Download the nigerian bond market

THE NIGERIAN BOND MARKET
SECURITIES AND EXCHANGE COMMISSION,
NIGERIA
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The Nigerian Bond market
BONDS
What is a bond?
A bond is an interest-bearing debt security/instrument issued by corporate bodies,
governments and government agencies for the financing of infrastructure or for
expansion purposes. It involves a promise to make periodic investment payment to the
subscribers and also the repayment or the initial amount borrowed at maturity of the
bond. Repayment of the principal is usually in a steady and regular stream of payments.
This is done by means of a sinking fund. Each year, certain sum of money is kept in
the sinking fund, which is used to repay the debt at maturity. (A financial system usually
has units with surplus funds at its disposal and units with insufficient funds. Bond
investment belongs to the unit with surplus funds and would include insurance
companies, investment and fund managers, pension fund administers, etc.)
General Features of a Bond
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It is an IOU for a fixed amount.
It is a debt instrument with a par/face value printed on the face of the selling
document.
It usually has a redemption / maturity date.
It is a negotiable instrument.This means that it can be transferred to a third party
either through sale at the stock exchange or through a nominal transfer to a blood
relation.
It has a market price which may be different from its face value. The initial
market price is the price at which the bond was bond was sold in the primary
market, while the subsequent market price at which it is sold on a stock exchange
(which is dependent on the forces of demand and supply).
The interest payment is usually twice a year.
Types of Bonds
Bonds can be categorized according to their issuer. Thus there are Federal Government
(sovereign) Bonds, Government Agency Bonds, State and Local Governments Bonds,
and Corporate Bonds.
Federal Government (sovereign) Bonds are issued by a national government .They are
regarded as the safest bond investment for the simple reason that they are backed by the
full faith and credit of the federal government, but they may not yield the highest returns
in comparison with other types of bonds. They are usually used as benchmark by other
bond issuers in determining the interest rates and maturity of their bonds.
Government Agency Bonds are issued by government agencies or privately owned
corporations that are sponsored by government agencies. They are also considered safe
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bond investments have higher yields than sovereign bonds. Examples of such bonds are
mortgage backed bonds.
State and Local Government Bonds are issued by state and local governments. They are
also called municipal bonds. They can be general obligation or revenue bonds. General
obligation bonds are issued to finance the various projects of the government, and backed
by the income of the specific project for which the bond was issued.
Corporate Bonds: Apart from issuing of shares, companies also issue debt instrument to
raise funds to finance their various projects. One reasons for adopting such option of
financing is to avoid dilution of their shareholdings. Corporate bonds otherwise called
debentures (if not secured)are the risks are the riskiest of fixed income securities
because of the possibility that the issuing company can delay or default in payment of the
interests and principal due to unforeseen economic /financial downturn .For this risk they
offer the highest returns in comparison to other fixed income securities.
The issuing of bonds may cut across national borders may cut across national borders.
For example Global (international) Bonds are denominated in a single currency in
various countries.
Features of bonds
i. Redeemable or Irredeemable Bond
With a redeemable feature, the principal of the debt instrument is redeemed or paid back
to the creditors on a specified date or at specified intervals.
With an irredeemable feature, there is no such arrangement to pay back the principal to
the creditors. The debts have no fixed date of maturity and could be held for ever but
interest will continue to be paid on the debt, and if the holders so wish, they can sell off
their holdings other interested investors.
ii. Fixed or Floating Interest Rate Bond
A bond with a fixed interest rate means that the stated percentage of the nominal /face
value of the bond will be paid as interest to the bondholders yearly prior to the maturity
of the bond.
Whereas interest rate payment on a floating rate bond will vary from year to year
depending on a benchmark interest rate could be the Minimum Rediscount Rate (MRR)
of the Central Bank of Nigeria (CBN).
iii. Convertible or Non convertible Bond
The convertible feature gives the investors the right to convert the interest- bearing
securities to other securities (particularly equities) usually within a specified period. A
Non-convertible debt security cannot be converted into any other form of securities.
iv. Secured or Unsecured
A secured debenture is guaranteed against certain assets of the company; and in case the
company winds up during the life of the secured debt, the holder of the security has a
preferential claim over the specified assets of the company.
