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Bonds are fixed income instrument that can be bought or sold in an organized financial market. It is a contractual agreement between the issuer and the bondholders that represent an acknowledgement of debt. Bond is one of the sources of long-term financing needs of an entity. It is a form of I owe you (IOU) or loan between the borrower (debtor) and lender (investor). Generally, public, and private organizations use bond as a means of financing their capital expenditures, including construction of roads, dams, bridges, buildings, refineries, etc. Bond can also be used by government to finance budget deficit.
For example, when an entity needs money to finance a project, and the required financial resources is not readily available, the borrower may be compelled to approach investors to source for the needed funds by raising bonds. Bond can be redeemable or irredeemable, callable, or non-callable.
The redeemable bond is also known as callable bond. It is a type of bond in which the issuer will pay both the annual fixed interest and the principal on or before the maturity date. It allows the issuer to settle the debt prior to maturity date. The callable bond offers some degree of flexibility. Because when the market interest rate falls below the bond interest rate, the issuer may want to call back the bond. This will then allow the issuer to raise another bond at a lower interest rate, thereby enabling it to save money and preclude the issuer from facing any financial challenges that may arise in the future in case the economic condition or its financial situation deteriorate.
However, callable bond is generally issued at a price marginally above the par value to compensate the investors for taken higher risk. To this end, the callable bond is expected to pay a higher rate of return (interest rate) to the investors, relative to non-callable bond. This higher interest rate will invariably increase the overall costs of the potential investment or project.
This is also known as perpetual bond. It is the one in which the issuer will only make the annual interest payments for the foreseeable future, but the principal will not be repaid. There is relatively small market that exist for irredeemable bond due to its non-attractiveness. Because investors will not want to invest their limited scarce financial resources in a bond in which the principal will never be repaid. And that is why the perpetual bond is often referred to as a kind of equity, rather than being called a debt, since equity and irredeemable bond offer some level of return to infinity, or for an indefinite period.
The price or market value of the irredeemable bond is the present value of the future expected cash flows discounted at the required rate of return.
The non-callable bond is a type of bond that is not redeemable or that cannot be recalled prior to its maturity date. If the issuer wants to call back the bond before the maturity date, the issuer must be ready to pay the underlying penalties to the investors. The issuer of con-callable bond is exposed to interest rate risk. This is because if market interest rate falls, the issuer will continue to pay the agreed higher interest rate until the redemption date. Therefore, it does not offer the issuer any form of flexibility and the ability to profit from positive market conditions during the life of the bond.
Generally, most treasury securities and municipal bond instruments are non-callable.
The main features of a bond include the:
These are entities that issue bonds, including private Individuals, Companies, National, State & Local Governments, and Supranational Organizations. The issuers sell bonds in the bond market for the purpose of achieving their financing needs. The bond markets are categorized into different sectors by the market participants by their issuers including:
The maturity date of a bond is the specified future date in which the issuer is obligated to redeem the bond after paying the outstanding principal amount to the bondholder. The maturity date is also known as the redemption date, or termination date. The maturity date of a bond can be classified into:
The maturing date of a bond can range from 1 year to over 30 years. The maturity date is usually printed on the bond certificate. A bond certificate is a legal document that shows the details of the bond instrument, including the name of the issuer, the face value, the coupon rate, and the maturity date. It is a receipt that show the evidence of ownership to the bondholder, including the terms of the bond.
The par value of a bond represents the nominal value that the issuer agrees to repay the lender (bondholders) on the redemption date. The par value is also known as face value, nominal value, maturity value or redemption value. The par value is expressly stated on the face of the bond certificate. However, by way of standard convention, the par value of a bond is mostly quoted at N1,000 or $1,000 per unit.
Generally, and in practice, bond prices are quoted as a percentage of its face value. Say for instance, a bond with nominal value of N1,000 is quoted at 97%. This means that the bond price is N970 calculated as 97% of N1,000. Again, let us assume that you bought FGN Savings bond at N1,000 per unit at an annual interest rate of 15 per cent. This means that you will earn an annual return on your investment of N150 per unit of the bond (i.e., N1,000 x 15%).
Bonds can be priced at 100%, less than 100%, or above 100% of the face value, depending on whether the bond is quoted at par, discount, or premium. When the bond is priced at the nominal value of N1,000 or 100%, then the bond is trading at par. If the bond price is quoted below the par value, the bond is said to be trading at a discount. But if the bond price is quoted above the par value of 100%, then the bond is trading at a premium.
The coupon payment represents the annual amount of interest payable to the bondholders by the issuer. The coupon rate is the annual interest rate that the issuer agrees to pay the bondholders until the maturity date. A bond’s coupon payment can be estimated by multiplying the coupon rate with the nominal value of the bond. For instance, if a bond has a coupon rate of 4% on the par value of N1,000, then the annual interest payment will be N40 (i.e., 4% x N1,000). The coupon rate of a bond can be calculated as the ratio of annual coupon payments to the par value of the bond, multiply by 100% i.e., coupon payments divided by the nominal value.
Coupon payment may be paid quarterly, semi-annual, or on an annual basis.
The price of a bond is the present value of the expected future cash flows (interest and principal repayment) discounted at the required rate of return (yield), or cost of the bond. It should be noted that the price of a bond is sensitive to a change in interest rate. This means that:
This is the rate of return expected by the bondholders from their investments. It is the rate of return received from investing in the bond instrument. There are basically two types of bond yield, including current yield and yield to maturity. Normally, bond of the same risk class is expected to have the same rate of return.
This is the currency at which a bond is issued. Bonds can be issued in any currency e.g., Nigerian Naira, US Dollar, Euro etc. But majority of the bonds are issued in either US dollars or euros. The currency of issue may affect bond’s attractiveness. If the currency is not liquid, freely traded, or if the currency is susceptible to gyrations against major currencies in the market, the currency may not appeal to many investors. In this case, it is usually advisable for issuers in the countries with volatile currency to issue bonds in major currencies such as US dollar, instead of their domestic currency. However, a bond that is designed principally to attract local investors can be issued in the local currency.
Bonds are usually rated by credit rating agencies (CRA) and the higher the credit rating, the lower will be the coupon rate required to pay by the issuer and vice versa. The credit rating enhances the creditworthiness of a bond. It represents a financial indicator to potential lender. The global and well-known credit rating agencies include:
The highest rating for an entity’s bond is AAA or Aaa, and such bond is regarded as top-quality and have the lowest degree of risk. This class of rating is not common and as such, not awarded very often. An entity’s credit rating can improve or worsen based on its financial conditions.
Basically, there are Investment grade and non-investment grade bonds. The investment grade bonds are bonds that are usually considered by the rating agency to be more than likely to meet payment obligations. On the flip side, the non-investment grade bonds are generally rated below the investment grade, and they are of low quality. They are often considered as high yield rated or junk bonds.
In Nigeria, an intending or operating credit rating agency must be duly licensed by the Nigeria Securities and Exchange Commission (SEC).
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