Bonds as financial instrument: What you need to know about it
A bond is a fixed income debt instrument issued by the government (federal or state government) or corporate institutions with a definite date of maturity.
It also comes with fixed interest payment (known as coupon) payable either semi-annually or annually.
Unlike equities, bonds are issued with a guarantee of the initial investment and can have tenors as long as 20 years.
Treasury: Note or Bond
A treasury note refers to a government bond instrument with a term to maturity of 1 to 10 years while a treasury bond has a maturity of 10 years and above.
Bonds issued by state governments of a country are referred to as municipal bonds while those issued by organizations are corporate bonds.
The government usually issue bonds at the primary market to raise domestic funds to meet its fiscal responsibilities.
This can be done from time to time as the need arises. Nigerian FGN bond instruments are named by their maturity, coupon, tenor etc. such as 13.05% FGN AUG 2016 instrument.
How is Return Determined?
Bonds are mostly issued with a coupon otherwise known as the periodic interest payable.
Bond instruments are usually issued at par; that is, N100 or N1,000 as is the case with Nigerian bonds.
A 2-year bond issued at 12% annual coupon with a par value of N1000 implies that the issuer will make 3 semi-annual payments of N60, and a final N1060 on the maturity date.
Bonds can be purchased at both the primary and secondary markets, they are either quoted in price or yields.
There is an inverse relationship between the price of a bond and its yield to maturity (YTM).
At issuance, the yield on a bond instrument is most likely the coupon on that instrument.
At the secondary market therefore, an investor can trade bonds by quoting a yield that reflects the variance between the par value and the current price based on the current market dynamics.
How does the Auction Process work?
Bonds as financial instruments are issued through a competitive bidding process at auctions as conducted by the Debt Management Office which serves as the representative of the government.
An existing government instrument can be re-issued also at the primary market in which case the DMO re-issues based on the current market yield to maturity.
Bonds are auctioned at established rates which determine the return to investors.
Purchasing these financial instruments in the primary market and holding it till maturity would mean that the investor gets a fixed interest payment.
However, there is a secondary market in which investors can trade these bonds to meet their immediate liquidity needs.
Bonds as financial instrument: What you need to know about it
