Q. I have heard the term “stocks and bonds”. What are the differences? And what affects price movements of bonds?
- Simply, Stocks are shares of ownership issued by a corporation to raise equity; investors in shares literally own part of the company. Bonds are issued by corporations, municipalities or states and the Federal Government as debt, similar to bank loans where the company owes investors periodical interest payments over the life of the bond plus principal reimbursement at the maturity of the bond. Shares have an infinite life; bonds have a finite life. Share prices are often determined by supply and demand dynamics, with a greater demand (e.g. due to expected growth of net income) moving the share prices up; bond prices are often determined by interest rate movements, (e.g., a lower expected inflation rate will move existing bond prices up) among other factors; price and rates have inverse relationships, i.e., as interest rates move up, prices on existing bonds move down. The price of an existing bond is a function of prevailing interest rates. As rates go up, the price of the bond goes down, because that particular bond becomes less attractive (i.e., pays less interest) when compared to current offerings. As rates go down, the price of the existing bond goes up, because that particular bond becomes more attractive (i.e., pays more interest) when compared to current offerings. The price also fluctuates in response to the risk perceived for the debt of the particular organization.
Q. Can you please explain some basic terms related to Bonds for greater understanding?
- Accrued interest- Interest deemed to be earned on a security but not yet paid to the investor, i.e., interest earned on a particular date between the last interest payment date and the next interest payment date.
- Bond – Tradable security issued by borrower (bond issuer) representing formal agreement to repay the lender (the bond holder) the full amount plus interest over the lifetime of the bond; in Nigeria, the bond may be publicly placed (i.e., listed on an exchange for trading) for trading by the public, or may be a private placement, sold to Qualified Investors, i.e., institutional investors (like Pension Funds, Banks, etc.) and high net worth individuals.
- Callable Bonds- Bonds that are redeemable by the issuer prior to the maturity date, at a specified price at or above par. This feature provides some protection for the issuer, e.g., as interest rates drop, the issuer may call…pay off…the bonds and re-issue another bond at a lower coupon rate. Conversely, the investor would be paid the principal amount earlier than expected and may have a choice to reinvest the money into a lower coupon.
- Coupon Rate – Annual interest rate paid as a percentage of the bond’s par value, determines amount of interest paid to borrower at regular intervals; interest may be paid on a quarterly, semi-annual, or annual basis; additionally, the coupon rate may be “zero”, whereas the bond is sold at a discount to par and matures at par, paying no interest (thus would qualify for Shariah Finance).
- Credit Enhancement – A method by which an issuer attempts to improve its creditworthiness. Through credit enhancement, the lender (investor) is provided with reassurance that the borrower (the issuer) will honor the obligations of paying interest and principal on a timely basis, through e.g., additional collateral, insurance, or a third party guarantee. Credit enhancement reduces credit/default risk of a debt, thereby increasing the overall credit rating and lowering interest rates.
- Credit Rating Agency (CRA) – A company that analyzes the credit worthiness of a company or security, and indicates that credit quality by means of a grade, or credit rating. An operating CRA must be licensed by the SEC Nigeria.
- Default- A failure by an issuer to pay principal or interest when due.
- Discount- The condition under which the par value of a bond exceeds its market price. For example, aN100,000 par amount bond, which is valued at
N 98,000 would be said to be trading at a 2% discount, i.e., N 100,000 –
N 98,000)/ N 100,000 = 2% discount.
- FGN Bond– Federal Government of Nigeria bond.
- Issuer – Organization raising capital through bond issue and which is borrowing money from bond investors.
- Principal (or ‘nominal’ or ‘par’ value) – Amount borrowed on which interest is paid by the issuer; principal is paid at maturity or redemption of the bond.
- Prospectus – Like all publicly-traded securities in Nigeria, Corporate and State bonds have a prospectus available for investors. The prospectus is either written in hard copy or is retained in electronic form and invites the public to an offering for subscription or purchase, any shares, bonds, or other approved and recognized securities of a company and other issues or scheme. The prospectus tells you how the investment works. It should tell you everything you need to know about the company issuing the bonds, what it will do with your money, and the terms of the investment. A prospectus must be registered with the SEC before it can be used to raise money from investors. However, this does not mean that the SEC has checked or endorsed the investment in any way.
