Bonds are a common investment, however, to many investors they remain a mystery, so let’s explore what a bond is and how it can benefit your investment portfolio.
What You Should Know About Bonds
What are Bonds?
“FGN Bonds are debt securities (liabilities) of the Federal Government of Nigeria (FGN) issued by the Debt Management Office (DMO) for and on behalf of the Federal Government. The FGN has an obligation to pay the bondholder the principal and agreed interest as and when due. When you buy FGN Bonds, you are lending to the FGN for a specified period of time. The FGN Bonds are considered as the safest of all investments in domestic debt market because it is backed by the ‘full faith and credit’ of the Federal Government, and as such it is classified as a risk-free debt instrument. They have no default risk, meaning that it is absolutely certain your interest and principal will be paid as and when due. The interest income earned from the securities are tax exempt”.
-Debt Management Office
Consider this example, the Federal Government of Nigeria wants to build a new bridge in Lagos (fourth mainland bridge) and decides to issue bonds to raise money, each bond is a loan which the Federal Government promises to payback over a certain period. To make this loan more attractive to investors, the Federal Government agrees to pay an annual interest rate of 5% which in the bond rule is known as a ‘coupon rate’.
Government bonds are a more secure investment opportunity, they come with tax benefits and allow investors to support practical projects. Capital preservation and income generation are two major ways bonds can be a part of a diversified portfolio. Due to the fact that bonds offer regularly scheduled payments and a return on invested principal, bonds are often viewed as a more predictable and stable form of investment.
Similar to other types of investments, bonds are not without risk. One risk that bonds investors face is the possibility that the issuer defaults on paying back the principal. This is what is known as ‘default risk’. Typically, bonds with higher defaults risk also come with higher coupon rates. The amount of risk mostly depends on the financial capability of the issuer. For example, most governments are generally considered stable issuers and they issue bonds with a relatively low coupon rate. Cooperate bonds typically represent a greater risk of default as companies can and do go bankrupt.
Another risk to consider is the ‘interest rate risk’. This is the risk that interest rate would go up and any bond you own will be worth less if sold before the maturity date. After all, when interest rate rise, more investors allocate their money into the new higher interest rate bonds. If you want to unload the low interest rate bond to take advantage of these new rates, you would have to sell your bonds at a discount price to make it a worthwhile purchase for another investor.
Several credit rating agencies assign rankings to different bonds. This can help bond investors to gauge the financial strength of the bond issuer. This rating agencies often use different criteria for measuring risk, so, it is a good idea to compare ratings when considering a particular bond.
However, keep in mind that rating agencies are not always accurate, so you should research a bond and its risk thoroughly before investing.