In the corporate world, companies raise money for operations or long-term projects in two ways, i.e.
• by issuing equity
• by issuing debt
In issuing equity, the company essentially sells a portion of itself to the public (in an IPO) or to private investors (in a Private Equity Placement). The buyers are then known as shareholders and own a part of the company. In issuing debt, the company borrows from various sources.
One way of issuing debt is through a bond. Bonds can also be issued to the public (PBO) or issued to select investors (Private Bond Placement). The lenders are referred to as bondholders.
In the event of liquidation or bankruptcy of a company, bond holders rank higher (have higher claim on assets) than shareholders do and are thus paid first. This is because bond holders are creditors. They, however, do not share in the company’s profitability.
Shareholders are part owners of the company. With this ownership comes voting rights and the right to share in any future profits of the company. Ordinary shareholders are therefore the last to be paid. It is also worth noting here that as opposed to stocks, bonds have a defined term (maturity) after which the bond is redeemed. Stocks may be outstanding indefinitely. Returns on bonds are generally lower than those on stocks but are a much safer investment. Bonds’ safety and stability act as a counter to the fluctuations common to stocks.
All it takes is a bear market to remind investors of the virtues of a bond’s safety. It therefore makes sense for any investor to have at least part of their portfolio invested in bonds.
The participants in the debt market are usually: institutional investors (pension funds, banks and mutual funds), governments, traders and individual investors.
A bond is a debt instrument. In even simpler terms, a bond is a loan in which the terms, pay-back date and interest rates are detailed in a legal document. In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and is obliged to pay interest (coupon) and repay the principal at a later date.
It is a formal contract to repay borrowed money with interest at fixed intervals.
Bonds are also referred to as fixed income securities.
In the debt market, there exists a ‘primary market’ and a ‘secondary market’. The primary market is where the bonds are issued and sold for the first time (such as in a PBO). The secondary market is where bonds are later traded (i.e. the securities exchange – NSE).
When a bond is issued, it is given a certain value referred to as face value, par value or principal of the bond. This refers to the amount of money the borrower must return to the lender at the end of the ‘loan period’. Nearly all bonds pay interest. The rate (coupon rate) will vary depending on a number of factors (such as current market interest rates, term to maturity, creditworthiness of the issuer, etc) but these rates usually tend to have a relationship to risk.
The more likely it is that a bond issuer will default on a loan, the higher the interest rate he must pay to attract investors. Interest rates are calculated as a percentage of the bond’s face value. These payments are usually made twice a year. The annual interest rate on a bond is referred to as the yield.
A bond’s maturity date refers to the time when the bond’s issuer must return the principal to the investors. Bonds with maturities of up to 5 years are referred to as short term bonds. Those with maturities of between 5 and 12 years are referred to as medium term bonds and those with maturities of more than 12 years are long-term bonds.
Secured vs Unsecured Bonds
Bonds may be secured or unsecured. A secured bond is backed by collateral, meaning it has the money or physical assets that a bond issuer must give to investors if the bond defaults. Securing ensures that capital will be available to pay the principal on the bond.
Unsecured bonds (sometimes called debentures) are not backed by any collateral. Instead, the issuer promises that the lenders will be repaid. This promise is frequently called “full faith and credit”.
Unsecured bonds could be issued in this manner either because the company does not have enough assets to collateralize or the company is well established and is therefore trusted to repay its debts. Unsecured bonds naturally carry more risk than secured bonds and therefore pay higher yields.
Fixed Rate vs Floating Rate Bonds
A bond whose interest rate stays the same over its lifespan is referred to as afixed interest bond.
A bond whose interest rate varies periodically over its life span is referred to as a floating interest bond. The changes in rates usually reflect economic conditions. A floating rate is usually pegged to another economic indicator such as Treasury bill rates or even inflation and is determined using a prescribed formula.
Nairobi Stock Exchange & Central Bank of Kenya
On the Nairobi Stock Exchange, there are currently 68 government bonds issued by the Government of Kenya and 10 corporate bonds issued by 7 companies. Of the corporate bonds, there is none whose issued value is more than Kshs. 2 billion. The combined value of all listed government bonds is approximately Kshs.350 billion, while that of the listed corporate bonds is approximately Kshs.10 billion, bringing the NSE debt market’s capitalization to about Kshs. 360 billion.
The maturities of the government bonds range between one and twenty years while those of the corporate bonds range between two and eight years. All the listed government bonds have fixed coupon rates ranging between 6% and 14%.
The corporate bonds are either fixed or floating.
The floating rate coupons are pegged to the 91-day Treasury Bill average rate. Bond trading is still manual despite the NSE’s automation in 2006. In order for one to buy a Government of Kenya bond, one must open a CDS account at the Central Bank of Kenya. No fee is charged for CDS account opening. CBK, however, reserves the right to amend the requirements and call upon investors to comply with any changes deemed appropriate.
To buy a corporate bond, one must open an account with the arrangers of the issue who will facilitate the purchase of the bond and communicate the same to the registrar who will then print a ‘bond certificate’ with the details of the bond showing the bond holder, face value, maturity and coupon among other details. Treasury Bonds, however, are paperless securities i.e. no paper certificate is issued.
Investors instead receive a statement showing their holdings which have been registered with the CBK CDS.
Interest earned on bonds is subject to 15% withholding tax for individuals and institutions. For an institution, the interest earned on bonds is further subject to corporate tax as it falls under interest income.
Interest payments are made directly into the investors’ bank accounts when the payments fall due. It is worth noting that as per the Income Tax Act 2006, Schedule 1, Part 1, Section 51, interest earned on listed infrastructure bondswith at least 3 years to maturity is both withholding and income tax exempt