- Put Provision – A bond may have a put provision, which gives an investor the option to sell the bond to an issuer at a specified price and date prior to maturity. Typically, investors exercise a put provision when they need cash or when interest rates have risen so that they may then reinvest the proceeds at a higher interest/coupon rate. Since a put provision offers protection to the investor, bonds with such features usually offer a lower annual return than comparable bonds without a put provision to compensate the issuer.
- Redemption (or ‘maturity’) date – Date on which issuer agrees to pay back principal.
- Secured bonds – Bonds backed by collateral. If the bond issuer defaults, the secured debt holder has first claim to the posted collateral. ‘Asset-backed’ and ‘mortgage-backed’ bonds are examples of secured bonds.
- Trustee – An institution, usually a bank, designated by the issuer as the custodian of funds and official representative of bondholders. Trustees are appointed to ensure compliance with the trust indenture and represent bondholders to enforce their contracts with the issuers.
- Yield Curve – the relation between the interest rate (yield or cost of borrowing) and the time to maturity of the debt, formed by the various rates and maturities of (benchmark issues) Government Bonds. This Yield Curve forms the basis for other debt instruments to be priced. A typical yield curve looks like this below::
Q. What institutions issue bonds in Nigeria?
- Corporate Bonds, issued by corporations. Corporate bonds are issued by companies of all sizes. Bondholders are not owners of the corporation. But if the company gets into financial trouble and needs to dissolve, bondholders must be paid off in full before shareholders get anything. If the corporation defaults on any bond payment, any bondholder can go into bankruptcy court and request the corporation be placed in bankruptcy. Corporate bonds issued by Public companies are regulated by the SEC Nigeria; Bonds issued by private companies are not regulated by the SEC Nigeria.
- Sub-National (or State) Bonds, issued by States (also called municipal bonds in some parts of the world). Some state bonds are backed by the tax authority of the state, while others rely on earning income to pay the bond interest and principal. Most State Bonds, in fact all except for Lagos State, issued in Nigeria are also issued with an Irrevocable Standing Payment Order (ISPO), a credit enhancement tool as it is backed by the full faith and credit of the Federal Government of Nigeria. In other words, it improves the credit rating of the instrument and enhances the attractiveness of the instrument to prospective investors.
- FGN (Federal Government of Nigeria) Bonds, issued by the Federal Government of Nigeria.
Q. What are common lengths of maturities of bonds?
- Bonds around the world commonly have maturities up to 30 years. In Nigeria, the FGN bonds have maturity ranges from a few months to 20 years. Corporate and State bonds in Nigeria have maturities up to 7 years, but can be longer.
Q. How can I buy bonds?
- Like stocks, bonds can be packaged into a bond collective investment scheme, or mutual fund. This is a good way for an individual investor to let an experienced mutual fund manager pick the best selection of corporate and other bonds. A bond fund can also reduce risk through diversification. Otherwise, contact your brokerage firm for more information on purchasing bonds. Keep in mind that units of bonds sold are for large quantities of bonds that represent larger amounts of money for investment. Bonds can be bought on a Securities Exchange or the over-the-counter markets in Nigeria.
Q. Why do organizations issue bonds?
- Let’s say a corporation needs to build a new office building, or needs to purchase manufacturing equipment, or needs to purchase aircraft. A company can gain funding for these projects without diluting ownership in the company through issuance of shares. Banks may lend the money to companies, but these days, the loans are for very short terms and for very high interest rates. Otherwise, generally speaking, a less expensive way is to issue (sell) bonds. The organization will agree to pay some interest rate on the bonds and further agree to redeem the bonds (i.e., buy them back) at some time in the future (the “redemption” or “maturity” date”).
- Or perhaps a state government, like Ebonyi State, needs to construct a new school, repair or construct roads, or renovate the sewers.
- The Federal Government of Nigeria issues bonds to fund the budget deficit. FGN bonds and are considered to be safer than corporate bonds, so they pay less interest than similar term corporate bonds. Treasury bonds are not taxable; a Tax Waiver has been signed by the President and awaiting to be published in the Gazette to put ALL bonds on equal tax treatment as FGNs.
