Lesson 12: How bonds work

Bonds as Debt

Whether we admit it or not, stocks, currencies and bonds are somehow interlinked. Of course when mentioning stocks, it is in reference to businesses. I have mentioned a number of times in previous lessons, when you are buying stocks, technically, you are buying businesses. We have briefly looked into how to assess a company’s financial statements.

Although not really necessary, having the ability to properly anticipate debt cycles in the market can give you a significant advantage over other market participants as it enables you to anticipate some developments you would have otherwise been unable to. It is not an easy task and has a lot that has to be considered which we will not cover in this particular lesson. Soros managed to anticipate some of the debt cycle patterns  and did offer extensive explanation on his approach of which could have partly contributed to his notable success in the financial markets as it enabled him to invest in businesses that would largely benefit from particular stages of debt cycles.

Whatever happens in the debt market almost always has to have an effect on both currencies and stocks. The link is especially more significant in relation to bonds and stocks. You only need to look into a few of the previous debt market bursts in different countries to see the significant effect they have had on the stock market movements (which is usually a good barometer on how business are generally doing especially in markets with a large diverse number of listed companies).

The debt crises in the process tend to create a lot of opportunities in the stock market as usually when a country is recovering from a debt market crash, stocks are usually very cheap due to the psychological impact the debt cycles have on investors. Businesses source for funding to grow their business from the debt market. They borrow in order to grow earnings in a way they would have otherwise been unable to. As an example, when debt markets crash, interest rates go up sharply because risks rise, when interest rates rise, it becomes difficult for businesses to finance their activities and investors may shy away from financing companies in the country and thereby worsening the situation and may lead to company collapses and bailouts especially in those companies that were reckless about debt.

The issue of  debt markets is a bit wide and to explain and I would have to spread out the lessons. I will begin by explaining on how to invest in the bond.

BONDS

To define it simply, a bond is just a loan. Companies &  governments issue bonds to raise money from investors willing to lend them money for a certain amount of time (Also called maturity period).

Bonds are very popular as very low risk investments. Investors constantly use them to diversify their portfolios, so that they wouldn’t suffer significant loss in case there is significant market shock affecting investments in other financial instruments. By market shock, I mean events that may hurt performance of your stock purchases. Besides, its a better way to save up for retirement instead of stashing your money under the pillow(where you money loses against inflation), in the bank(paying little or no interest) or funds offering very little return over the long-term.

When you are buying a bond, you become a creditor for the company or government. You would be extending a loan that has compensations in form of periodic payments in form coupon interest. At the end of the agreed time period of the bond, you get back the amount of money you gave the government or company.

To illustrate, let us assume you are the Chief Finance Officer of a company called Home Kenya. You realize the business needs some 5 billion shillings to expand reach or finance a few projects you have identified have significant potential to create a future stream of income or boost your business financial position. You then talk to an adviser on the best way to raise funding.  The adviser may offer a range of options on how you can raise funding which include equity dilution, loan from bank or bond issue. You then maybe decide that you don’t want to dilute your company’s earnings per share since the owners of the business might not be happy about it. You also figure out that raising funding from banks may be a little bit expensive and some banks may be unwilling to extend to you the amount of money you require in a way where the business would remain profitable. Remember, high interests on loans you take will be eating up a huge portion of your earnings. (Some jurisdictions like Kenya require you to consult a professional by law).

You then decide to approach an investment bank to handle the issue(Also a mandatory requirement in some jurisdictions). The bank will then evaluate the ability of your company company to pay back the loan (bond inclusive of interest payments) before deciding on the rate at which the loan you will take, in form of a bond, will accumulate interest. If the bank determines it is healthy, they then facilitate the entire process by first restructuring the loan into a bond. They then decide on the lending rate to use which can be say for this situation 5% per year.

Bond

The bank can decide to split the loan into minimum amounts each investor can invest. In this case they split it into 500,000 bonds with each bond at a par value of 100,000. Par value is the minimum amount that lenders will lend to you and that you will have to pay back at the end of the agreed period of time.

The loan has to have a repayment period which in this case we can assume is 30 years. At the end of the 30 years, all those who bought the bonds and are holding the bonds issued by the company will get back  the per value of the bond which is equivalent to the money they invested when the bond was being issued.

To summarize, your bonds would look something like this

Bond per value : sh100,000

Term : 30 years

Coupon rate: 5%.

You will find that, instead of investors paying 100,000 for every bond, they may pay, 105,000 for the bond. The 5,000 extra is what the bank makes from facilitating the bond sale. Investors who buy the bond will make 5% every year. It is usually structured in a way where investors will receive money semi-annually. In this case it means after every 6 months, investors will receive a cheque of 2500 shillings for every bond they bought. At the end of the 30 years, they will get their 100,000 shillings back on every bond they bought.

Once investors buy the bonds, the relationship is now between the company and investors directly.

Some bonds have evolved and there are even smaller versions now called mini-bonds in some countries that are issued by very small businesses but are generally unsupervised and are considered high risk. They would however be deemed by the Act in Kenya as illegal as they do not meet the requirements stipulated in the act.

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