Dynamics and importance of bonds (1)

The bond market is the largest securities market in the world and is a major factor in the development of economies. Global bond markets are three times the size of the stock markets, at US$157 trillion and US$54 trillion, respectively, according to a report by McKinsey and Co. And the US bond market is the largest in the world, comprising various sectors with each category consisting of its own network and trading systems. Bonds offer sovereign governments and businesses access to raise medium to long-term funding for infrastructure with strong socio-economic impacts. Americans are very proud of their bond market and other capital markets because it plays a vital role on the global stage, in the US economy and the daily life of every American: “The next time you drive on a smoothly-paved highway, hear of a factory expansion that is creating new jobs, see an office park rising in your neighbourhood, borrow a DVD from your library, consider the role of the bond market.”

Types of outstanding bonds in US valued in trillions include Municipal ($2.93trn), Treasury ($8.85trn), Mortgage related ($8.911trn), Corporate ($7.54trn), Federal Agencies ($2.73trn), Money market ($2.86trn) and Asset-Backed ($2.15trn). Total outstanding in Q1, Q2, Q3 and Q4 2014 stood at $38,136.9, $38,258.8, $38,547.5 and $38,994.2, respectively. Average daily trading volume in January 2015 was $802.3trn.

A bond is a fixed income security which represents a loan from the investing public (bond holder) to the entities selling the bond (borrower/issuer). It is an IOU which offers the holder a guaranteed annual income and a specified amount upon maturity. Thus, it is a way to invest in the security and infrastructure of a nation, the growth of economies and the expansion of business. Types of bonds include fixed rate bonds, zero coupon bonds (also known as deep discount bonds), floatation rate bonds, irredeemable debenture stock or perpetual bonds and redeemable debenture stocks. Others are naked debenture stocks, secured debenture stocks, callable debenture stocks, convertible debenture stocks and debenture with warrants.

Unlike ordinary shares or equities, a bond does not confer on the holder a part ownership status except if it has a convertibility characteristic. Some of the strategic reasons corporate bodies issue bonds is to avoid dilution of current shareholders’ equity and the need to maintain a fixed coupon rate over a term than it could at a bank. The tenor of bonds ranges from 5, 10 and 20 years. The longer the tenor, the higher the coupon rate (interest to be paid by the borrower), and vice versa for shorter maturities. Corporate bonds could be called or retired by the issuing company prior to maturity, but at a premium depending on the market condition, or if changing company strategy requires the management to rearrange its capital structure. The return/yield on bonds is determined by the associated risk factors such as marketability/liquidity, interest rate, inflation rate, exchange rate, default rate. Typically, long-dated securities are more risky and so attract higher coupon rates and yields.

Bonds are mostly traded in Over-the-Counter (OTC) markets, a decentralized market without a centralized physical location where market participants trade with one another (interdealer) or with their clients (customer market) through various communication applications such as telephones, email and proprietary electronic systems. OTC market is big ticket for institutional investors and high net worth individuals. In the mechanics of bonds, bond markets as an investment is affected by developments in the stock market. There is a negative correlation between the stock market index and volume of bonds. The bond market is also very sensitive to interest rates and bond yield move in an opposite direction to the bond price. When interest rates go up price of bonds fall and the yield increases, and when interest rates fall price of bonds rises and the yield falls. A yield curve is a measure of the return of fixed income securities. It is a major indicator of business cycles and provides the necessary guide to the future behaviour of inflation and interest rates. Low inflation rate and stable currency boost bond markets.

Africa needs vibrant and efficient bond markets to accelerate growth in the massively endowed continent. The slow pace of development in Africa has been linked to the absence of vibrant capital markets. The International Finance Corporation (IFC) noted that “Africa cannot adequately address its enormous development financing and investment needs with existing funding sources. The funding gap on infrastructure alone is estimated at $31billion. The private sector, through the capital markets, can help bridge this financing gap”.

African countries have been noted to commit what is termed “Original Sin”, which is inability to issue debt in local currency. “They mostly rely on external grants and concessional loans to fund government deficits and capital spending which tend to pass currency risk to consumers”. In an IMF working paper, “Bond Markets in Africa”, Yibin Mu, Peter Phelps and Janet G. Stosky noted that “though Africa needs money, it is a net exporter of capital to the rest of the world, mainly because there is a lack of intermediate channels to absorb capital and bond markets are an effective way to intermediate capital savers with capital users”.

With the exception of South Africa and the developing bond market in Nigeria and a few other markets in infancy, the bond market in Africa is virtually dormant despite the continent’s huge infrastructure financing needs.

Arize Nwobu