Kevin Maina, a licensed Equities Trader at Genghis Capital, explains the workings of treasury bonds and bills.
What are government bonds?
Government bonds are essentially what we call an IOU. An IOU is an agreement between parties acknowledging debt and a promise on when it will be paid. A government bond hence is an IOU between yourself and the government.
Why governments do issue bonds?
Governments issue bonds because they need money. The government needs money for whatever expenditure and the investor lends the money at a prescribed interest rate. After a certain period, called maturity, the government returns the money and during this tenure the investor will be getting some periodical interest income called coupons.
Why invest in a government bond?
A government bond is the safest kind of investment. The only risk to a government bond is default and for a government to default the economy has to be really bad. This will be like in situations of a coup or other extreme events. By this time all other investment vehicles like banks, Saccos, and listed companies would have collapsed (with your money).
Government bonds is borrowing local money. If they (government) cannot pay, the worst-case scenario is that the government can print money or increase taxes to get you your money.
Banks also invest in government bonds. They use your money (deposits) to loan it to someone else or the government through bonds at higher interest rates (currently it is about 13 per cent) to make profit and later give you six percent through your fixed deposit account.
How many types of investments does the government have?
There are two types of investments with the government- Treasury Bills and government bonds. Treasury Bills also known as T-Bills are more or less like a bond but less than one year. Under that, we have a three-month, six-month and a one-year T-Bill. Anything above one year is considered a bond. There is the benchmark bond which is two, five, 10, 15, 20 and 25 but in between, there are three, seven and 11-year papers; so the duration is up to you to choose.
If the government is issuing an 11-year paper this month and you do not want you just wait it out until you get the one you want.
Terms to understand while investing in bond
Coupon –The interest rate the government will pay you for using your money. If you lend the government Sh100, 000 and they commit to pay 10 per cent that is the coupon. And it is paid semi-annually around June and December. In this case, the interest is Sh10,000 so you will end up getting Sh5,000 in June and the other Sh5,000 in December.
Paper –This is essentially the bond. If the government is issuing a five-year bond, it is called a five-year paper. This is a term usually used in the secondary market when someone decides to sell off their bond before maturity in order to get their money back.
Bid – This is an intention to buy. For instance, you tell the government you have Sh100,000 that you intend to lend them. In return, you get an IOU. You can choose between competitive and non-competitive. Anything below Sh20 million you bid noncompetitively while anything more you have to quote your own rate that you wish to lend the government at.
Auction period –The period within which the government is selling that paper.
Who can invest in a bond?
Anyone can buy a government bond as long as you are law abiding citizen. This is to ensure no one uses this investment vehicle for money laundering or hiding proceeds of crime.
Commercial banks, corporate and pension schemes are some of largest investors according to Central Bank of Kenya (CBK).
You must have a bank account with a commercial bank in Kenya and open a Central Depository System(CDS) account with CBK.
If you’re interested in investing in government securities you must have a bank account with a commercial bank in Kenya, and open a CDS account with the CBK. Kenyans and foreign investors who meet these qualifications are free to invest in government securities.
Opening a CDS account with CBK is free but a commercial bank will levy a fee.
How do you invest in a bond?
Once the government issues a bond or floats a paper, you can place a bid on it. The minimum amount is Sh100,000 if you are investing through a commercial bank and later you can top up with periodic deposits of Sh50,000. However, CBK on its website says the minimum is Sh50,000 for a government bond and Sh100,000 for Treasury Bills.
Once the auction period elapses, the government will then come back and say “We wanted Sh10 billion and we have received bids worth xxx amount.” First, they pick noncompetitive bids and leave a fraction for competitive, then the rest are cut off and will try their luck another time.
Competitive bids are any below Sh20 million. Anything above is competitive and the bidder has the luxury of dictating the interest rate which they want to lend to the government that cash. As such, they might quote a higher rate than what the government will over.
Once your bid is accepted, you are now in business with the government. If the auction was closed in January, it means from June that year you will start receiving your interest.
Once the tenure ends, in the last year, the government will give you back your Sh100,000 plus interest for that year.
Can you opt out?
There is that option and CBK warns that it comes with consequences. This could cost you three or six per cent of your investment. However, in order to ensure CBK does not penalise you, you can go to the secondary market through traders like Genghis Capital who can get you a buyer at the initial issued price. The paper will then be put on the buyer’s name and you will be issued with your money.
The new buyer then will be the one receiving the bi annual interest and the final payment on maturity.
CBK says investors who need to redeem their securities before they mature can rediscount those securities as a last resort. The Central Bank will buy the securities back, but it does so at a punitive rate to discourage investors from doing this, and recommends that investors hold their securities until maturity.
Treasury bonds are traded on the secondary market, giving bondholders the opportunity to receive money for their security without rediscounting. Treasury Bills, however, are not traded on the secondary market.
Both types of securities can be transferred to other parties.