should a company fall on hard times, the interest on the bond must be paid before ever the common or preference stockholders receive dividends. In addition, if the company is forced into bankruptcy, the bondholder has first claim on any assets.
Rate of return on investment is guaranteed. The interest coupon on a bond is fixed and payable to the bond-holder whether the issuer made profit or not, unlike a dividend (return) on a stock which may not be paid if the issuing company did not make a profit during the period. Even though the bond price may fluctuate, each bond yields a fixed interest component per year.
Principal is guaranteed on maturity. All bonds are redeemed at face value. Traditionally, bonds have been considered a store of value although a steep inflation may overturn tradition completely. In this later case, bonds may be considered a good vehicle for short-term speculation on interest rates.
In the corporate world, interest payments are not taxed whereas dividends are taxed. That makes debt a lot cheaper than equity.
Of course there are costs to debt financing (for example, the risks of bankruptcy), but the tax savings far outweigh them.
Arguments Against
Principal repayments (e.g., during depression) are not completely secure. It can be defaulted when corporations find themselves in distress. In times of economic downturn, old bonds are rarely retired with ease by corporations, and even governments, but may only be re-financed by the issuance of new bonds. This situation has the tendency to increase the net indebtedness of affected facilities. Subsequently as the economy grinds further down, the issuers are less likely to honour the full obligations. This is a real danger especially if the debt portfolio increases at a faster rate than corporate profits decline in real terms; and in the case of governments, the situation could be grave when there are consistent shortfalls in the projected revenues accruing to the issuing country over the years. This has been the fate of corporate organisations or governments saddled with debt in many countries. Worst still, if the government attempts to inflate the economy the bond may at best be repaid in worthless currency. This is the reason why long-term debt hardly exists in places like South America where a number of bond holders have had bitter experiences; and have lost certain degrees of confidence in the system. In, effect, the main reason for investing in bonds in a period of economic stability (characterised by security of principal) has become the main reason for not investing in them in a period of depression.
Rate of return is hence, guaranteed to be inadequate in a situation where the dynamic process of inflation makes bond yields provide inadequate return to maturity. On the other hand, where the government tries to deflate, there would tend to be numerous bond defaults because repayments would become costlier.
Bonds may be safer securities than shares but may not be safer than other investment vehicles.
Similarly, the principal repayment of bondholders may be considered before those of stockholders during liquidation but they come after everyone else’s. Property Taxes, Value Added Tax, social security ties and trusts, among others, must be covered first in a situation when the indebted entity goes into liquidation. Next to be paid off are the beneficiaries of any improperly funded pension plans (termed second mortgage on earnings). After them are short-term notes and accounts payable. At times when short-term obligations accumulate, new bonds are floated just to pay them off. The consequent effect is such that bond-holders come last when repayments are being considered by the indebted government or corporation.
Appraising your Bonds
Following from the Arguments Against, discussed in the foregoing, there are four important points that an investor must consider before going into long-term investment in bonds.
- What is needed to negate inflation? If inflation is 12 percent, for instance, a bond must yield more than that for it to be worth investing in.
- What is needed to negate the effect of taxes? If the bond just mentioned would yield higher than the combined rates of inflation and taxes (suppose the government introduces tax on debt), then it is worth investing in; otherwise it is not. For instance, if the tax rate is 10 per cent with inflation at 12 percent, then the bond yield should well remain above 22 percent.
- What is needed to compensate for danger or risk of default? That is, what factor must be assigned on top of our tax and inflation rates of 22 percent for the investment to merit consideration? That is, the default rate is roughly an additional ten percent of the inflation rate, that is, about +2 per cent. The bond being assessed here should therefore not yield less than 24 percent to merit consideration as a viable investment vehicle. If there is absence of tax, the yield to maturity must not be below 14%.
- What real return do you desire on your money for taking the trouble and risk of investing in the first place? After all, if you can get 12 to 14 percent on your time deposit in a commercial bank, why go through all the trouble of investing in bonds in the first place? Therefore, a bond should yield at least about 26 percent to maturity (the original 12 percent inflation rate plus the 2 percent default rate plus the 12 percent Bank time or deposit rate, not including taxes) to be considered a conservative, long- term lucrative investment. Yield to maturity (YTM) is the rate of return accruable to a bondholder; the cost of capital an investor would expect from his loan.
Best Advice for debtors and investors
The debtor is the person or corporate body or government issuing the bond. The investor (also called the bond holder or creditor) is the individual or institution subscribing to or buying or holding the bond; when he buys, he gives up his money in exchange.
Overall, the best advice for debtors is to issue bonds and other long term debt securities only when they find themselves in a period of prolonged distress. On the other hand, the investor who intends to buy a bond must ensure that he gets reasonable returns (YTM) on his investment, taking into consideration the inflation, default and prevailing deposit rates. The issuer of the bond should then strive to recover, and thereafter stay out of debt until the particular corporate debt is fully repaid; or if she is a government, stay out of debt until the country returns to a sound and stable economy. A mono-cultural developing economy must ensure it does not accumulate debts that are more than 10% of her GDP, given the cyclical gyrations of the international commodity markets, which would likely not guarantee stable foreign exchange reserves that could finance future development and at the same repay outstanding long-term debts. [Currently, Nigeria’s outstanding loans amount to about a quarter (25%) of its economic output and the country spends more than half of its revenue servicing debts. The International Monetary Fund has warned that without major revenue reforms (economic diversification), the debts could rise to almost 36% of GDP by 2024, with interest payments taking as much as 75% of government revenue].
The practical reality on ground today is that the level of awareness for bonds is very low in Nigeria, relative to that for stock (shares). This is complicated by the untrustworthy state of the national economy which restrains active participation of investors in both industrial/ corporate bonds or government bond issues even in situations when the bond coupon rate is far higher than the stock dividends, or money market interest/ deposit rates.
The writer could be reached for further conversation via chukwudiodili902@yahoo.com
