THIRD INVESTMENTS: PART I

HERE, I describe the investment and risk characteristics of some types of assets available for investment purposes: fixed interest government borrowing, fixed interest borrowing by other bodies, shares and other equity-type finance, and derivatives.

A derivative is a security with a price that is dependent upon, or derived from one or more underlying assets. The derivative itself is a contract between two or more parties.

A government, local authority, private company or other body may raise money by floating a loan on a stock exchange. The terms of the issue are set out by the borrower, and investors may be invited to subscribe to the loan at a given price (called the issue price), or the issue may be by tender, in which case investors are invited to nominate the price that they are prepared to pay and the loan is then issued to the highest bidders, subject to certain rules of allocation.

In either case, the loan may be underwritten by a financial institution, which thereby agrees to purchase, at a certain price, any of the issue which is not subscribed by other investors. Government Bonds by definition, is a debt security issued by the state to support government spending, most often issued in the country's domestic currency.

In simplicity when an investor buys a government bond, they are lending money to government that issued the bond, the government that issued the bond is agreeing to pay the investor money back with interest, at some point.

In other words, a bond is an instrument of indebtedness of the bond issuer to the holders. The most common types of bonds include municipal bonds and corporate bonds.

Features of a fixed interest security bond; to begin with, a bond is a formal contract between the issuer and the investor.

The following features of the bonds are agreed upon at the issue date:

(i) Face value (F): also known as par or principal value is the amount printed on the bond. This value is the base for the calculation of the amount of periodic interest payments.

(ii) Redemption Value (R): a bond's redemption value or maturity value is the amount that the issuer promises to pay on the redemption date. The redemption date is the date on which the redemption money is due to be paid. In most cases the redemption value is the same as the face value. If R is equal to F the bond is said to be redeemable at par, if R is greater than F the bond is said to be redeemable at a premium, if R is less than F it is said to be redeemable below par or at a discount.

(iii) Time to maturity: this refers to the length of time before the redemption value is repaid to the investor. It may be as short as a few months, or as long as 25 years (or even longer)

(iv) Coupon Rate (C): this is the rate at which the bond pays interest on its face value at regular time intervals until the redemption date. Some securities have varying coupon rates or varying redemption prices. Some bonds have variable redemption dates, in which case the redemption date may be chosen by the borrower (or perhaps by the lender) as any interest date within a certain period, or any interest date on or after a given date.

In the latter case the stock is said to have no final redemption date or to be undated. We consider the following;

(i) looking at default-free bonds, we assume that the issuer may pay all interests and the principle repayment as scheduled.

(ii) Before purchasing a bond, the prospective investor needs to consider several factors in relation to the bond features. These include: (a) the number of coupon payment periods (n) from the date of purchase (or date of settlement) to the maturity date. (b) the rate of return (I) of the investment (called the yield rate) - it reflects the current market conditions and is determined by market forces, giving investors a fair compensation in bearing the risk of investing in the bond. (c) the purchase price (P) which is the sum of the present values of all coupon payments plus the present value of the redemption value due at maturity.

It cannot be argued that, one of the main risk factors for bonds is interest rate risk, as most bonds offer payments at a fixed rate. Another risk factor is the risk of default, which represents the probability or chance that the issuer will not be able to pay the coupon payments on time and or the principal on the maturity date.

The issuer will have to declare bankruptcy if it defaults on its bond issues.

There are a few internationally recognised rating companies (such as the Standard & Poor and Moody's) that provide ratings for municipal (state and local government debt instruments) and corporate bonds based on their default risk categories.

The ratings assigned by those companies significantly affect the interest rates of their bonds. A drop in the rating usually sends a signal to the investors that a bond's default risk has increased.

This will lead to an increase in the interest rate of the bonds because investors will be seeking a higher risk premium to compensate for the higher risk level.

Further, Government Treasury Bills are short dated securities, typically three months, issued by government to fund short term spending requirements. They are issued at a discount and redeemed at par (maturity) with no coupons. Keep in mind the following; (i) they are issued at face value, and are redeemed on maturity at par;

(ii) three months is a typical term for a government bill,

(iii) they are mostly dominated in domestic currency, although issues can be made in other currencies;

(iv) the yield is usually the simple rate of discount for the term of the bill. For instance, if the bill is quoted as offered at two percent discount, then the initial investment to buy a bill would be two percent off, at payment three months later. Take note that, government Treasury bills are absolutely secure and often highly marketable, despite not being quoted. They are often used as a bench mark for risk free short-term investments.

One of the main objectives for Treasury bills is that Governments’ use them as a primary instrument for regulating money supply and raising funds via open market operations.

Issued through the country's central bank, bills commonly pay no explicit interest but are sold at a discount, their yield being the difference between the purchase price and the redemption value.

This yield is closely watched by financial markets and affects the yield on municipal and corporate bonds and bank interest rates. Although their yield is lower than on other securities with similar maturities, T-bills come closest to a risk free investment because they are guaranteed by government.

Additionally, under fixed interest borrowing by other bodies, we look at corporate debt. These are transactions, whereby companies borrow from investors by issuing a corporate bond.

A bond is issued by a particular company, the working mechanism and cash flows are similar to those of the government bond.

It must be mentioned that, the differences between corporate bonds and government bonds lie in the following;

(i) corporate bonds are less secure than government bonds. The level of security depends on the type of bond, the company which issued it, and the term of the bond.

(ii) corporate bonds are less marketable than government bonds because the sizes of issue are smaller.

(iii) corporate bonds yield higher investment returns to compensate for the lower security and marketability. The size of the yield margin depends on both the security and marketability of the debt. Because of the low security and marketability, companies or individuals go for large yield margins, while large secure issue trade at small yield margin to the closest equivalent government bonds.

Furthermore, Debentures are a type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general credit worthiness and reputation of the issuer.

Both corporations and governments frequently issue this type of bond in order to secure capital. Thus debentures are used as part of loan capital for companies, usually long term.

They are more risky and are less marketable than government bonds and so investors require a high yield. The security of a debenture can either be in form of a fixed charge or specific asset or a floating charge. Lenders have a prior right in the event of a windup over all assets of the company.