Q. What (possible) benefits are there for corporations issuing bonds?
- Less costly than a bank loan, including fees, debt service, and expenses. Keep in mind that expenses that a company incurs in coming to the market to issue a bond are one-time only and should be amortized over the number of years of the bond.
- Longer term financing available, greater than tenor of a bank loan (generally a year or two) or through the issuance of commercial paper (less than nine months)
- The Tax Waiver will provide tax benefits to the issuer and to the investor.
- A company will not dilute existing share ownership with a bond issuance.
- Can issuer through a shelf registration offering (a medium term note program) issuing a first tranche now and later (within two years) issuing other tranches, e.g., when interest rates fall…at lower coupon rates.
- Greater exposure/enhanced public relations for a company; can be traded or quoted on an exchange.
Q. What (possible) benefits are there in investing in Corporate or State bonds?
- Income stream: A predictable income stream is paid to investors on a regular basis (i.e., interest) and the principal is returned at maturity. Corporate and State bonds generally pay higher returns than FGN bonds and bank deposits, but the risks may be higher too.
- Diversity: Corporate and State Bonds help achieve balance in an investment portfolio weighted with equities. Bonds provide an opportunity to choose from a variety of sectors, structures, and credit-quality characteristics to meet investment objectives; some institutions have fixed liabilities in the future, e.g., pension funds and insurance companies, and therefore can match liability timeframes with asset maturities.
- Safety: Corporate and State bonds are evaluated and assigned a rating based on credit history and ability to repay obligations. The higher the rating, the safer the investment as measured by the likelihood of repayment of principal and interest. If a company goes bankrupt, debt holders are ahead of shareholders in the line to get paid. In a worst-case scenario such as bankruptcy, the creditors (debt holders) usually get at least some of their money back, while shareholders often lose their entire investment.
- Planning for life events: Zero coupon bonds are bought at a discount from par value and pay off at maturity the interest accrued plus principal. Some life events such as children’s university educations, weddings, and retirement may be (partially) financed through investments in these bonds. During retirement, bonds with coupons will provide a steady stream of income.
Q. What about the tax situation in issuing as well as in investing in corporate and State Bonds?
The President signed a Tax Waiver on Bonds back in March 2010. Unfortunately, this Tax Waiver has yet to be published in the Official Gazette of Nigeria. The Tax Waiver provided for equal benefits to issuers and investors alike in corporate and State Bonds…equal to that for Federal Government Bonds. Sub-nationals, i.e., States, and corporate entities would be able to access long term capital by issuing bonds at a relatively cheaper cost than they would have if there had been no tax exemptions. All bonds issued by sub-nationals, corporates and supra-nationals and bonds relating to different categories of Mortgages, as well as, asset-backed securities would be tax exempt. The Waiver would provide investors with more investment options while also, providing an opportunity for increased portfolio diversification.
Benefits to include:
(1) Issuers would be provided a reduction in stamp duties for the re-issuance of previously executed debentures to 20 per cent of the stamp duty payable on a new bond of the same value.
(2) A level playing field would be created for all bonds regardless of the issuer, thus reducing the dominance of FGNs in the market place.
(3) Multilaterals such as the World Bank, International Finance Corporation and the African Development bank among several others can issue bonds which will be exempt from Nigerian taxes. The effect of this would serve to encourage multinationals to participate in the development of the Nigerian domestic bond market, while the perception of Nigeria in the international financial markets will be improved.
(4) The tax exemptions will increase the range of securities/options available to investors, encourage the development of new products and attract foreign investors to the domestic capital market.
(5) Issuers would have an opportunity to raise more stable capital from a large investor base at a relatively lower cost.
(6) It would help improve the lull in the capital market and also help even out the imbalance between interests in equity versus debt securities.
(7) It is hoped that the subsequent investment activities that should necessarily follow the waivers would ultimately translate into an increase in gross domestic product (GDP).
The tax exemptions granted would be for an initial period of ten years and are to include (in addition to the exemptions for bonds previously granted under the Companies Income Tax Act) taxes under: the Personal Income Tax Act, Value Added Tax and the Capital Gains Tax Act.
The SEC among other institutions has been lobbying for the Tax Waiver to be published in the Gazette.