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An unsecured bond means there is no pledge against the assets of the company. In the
case of liquidation, secured debt securities holders are considered first, followed by
unsecured debt securities holders.
Status of Bondholders
The subscribers of the bond issue are like creditors to the issuer. They do not have voting
powers. The payment of the interest is therefore regarded as cost to the issuer and is paid
from the before-tax income of the issuing authority.
Reasons for Issuing Bond
Some of the reasons why corporate bodies, government and agencies issue bond are
given below.
ƒ It is used to finance capital projects with long gestation period such as upgrading
of information Technology (IT), construction of roads, provision of rural
electrification, etc.
ƒ It is used to re-establish a more rational strategy for financing the local currency
portion of government budget deficits and other long – term programmes.
ƒ It is used to reduce local and external debt stocks .By issuing bonds the proportion
of treasury bills in government debt profile is reduced.
Advantages of Issuing/Investing in Bonds.
There are many advantages of issuing or investing in bonds to the government, corporate
bodies and individuals alike. These are briefly discussed below.
To the government
ƒ The cost of bond floatation is cheaper than money market interest rate.
ƒ It offers them breathing space, as they will not be obligated to pay interest in the
bond until the specified period of time, usually twice a year. It is more tolerable
than banks that charge and demand interest almost immediately.
ƒ It is consistent with the long-term nature of government investments in
infrastructure are not self liquidating, and banks bys their nature lend long borrow
short. The use of money market funds will create a dislocation in the in the
maturity transformation practice in money market. Also, Government in the past
had resulted to other means to finance budget deficit e. g. printing of more
currency, with its inflationary and economic distortion effects.
ƒ Thus it has the potential of reducing inflationary trend in the economy.
To investors:
ƒ It is a safe investment window as it guarantees the repayment of capital with
interest.
ƒ It offers opportunity of reaping good returns as against bank’s deposit rates.
ƒ It offers investors the opportunity to diversity their portfolio. By adding bonds to
their investment portfolio, investors lengthen the tenure and lower the risk of their
portfolios.
ƒ It encourages saving among the citizenry.
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Risks & Rewards Associated With Investing in Bonds
The various risks that can be associated with investing in bonds in a general sense are:
Interest rate risk:
This is an investment risk related to fluctuation in interest rates. For instance when
interest rates rise, the prices of existing bonds rise.
Default risk:
This is the risk that the issuer will default in paying the stated interest and principal
amount as when due.
Maturity risk:
This is an investing risk associated with the tenure or maturity period of the bond. The
longer the tenure, the higher the risk assumed; the shorter the risk the lesser the risk
assumed.
Inflation risk:
This is a risk that has to do with the reduction I the real value of returns on investment in
bonds due to an increase in the rate of inflation .Since the interest payment is usually a
fixed amount, a rise in the rate of inflation will reduce the value of the interest payment.
Liquidity risk:
This has to do with the ease of converting securities into cash. If you intend to hold the
bond till its maturity date, such a risk may not rise, but if you intend to dispose of the
bond till its maturity date, you may then consider the activeness of the secondary market
for trading in bonds. The more difficult it is to convert to cash the more the liquidity risk.
It should however be noted that the higher the risks the higher the prospect of return on
such bonds.
Risk– based Investment strategies
In order to overcome some of the risks mentioned above, investors are advised to adopt
an investment strategy in which their investment portfolio comprise of bond with varying
maturity periods over their investment time frame. For example an investor that has an
investment in bonds (among other securities) that mature in say
1,2,3,4,5,6,…….,10years. When interest rates rise, the market price of existing bonds fall,
one can therefore use the proceeds of a maturing bond to buy such bond at a discount. On
the hand, when interest rates fall, the market price of existing bonds rise, thus increasing
the market price value of such portfolio. The investor can then sell part of the bond
portfolio at a premium.
