In our investing journeys, I am sure you have severally come across the word ‘bond’ as an investment option. From the questions I get from my clients, bonds often seem so complicated and today we are going to try make it as simple as possible. So for those wondering, a bond is a debt instrument issued to the public to raise funds. Think of it as a loan. A loan that you are giving to a company or a government.
Types of bonds
There are many different types of bonds and they vary according to who issues them and the length of the bond. In this post we will talk about the most common types of bonds.
- Treasury bills – These are short term debt instruments used by the government to borrow money from the public. They are referred to as treasury as they are issued by the central bank. They usually have a maturity period of less than one year.
- Treasury bonds – Similar to treasury bills, they are debt instruments issued by the government but for a longer period of time. They usually have a maturity period of between 1 year – 30 years.
- Commercial papers – These are short term debt instruments issued by companies to raise capital. Similarly to T-bills, their maturity period is less than 1 year. However, unlike T-bills, they are more risky and their risk is dependent on how credit worthy the company is.
- Corporate Bonds – They are similar to commercial papers however, they are long term in nature. They have a maturity period of more than one year which makes them more risky than commercial papers.
How bonds work
Just like a loan, where you will approach a bank to request for a loan and in case the bank decides to advance you the loan, you will agree on a loan period and how much interest you will pay. Similarly, an organization (bond issuer) will go to the public (which is you) and request the public to give them their funds for whatever reason e.g. for a company to expand its business or for a government to improve infrastructure. The organization shall promise to pay the bond back at an agreed-upon date (e.g. it can be after 2 years, 8 years 15 years etc.). In addition, the organization shall also promise to pay an interest (a percentage per annum) as compensation to the public for using their funds which shall be your earnings.
Therefore, until when the bond is paid back, the organization shall make the agreed-upon interest payments to the bondholders (those who bought the bond) at agreed intervals (e.g. semiannually, quarterly etc.). Then at the end of the bond period, the organization shall pay back the bondholder their principal and last interest payment.
For example, if you buy a 5 yrs. treasury bill being auctioned on the primary market for Kshs 100,000 at 12%p.a paid semiannually. This means that the Treasury bond has a maturity period of 5 years and interest shall be paid semiannually. So the government will be paying you Kshs 6,000 every six months as interest payment for using your money and on 13/12/2024 (5 years later) it will pay you Kshs106,000 as your initial principal (Kshs 100,00) and last interest payment (Kshs 6,000). The Kshs 6,000 you will be paid every 6 months for the 5 years will be your return for investing in the bond.
- Bonds are low risk, you are guaranteed that the borrower will pay back the initial principal at the end of the bond period and interest payments periodically as agreed in the contract unless the borrower defaults. (However do note that corporate bonds have a significantly higher risk than treasury bonds)
- Since interest is paid periodically, bonds are a good predictable long term source of income. On the other hand if one is not willing to hold the bond till maturity, bonds are easily tradable in the secondary market. One can sell their bonds in the Securities Exchange and even get lucky to sell it at a profit.
- In the long term, bonds have a lower return than more risky investments like stocks and real estate. Hence you may want to diversify your portfolio with investments that offer higher returns to boost your portfolio average return.
- Secondly, selling in the secondary market can be difficult for most individuals as valuing bonds can be complicated hence you can easily incur losses. Therefore, before buying/selling your bonds in the secondary market kindly seek professional investment advice.
- Unfortunately, most bonds have a minimum amount (Kshs 50,000) you can invest in, hence it may not be affordable to everyone. However, in 2017, the government was gracious enough to introduce M-Akiba which simplified the complicated process of purchasing T-bonds and made it affordable to most Kenyans. With only Kshs 3,000 one can start investing through their mobile phones.
In order to purchase a treasury bond, one must have a CDS account with the central bank of Kenya while to buy a corporate bond, one must have a CDSC account with Central Depository and Settlement Corporation which operates and manages the Central Depository System in Kenya for securities listed on the Nairobi Securities Exchange. (We can talk about this in a separate post)
I believe, bonds are an easy, low risk investment that can be a good start to your investing journey. And those who still feel like it’s still complicated and a lot of work, you can invest in bonds through a bond mutual fund and your fund manager will do the heavy lifting for you.
PS. None of this content is financial or investment advice. It’s for educational purposes only. Please do your own research and/or consult with a professional if you want advice customized to your specific situation.
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