Financial Planning (9) Bonds

So in lesson 8, we rounded up by discussing education plans. This week we start a new series on investment, we will talk about investing in Bonds, Equity, Real Estate and Alternative Investments. We start with Bonds.
However before you invest, it’s very important you have protected your income by buying Life Insurance and setting up an Emergency Fund. 
Thus if you have dependents that rely on your income, buy Life Insurance first. After that protection, build your emergency fund to cover your Non-Discretionary expenses for 3-6 months (We discussed Emergency Fund in Lesson 3). Only after you have done this, should you start an investment plan.
To investment, you must write out your plan, 
1. Why are you investing? What’s the goal? What will you do with the investment returns? Save it? Reinvest it?
2. What is your expected return? If an investment achieves your investment return will you sell and exit? Hold?
3. Are you investing for short or long term? When will you need your principal back?
4. What’s your risk tolerance? Can you risk your investment capital?
5. Do you have any constraints? Are you an ethical investor?
6. How often do you want to review your portfolio?
It’s important you discuss and agree these with your financial adviser, it helps in implementing strategy. You then commence investing only after you have protected your Income, established an Emergency Fund and agreed your written investment plan with an adviser.
Ok so let’s discuss Investment, starting with Bonds. A bond is essentially an IOU given to you when you lend money to an institution. That Institution can the government or the private sector.
If the borrowing is for less than 91 days the IOU is called a Treasury bill
If the borrowing is for more than 91 days but less than 180 days, the IOU is called a Treasury certificate
If the borrowing is for more than 365 days, the IOU is called a Treasury bond
If the borrowing is done by a Local Government, the IOU issued is called a Municipal bond.
If the borrowing is done by a private company the IOU issued is called a corporate bond. A debenture is a type of corporate bond.
Bonds pay a fixed return called a coupon on the principal invested by the investors. Most bonds pay this coupon semiannually i.e. twice a year. So if a bond pays 10% coupon, the investor who invest N1,000 as principal, and get N100 a year (N50 coupon payment every six months). At the end of the duration of the bond, the principal of N1,000 is repaid.
There are also bonds which pay no coupons, they are called zero coupon bonds, and the investors buys the bond at a discount. Eg the borrower will issue a N1,000 bond for N900, thus the investor makes N100 by holding the bond to maturity.
Bonds are usually quoted with their Coupon Rate, Duration and Issuer, so a 5 year bond issued on 20 October 2015 by the Federal Government paying a coupon of 10% will be called “10.00 20-Oct 2020 FGN”……Meaning the bond will pay 10% annually (5% every 6 months), and the full principal repaid on the 20th Day of October 2020.
So what’s the benefits of investing in Bonds?
1. You get a predictable return. Bonds are classified as Fixed Return financial instruments
2. Federal Government Bond are tax exempt, if you invest in a FGN bond, you don’t pay taxes on the returns you earn
What’s the down side to investing in Bonds?
3. Bonds pay a fixed return, thus in periods of high inflation, the value of the coupon payments decrease
So how should you invest in Bonds?
A Federal Government Bond is usually the safest investment in the market. Thus the coupon earned by investing in a FGN bond is usually considered the risk free rate in the market. This means if you want to invest N100,000 for say 2 years, the first thing you do is consider what the “risk free rate” is, this risk free rate will be the coupon offered on a FGN 2 year bond.
If the FGN bond is paying 10%, this becomes your base rate, you don’t invest in any fixed income instrument that pays 10% or below, why? By Investing in the 10% 2017 FGN you get 10% Risk Free. Any investment has to offer you a higher coupon rate to make you leave you risk free investment.
What this clearly means is that you should not leave cash in saving accounts that you won’t use for a long period of time. Much better to invest that cash in a FGN instrument that currently pays higher rates and is safer.
Also the longer the duration of the bond the higher the coupon you should demand. For example a 5 year bond should pay a higher coupon than a 2 year bond all thing being equal. So if you have an 8% 13-Oct 2020 FGN bond and an 8% 13-Oct 2019 FGN bond, it is advisable to buy the 2019 Bond. (Note we are not calculating the yield, just focusing on the duration)
Ok so if you decide to invest in the FGN bond it’s important to buy the bond with a maturity that corresponds with your investment horizon, thus if your investing for your daughter education in 5 years, you buy a 5 year bond. Do not put cash you will need in 2 years into a 5 year bond, that’s called a mismatch, and although you can sell your bond for cash, you may lose money.
A bond has a yield, that yield is the coupon paid divided by the price the bond was purchased. So imagine our 10% 13-Oct 2020. Sold for N10,000. Its yield is coupon divided by price or 10%/10,000 i.e. N100. After a bond is issued, it’s the Yield to Maturity that is used as the return not the coupon. Thus a 10% 13-Oct 2020 bond, in 13-Oct 2016 does not automatically return 10%. The Yield to maturity will depend on the price you buy the bond.
In simple terms, if the interest rate rises, the price of a bind will fall and vice versa. Finally when compared to Equity, Bonds offer a stable return, and they should form a part of any portfolio especially portfolios of older investors who will desire more stable returns and less capital appreciation.
Ok we stop here…next week Equities
Again before you invest, speak with your investment adviser, banker or any person proficient in investments. Make sure you do proper due diligence. This is not a recommendation to buy or sell any security
Financial Jargon of the Week
Primary Market is the market where a Security is first issued. Eg if a bond is issued for the first time, it’s issued in the Primary market. After the bond is issued, the bond can then be bought and sold in the Secondary market.
So bonds are traded in a secondary market, and bond prices rise and fall with rise and fall in interest rates. This is done by bond trader, that topic is beyond the limits of the post.
Question of the week
what’s the difference between a coupon and a dividend?