Another strategy than can be adopted is to invest in portfolio comprising bonds that cut
across various industries .This helps to further diversify your investment portfolio and
reduce the level of industry related risk on your portfolio.
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Other Factor to Consider When in Buying Bonds
One major consideration is the appropriateness of bond investment of your financial
circumstance. Will a fixed stream of income investment be appropriate to your financial
needs in the light of the investment alternatives? If not you may consider other means
that reap quick returns.
In choosing which bond to invest in, you will need to consider the following: the tenure
(maturity date of the bond), the interest rate payable in relation to the price of purchase, if
any special feature is feature is attached to the bond (such as call or conversion clause),
and the credit rating of the issuer (i.e. the ability of the issuer to pay interest and principal
obligations on the bond vis-à-vis its of income).
A bond with a longer tenure means it will require more time before you receive the face
value of the bond. To compensate for this longer period, you will expect the interest rate
to be higher than short-term bonds. Identifying the coupon rate may not be enough as the
nominal value of the return should be compared with the bond’s market price to enable
you asses its current yield .A bond with a call feature means the issuer can redeem it
before the maturity date if the current market interest rate is much lower than the interest
rate of the bond .If this is the case, the bondholders are often compensated for this early
redemption. The compensation or premium may be interest of a year or two, in addition
to the par value of the bond. The bond may however not be redeemed if the current
market interest is higher than bond’s interest rate. Therefore for a bond with such call
feature, you need to anticipate the general trend of market interest rate to ascertain
whether the bond will be called or not. In addition, the credit rating of a bond issuer may
affect the success or otherwise of the bond issue. The higher the rating, the more likely
the bond, therefore the safer your investment.
Regulatory Requirements for Issuing Bonds
For state and local governments to issue bonds, they must ensure that they meet up or
comply with SEC’s requirements. Some of the requirements are stated below.
ƒ The loan must be project tied and authorized by the approving authority of the
issuer.
ƒ The total amount of loan outstanding of the issuer including the proposal loan
shall not exceed 50 percent of the revenue of the issuer during the life of the
bond.
This is to ensure that the issuer is able to meet its obligations while not being
placed in a difficult financial position.
ƒ The issuer must lodge a copy of an Irrevocable Standing Payment Orders (ISPO),
giving the Accountant-General of the Federation, the authority to deduct from its
statutory allocation in the event of default in meeting its payment obligations
under the loan agreement as contained in the Trust Deed.
ƒ The issuer must establish a sinking fund for the loan with periodic contributions
made for the purpose of redeeming the loan. Any amount deducted from the
statutory allocation by the Accountant-General shall also be paid into the sinking
fund account.
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The loan obligations shall be charged on and payable out of the general revenue
and assets of the body concerned and or the general revenue and assets of the
body concerned and of the assets or projects which is the beneficiary of the loan.
Details of the loan must be in a gazette or published in any other official
document.
The lifespan of the bond shall not exceed 25years. This is intended to prevent the
issuing of bonding with unduly long maturity dates.
A bond holder shall issue with a Bond Certificate evidencing the amount of his
holding.
Other information to be provided by the issuer include, name of the beneficiary
(i.e. the proposed project), the amount to be raised, the mode of raising the loan,
the interest rate and payment dates, the redemption date, the time at which the
appropriation of the general reserves and assets of the entity or project of the
entity shall be made as a contribution to the debt’s repayment.
Bond Issue: Critical Success Factors
For successful issuance of the bonds, the following factors should be put into considered
by the issuers.
ƒ Tenure of the bond: it has been observed that investors usually have a short-term
investment preference. When issuing a bond, the issuer must ensure that the
tenure of the bond is not falls within the life span of the issuing authority or
administration, the likelihood of honouring obligation of bond holders is higher.
