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Understanding Financial Securities – Bonds

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Bonds are loans given to corporations or governments to be paid after a stated period of time at a given interest rate. Unlike traditional loans contracted from banks, loans acquired through bonds come from individuals and other institutions. You invest in a bond by purchasing it from the issuer. An example is a 91-day treasury bill issued by government. If you purchase a 2-year bond for GHS 2,000 at a coupon rate of 5% to be paid annually, you are loaning GHS 2,000 to the government.

You are a Creditor

When you buy a bond, you are loaning money to the organization issuing the bond. The organization then becomes the debtor. Bondholders are the first to be paid by corporations. Even in case of a bankruptcy, the company’s assets will be liquidated to pay bondholders in full. This makes bonds very safe investments.

Maturity

A bond is said to mature when you receive the initial principal you invested. The exact date on which this happens is the maturity date, and is stated at the beginning of the transaction. In our example, you receive GHS 2,000 from the government after 2 years.

Face Value

The face value of a bond is the principal you receive when the bond matures. The face value of our example is GHS 2000.

Coupon Rate

Like interest payments on loans, bonds require the issuer to offer interest payments at stated intervals till maturity. This interest rate is called a coupon rate and is calculated on the price at which the organization issues the bond. From the example above, the coupon rate is 5% per annum, so the government will pay you GHS 100 (5% of 2000) every year for two years. The amount you receive is constant over the life of the bond.

Trading Bonds

You don’t have to wait till a bond matures to cash out. Like all securities, bonds can be traded in a secondary market where you can either sell your bonds or purchase new ones to increase your investment. As bonds get traded on the market, their prices change due to factors like uncertainty in the future of the issuing company or interest rates on other investment products.

Market Value

The price at which a bond is traded in the secondary market is its market value; this moves inversely to interest rates. If existing interest rates are 7%, it means investors will receive 7% on other investments while you will receive 5% on your bond. Because the GHS 100 coupon government pays remains constant, the only way someone will buy your bond is if they can get it at a cheaper rate than the GHS 2,000 you paid to acquire it.

The opposite happens if interest rates are lower than 5%. A bond whose market value is lower than its face value is trading at a discount. A bond is trading at a premium if the reverse is true. Note that on maturity, you will still receive the face value of GHS 2,000 regardless of the market value. Talk to Frontline to receive advice on which bonds to buy.

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