Introduction to Bond Investing for Millennials

If you are saving and you don’t need the money in the short term (in a year or less), bonds will give you a relatively better return without posing too much risk.

A bond is a fixed-income investment where an investor loans money to an entity (usually a government or a corporation) for a defined period at a fixed or variable interest rate.

Types of Bonds

1. Government Bonds: Issued by the government, these are considered very safe. In Nigeria, there’s the FGN (Federal Government of Nigeria) Bonds issued by the Federal Government of Nigeria and Sub-National (or State) Bonds issued by States.?
2. Corporate Bonds: Issued by companies, these usually offer higher interest rates than government bonds but come with higher risk.
3. Eurobonds: Issued in a currency different from the country’s own. For example, a Nigerian company might issue a bond in US dollars.

Understanding Key terms used in bond market

• Issuer: The entity that borrows money by issuing a bond. This can be a government (government bonds), or a corporation (corporate bonds).?
• Face value or par value: also known as the principal value, refers to the total amount on which the issuer pays interest and is also the amount that must be repaid to the bondholder at the bond’s maturity date.
• Coupon rate: The fixed or variable interest rate that the issuer pays to the bondholder, usually expressed as a percentage of the bond's face value. For instance, a bond with a face value of ?100,000 and a coupon rate of 5% pays ?5000 in interest annually.
• Maturity: The date when the bond issuer repays the bondholder the face value of the bond. Bonds can have short-term (less than 5 years), medium-term (5 to 12 years), or long-term (over 12 years) maturities.
• Credit rating: A measure of the borrower's creditworthiness, which affects the bond's risk and return. If a bond has an AAA rating, it is considered to be of the highest quality by credit rating agencies. This rating suggests that the issuer (whether it's a government or a corporation) has a very strong capacity to meet its financial commitments.?

On the other hand, if a bond has a lower rating, such as a B or C rating, it indicates that the issuer has a weaker capacity to meet its financial obligations. Bonds with lower ratings are considered riskier investments, and they usually offer higher interest rates or yields to compensate investors for the increased risk they're taking.?

How Bonds Pay Interest

Bonds typically pay interest in either of two ways:

1. Fixed Rate: The interest rate remains the same throughout the life of the bond.
2. Floating Rate: The interest rate is tied to a benchmark rate (monetary policy rate, MPR in the case of Nigeria) and can change over time.

Benefits of Investing in Bonds

1. Less Risky Than Stocks: Bonds are generally less volatile and risky than stocks, offering a safer investment option, especially government bonds that are considered risk-free to some extent
2. Preservation of Capital: Many bonds guarantee the return of the initial investment (principal) upon maturity, assuming the issuer doesn't default. This makes them appealing to investors who prioritize preserving their capital.
3. Tax Advantages: Certain types of bonds may offer tax advantages, such as exemption from federal and/or state income taxes on interest payments. Example, Interest on Federal Government bonds is tax exempt.
4. Priority in Bankruptcy: In the event of issuer bankruptcy, bondholders are typically prioritized over stockholders. This means they have a higher likelihood of recovering their investment.

What are possible risks associated with Bonds?

• Credit Risk: If the bond issuer faces financial trouble, they might default and be unable to make interest payments or repay the principal amount. The FGN bond is considered to have the least credit risk of all bond issuers in Nigeria.?
• Inflation Risk: Inflation erodes the purchasing power of future interest payments and principal repayment. Fixed-rate bonds are particularly susceptible to inflation risk because their returns may not keep pace with inflation.
• Interest Rate Risk: If an investor decides to sell a bond before it matures, the price they receive will be influenced by current market interest rates. If interest rates have risen since the bond was purchased, the bond's price will likely decrease. This is because new bonds are being issued at higher rates, making the older bond with a lower rate less attractive.?
• Liquidity Risk: Some bonds might be difficult to sell quickly without losing value. Government bonds are often highly liquid, meaning they can be bought and sold easily in the financial markets. This liquidity provides investors with the ability to quickly convert their bonds into cash if needed.

How to invest in bonds

You can do so through the primary and secondary markets with the assistance of licensed entities.?

1. Primary Market: Bonds are initially issued in the primary market through FGN Bonds Auctions conducted by the Debt Management Office (DMO) and Primary Dealer Market Makers (PDMMs) who are selected banks authorized to deal in FGN bonds.?
2. Secondary Market: Alternatively, investors can buy bonds in the secondary market, also known as the over-the-counter (OTC) market, where trading is conducted daily by licensed broker-dealers such as banks and stockbrokers on platforms like The Nigeria Securities Exchange (NSE) and FMDQ OTC Securities Exchange. In this market, pre-owned bonds are traded among investors.

The minimum required investment amount for bonds is typically N50,000,000.00 in the primary market. However, smaller investments can be made through mutual funds or exchange-traded funds (ETFs) in the secondary market.