The harrowing risk of default is one reason given for bonds falling due after the
tenure of the administration that issued them.
ƒ Federal Government bonds should be structured in Naira (N) and Dollar ($) to
enable both Nigerians and foreigners invest in them.
ƒ If a floating rate bond is considered, it should be allowed to float above the bench
mark rate (e.g. MMR) by a reasonable figure. Investors’ returns may however
drop if interest rates are falling.
ƒ There is need to underwrite the bond to safeguard against under-subscription.
ƒ There is need for the provision of some forms inducement to institutional
investors. This is based on the premise that institutional investors have a strategic
role to play when it comes to the success or otherwise of a bond issue. They are
well placed to buy up a large portion of the bond on offer.
ƒ There is need for proper timing of the issue to avoid a glut in the market.
ƒ Inactive bond market may affect the psyche of investors, as most people may
have lost touch with the benefits accruable from investing in bonds. The Federal
Government should ensure therefore that they make bond market as active as
possible.
The Nigeria Bond Market to Date
From 1999 to date there has been some encouraging level of bond floatation in the
Nigerian Capital Market. For instance, the Federal Government come to the market in
2003 to raise N150 billion. Many state governments have also access the market for fund
to finance various development projects. Currently the Federal Government through the
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Debt Management Office (DMO) is currently in the market with series of bond in
trenches aimed at financing the Nation’s budget deficit.
Some Terminologies in the Bond Market Par or Face Value: This is the stated principal amount of a bond. It is usually printed on
the face of the selling document.
Callable Bond: A bond is said to be callable when it can be redeemed (i.e. the paying
back of the principal amount) by the issuer before its maturity date. Usually a premium is
paid to the owner when the bond is called.
Discount Bond: A Bond is discounted when it is valued or sold at less than its face / par
value.
Premium Bond: When a bond is valued or sold at an amount more than its face value, it
is said to be sold at a premium.
Coupon rate: This is the interest rate payable on the bond. Payment is usually twice a
year. This means that the value of the annual rate is paid in two installments.
Zero –coupon bonds: These are bonds that do not have a specific coupon/interest rate
but are sold at a substantial discount of their face value. At maturity the investor receives
the face value of the bond. Thus the yield will be the difference between the purchase
price and the redemption value.
Accrued interest: This is the total interest due since the last payment was made.
Sinking Fund: A special fund set aside to retire a bond. Each year certain amount is paid
into the fund according to a set schedule.
Yield: This is an evaluation of the income generated by a bond. It is calculated by
dividing the amount of interest paid on a bond by its price.
Yield to maturity: This is the entire rate of return on a bond if held to maturity. It
includes both the coupon rate and the net gain or loss in the price of the bond (i.e. the
difference between the current price and the face value) per year as it moves to its
maturity date.
Current yield: This is the actual return a bondholder receives from his bond investment.
It is calculated by dividing the nominal value of the interest rate by the current market
price of the bond. Current yield is a more accurate measure of return on the bond because
it takes into cognizance the market price of the bond.
Term to maturity: This refers to the number of time (days) to the maturity date of a
bond.
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Bond indenture: This is the bond contract document that stipulates the duties of the
bond issuer and the rights of the bondholders and also discloses in details relevant
information that will enable the investors make wise investment decision.
Contact:
Research and Market Development Department
SECURITIES AND EXCHANGE COMMISSION
Head Office
Tower 421Constitution Avenue, Central Business Area, Abuja.
Tel: 09-2346272-5
Website: WWW.secngr.org
E-mail: [email protected]
Zonal Offices
Lagos:
UBA Building (3rd Floor) 57 Marina, PMB 1126638, Marina, Lagos.
Tel: 01-2661552, 2663210
Kano:
African Alliance House (4th Floor). Sani Abacha Way/Airport Road, Kano.
Tel: 064-314105, 312606
Port-Harcourt
First Banking Building, 22/24 Aba –Port Harcourt Road, Port Harcourt.
Tel: 089-575939, 575940
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