There are a number of key variables to look at when investing in bonds: the bond’s maturity, redemption features, credit quality, interest rate, price, and yield and tax status. Together, these factors help determine the value of your bond investment and the degree to which it matches your financial objectives.
Bond characteristics: Bonds have a number of characteristics of which you need to be aware. All of these factors play a role in determining the value of a bond and the extent to which it fits in your portfolio.
Face Value/Par Value: The face value (also known as par value or principal) is the amount of money a holder will get back once a bond matures. A newly issued bond usually sells at the par value. The treasury bond of the Rwandan Government carries Frw5 billion.
What confuses many people is that the par value is not the price of the bond. A bond’s price fluctuates throughout its life in response to a number of variables. When a bond trades at a price above the face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.
Premium: The difference between the higher prices paid for a fixed-income security and the security’s face value is an issue. At par a bond trades at 100% of the full value. At premium a bond trades at above 100% of par value.
For example if a bond with a par value of Frw100,000 is currently trading at Frw101,000, it is selling at premium.
Discount: When the price of a bond is lower than par. The discount equals the difference between the price paid for a security and the security’s par value. At par a security trades at 100% of the face value. At discount, a bond trades below 100% of the face or par value. For example, if a bond with a par value of Frw100,000 is currently selling for Frw99, 000, it is selling at a discount.
Maturity date: The date on which the principal amount of a bond or other debt instrument is due and is repaid to the investor and interest payments stop.
The maturity date tells you when you will get your principal back and how long you will receive interest payments.
However, it is important to note that some debt instruments, such as fixed-income securities, are “callable”, which means that the issuer of the debt is able to pay back the principal at any time before the maturity date. Thus, investors should inquire, before buying any fixed-income securities, whether the bond is callable or not.
Maturities can range from as little as one day to as long as 20 years. A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. Therefore, in general, the longer the time to maturity, the higher the interest rate. Also, all things being equal, a longer term bond will fluctuate, more than a shorter term bond.
Issuer: An entity which issues and is obligated to pay principal and interest on a debt security. For example, the issuer of the treasury bonds in Rwanda is the government.
Interest: Income or compensation paid or to be paid for the use of money. Interest is generally expressed as a percentage rate.
Advantages of Treasury bonds: A Treasury bond is considered risk free; the government guarantees the payment, so the government can not default. Treasury bonds are transferable and negotiable, meaning they can be exchanged for liquid cash in the secondary market before maturity date. They can be secured as collateral guaranteed as security. Treasury bonds carry a competitive rate of return.
Fixed-income security: This is an investment that provides a return in the form of fixed and periodic payments; and the eventual return of principal at maturity. Unlike a variable-income security, where payments change depending on some underlying fundamental such as short-term interest rates, the payments of a fixed-income security are known in advance.
Bonds are therefore, a core element of any financial plan to invest and grow wealth.
Over-the-counter market (OTC): OTC is the market in which shares, bonds and other instruments are issued and traded through over-the-counter markets.
Also known as the equity market, it is one of the most vital areas of a market economy as it provides companies with access to capital and investors with a slice of ownership in the company and the potential of gains based on the company’s future performance.
This market can be split into two main sections: the primary and secondary market. The primary market is where new issues are first offered, with any subsequent trading going on in the secondary market.
In the OTC market, trading occurs via a network of middlemen, called dealers, who carry inventories of securities to facilitate the buy and sell orders of investors.
Robert Mathu is the executive director of Capital Markets Advisory Council