What is a Bond?

In the financial world, there are different kinds of assets you can invest in to grow your money. These assets fall into two main categories: equity and fixed income. Equity investments tend to have a higher risk but a potentially much higher reward. Fixed-income investments tend to be safer, but they typically have a lower potential for growth.

Market professionals generally agree that investing in fixed income is the smart move for most individual investors, given their risk profile and long-term investment horizon. In this article, we explore what bonds are and why you should consider investing in them. We look at factors to consider before investing in bonds and how you can invest in bonds in Kenya.

What is a bond?

What is a Bond?

Bonds are fixed-income security issued to raise money for certain activities. When companies or the government need to raise money for growth, and infrastructure, they issue bonds. The information provided by the bond issuer includes the term of the bond, how interest payments will be made, and the date the funds will be returned.

Bonds are secure, medium- to long-term investments that offer an investor interest periodically. Most bonds offer investor interest semi-annually.

In Kenya, the central bank has auctions for Treasury bonds every month. They also offer bonds such as infrastructure bonds from time to time. Infrastructure bonds are tax-exempt, making them more attractive. The interest rate for bonds is determined at the auction, and it remains the same for the life of the bond.

Types of Bonds

There are different types of bonds that one can invest in the market. They have different interest risks. Here are the main bonds.

Corporate bonds

Corporate bonds are issued by public and private companies in a bid to raise money.

Government bonds

Government bonds are issued by the central bank to raise funds for various functions. Government bonds are risk-free as the income is guaranteed. Types of government bonds include the following:

Treasury bills

Treasury bills are short-term securities that mature in a few days to one year.

Notes

They are long-term securities that mature within 10 years.

Factors to consider when buying bonds

When choosing the bonds, you should consider the following:

Bond yields

Before you sign up for the bond, understand the different bond yields.

Coupon rate

The coupon rate is the interest paid to the bondholder by the issuer. When selecting the bond, make sure you check the coupon and ensure you get a good rate.

Yield to maturity (YTM)

Yield to maturity measures the return the bond will give an investor if it’s held to maturity and all coupons are reinvested at the YTM rate. Most of the coupons will be invested at a different rate than the actual return.

Current yield

The current yield compares the interest provided by a bond to the dividend you get from a stock. You can get the current yield by dividing the bond’s annual coupon by the current price. The current yield does not consider current gains or losses.

 Nominal yield

This is the interest to be paid on a bond periodically. It’s calculated by dividing the annual coupon by the par, or face value, of the bond. Nominal yield does not give an accurate estimate of the return and should be used for calculating other measures of return.

Yield to call (YTC)

If the bond you subscribe to is callable, it means there is a probability of a recall before maturity. In the event the bond is paid at a premium, the investor will earn a higher yield. Most investors want to know the yield realized at a particular date to weigh their options.

Realized yield

This is used to calculate the amount an investor will earn if they don’t wish to hold the bond to maturity. It’s hard to predict future returns, this makes it hard to estimate what the investor can expect.

Credit quality/bond rating

Bonds have a risk that the issuer may default. This means the issuer fails to pay the interest or the principal amount. Make sure the bond issuer has a good credit rating. The government is considered to have a high credit rating and is not likely to default.

Use the rating to determine the creditworthiness of the bond issuer.

Time to maturity

Issuers pay a higher return for long-term bonds. You need to check the maturity dates for bonds so you can assess how much you are likely to make. It’s also important to know for how long your money will be tied up.

Taxations

Consider investing in bonds that are tax-free or exempt. In Kenya, income from infrastructure bonds issued by the government is exempt from tax. Income from other may attract 15% withholding tax.

Liquidity preference

Consider the liquidity preference of the bond issuer. In cases of loss or debt, make sure the issuer gives the bondholder a preference if assets are sold.

Risk

Bonds are a relatively secure investment, but like any investment, they come with some risk. Here are the most common risks.

Interest risk

It’s hard to predict the market, especially for bonds with a long period before maturity. If the interest rates go up, the investor will have an instrument that is yielding below the market rate.

Bonds have an inverse relationship with interest. When the interest rates go up, the bonds tend to go down.

Default and credit risk

This is the risk that the bond issuer will not be able to pay the interest and the principal as per the agreed timelines. Before you buy the bonds, make sure the company has positive cash flow and a great operating income as compared to debt.