Q. What are some possible risks in investing in Bonds?
- Credit Risk – Credit risk is the risk associated with the issuer’s ability to make timely principal and interest payments to its creditors. The FGN bond is considered to have the least credit risk of all bond issuers in Nigeria. Corporate and State bonds are rated by the credit ratings agencies on an “alphabetical” scale.
- Interest Rate Risk – Risk that the value of the bond may be adversely affected by the higher direction of interest rates, i.e., the bond prices decline.
- Market Risk and Liquidity Risk – Bonds may be sold if there is a willing buyer. In some cases, the bond investor may not be able to find a buyer for bonds to be sold. Additionally, bonds are not ‘risk free’ as the market prices of bonds may decline, e.g., reacting inversely to factors such as higher interest rates, which may produce lower prices than at which the investor purchased.
- Call Risk – An issuer may redeem a bond, i.e., call a bond, earlier than its original maturity date if the bond is issued with a call feature. This risk is more relevant during periods of declining interest rates, where the investor receives the principal from the higher-coupon bond and may have to invest in a lower-coupon bond.
Q. How is the risk rating determined in Corporate and State issued bonds?
- A credit rating agency (CRA) analyzes each bond issued in Nigeria as to its capabilities of paying off interest and principal on a timely fashion. If a company or State does not pay interest and principal on a timely basis, that bond is deemed to be in default. Although five CRAs are approved by the Securities and Exchange Commission of Nigeria (SEC), only two to three of them are active. The SEC also recognizes international CRAs for their ratings, such as those from Standard and Poors, Moody’s, and Fitch. The SEC requires that all publicly traded bonds be issued with at least an “investment-grade” rating, i.e., “BBB” rating or above. The PenCom requires that all bonds purchased by pension funds have at least two investment grade ratings. Ratings are generally provided from the highest of “AAA”, then “AA”, then “A”, then “BBB”, etc., down to the lowest (i.e., in default) of “D”. Like grades in school, these ratings have gradations of “-” and “+”. Regardless of the CRA rating(s), an individual investor should always perform his/her own due diligence or would rely on a third party to perform such due diligence as to the creditworthiness of a particular bond, i.e., whether or not the company or State will be able to pay interest and principal on a timely basis. It is highly recommended that professional investors such as banks, pension funds, collective investment schemes, and insurance companies, have the capability to perform…and does perform…its own risk assessment due diligence.
Q. Issuers and issuing houses have asked: What factors could influence corporate and state bond coupon pricing on offerings in lowering the coupon rate in Nigeria, thus bringing the cost of the interest payments down for issuers?
- The ISPO of State Bonds may lower the coupon.
- Credit Enhancements lower the coupon, but make the bond more costly to issue.
- Futures or other hedging devices might bring the coupon down, giving investors the possibility to hedge their bond investments…however, as of yet, there are no hedging investments available in the Nigerian market.
- Greater International Institutional Investor demand may bring the coupon lower as supply and demand factors weigh in.
- A vibrant secondary market or trading/information platform for trading bonds may bring the coupon cost down as ‘liquidity’ with the added transparency is a benefit to those investors looking to cash out of the investment before the maturity date. It is a market principle that the size of the corporate or state issuance effects liquidity, i.e., the greater the size, the more likely the bond will trade.
- Put features on bonds may protect the investor, and thus, should bring the coupon costs down for issuers, the ‘give-and-take’ effect.
- Market Makers for non-government bond issues that would require (at least 2) dealers acting to make a market on each series of bonds issued. This is related to the liquidity concept mentioned above.
- More and greater capacity at Nigerian Credit Rating Agencies could make the quantity increase and quality of ratings methodologies improve. A higher credit rating should lower coupon costs on issuance.
- A lower inflation rate should provide a lower or flatter Government Bond Yield Curve, which in turn should cut the coupons on corporate and State bonds.
- If perceived Corruption Risk in Nigeria was lowered, coupons should follow in being reduced.
- More knowledgeable and professional Nigerian institutional investors should increase demand for the bond issuances, thus lowering the cost of coupons for the issuers (i.e., the ‘demand’ and ‘supply’ effects).
- Bonds denominated in international currencies, e.g., US Dollars or Euros, may increase demand from international and even from domestic investors, again showing the effects of a greater demand helping to lower the costs for issuers.