Prepayment risk

This is the risk that the bond issuer will pay off the bond earlier through a call provision. This results mostly when interest declines substantially.

Tips to follow when investing in bonds

When investing in bonds, here are some important tips you should follow:

Know the bond rating.

A bond’s rating shows its creditworthiness. The lower the rate, the higher the risk of default, and you would lose your investment. Bonds with an AAA rating are considered more creditworthy as compared to those with a C.

Get to know when the bonds mature.

The maturity date is when the investment will repay the money. This gives you an idea of when you can expect your money back.

Bond issuer track record

You need to know the previous history of the company issuing the bonds. This will help you decide whether to invest in the bond or not.

Risk

Make sure you understand the kind of risk you can tolerate. Bonds such as corporate bonds come with a higher return, but the risk is higher. Don’t invest solely based on the earnings you will get.

Know the macroeconomic risks.

When the rate of interest for other bonds goes up, the bonds on the market will lose value. Interest-rate risk is the risk that the rates will change before the bond matures. This does not affect bonds with a fixed interest rate.

Know how to diversify your portfolio.

Bonds are fixed-income securities that should help you diversify your portfolio. They will help balance your investment portfolio (stocks and other assets).

Read the bond prospectus carefully.

Before you invest in a bond, make sure you study the prospectus carefully. Analyze the type of bond and make sure you understand the fees and other terms of the bond.

Work with bonds from people who know the bond markets.

When investing, it’s best to work with brokers who understand the market.

Check the fees and other expenses.

Make sure you check all the fees and expenses and determine their impact on your income.

How to buy bonds in Kenya

You will need a minimum of Ksh 50,000 to invest in a regular bond and Ksh 100,000 to invest in an infrastructure bond. Here is how to buy bonds.

Through the Central Bank of Kenya

You will need to open a CDS account with the Central Bank of Kenya. You can open an account for an individual or a corporation. To open a CDS account, you will need to have a bank account and a filled-out mandate card. The mandate card is used during the verification process.

After the verification process, you will have a CDS account, and you can choose the bond to invest in, complete the application form, and submit it.

After the submission of the application form, you wait for the auction results. The Central Bank’s auction committee meets to consider the bids submitted and determine the cutoff rate and the weighted average of the accepted bids for the market-determined coupon rate bonds.

The results of the auction are published through Treasury Mobile Direct, Twitter, and the statistics section of the CBK website.

If you apply, you need to contact the CBK to determine how much you need to pay. Payments must be made the following Monday after the auction results.

 As a nominee

You can buy bonds through third parties such as brokers, commercial banks, and investment banks. This comes at a cost. The main advantage of using a third party to buy bonds is that you can easily sell your bonds in the secondary market.

Benefits of Investing in Bonds

Here are the main benefits of investing in bonds.

Capital preservation

Bonds are generally less risky than other assets. They are good for investors who want to preserve their capital.

Income generation

Bonds provide the investor with a fixed income at regular intervals in the form of coupon payments. Investors looking for a source of passive income can invest in bonds.

Diversification

Investing in bonds, stocks, and other assets gives you a portfolio that is diverse and can withstand all market conditions. When the stock market is down, bonds become more appealing to investors.

Risk management

You will earn a fixed income from bonds. They are considered less prone to microeconomic risks.

Give to the community.

Bonds are mostly used to build things like hospitals and roads. By investing in bonds, you are becoming part of a community.

What are the risks of investing in bonds?

Bonds have the following risk:

Interest rate risk

This is the risk that interest will go up, resulting in the fall of bond prices. This will make the bonds you hold have a lower value.

Inflation risk

In the event the rate of inflation outpaces the yield on your bond, you will lose purchasing power.

Credit risk

This is the risk the bond issuer is not able to honor their obligation of paying the interest and the principal.

Liquidity risk

This is the risk that you are willing to sell your bond, but you can find a buyer.

Bonds are debt securities that represent a loan between an investor and a borrower. The borrower could be a corporation, the government, or another entity. When you buy a bond, you are lending money to the issuer with the expectation of being paid back the principal plus interest over time. Bonds offer stability and security compared to other investments, making them an attractive option for many investors .

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