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The Story of Debts

Investing May 25, 2020

Bonds, T-Bills, and Sukuk

Do you think it is the “Can you lend me $200?” kind of debt?

Well, no, that isn’t what I was referring to. The debt of the big boys in the room is what I’m referring to here. Here we’d go all-in on debt financing.

Bringing back my bakery story here;

Let's say I own a bakery and sell all my goods without delivery services. After some years, I decide to open up another branch some miles away, but I don't have enough money for that. What do I do?

  • Option A: I give up and do not expand
  • Option B: I borrow money from a bank, friends or relatives
  • Option C: I collect money from people, and we become co-owners of the bakery — proportional to the money they give me.

A is definitely not an option if I genuinely want to expand. Option B is debt financing. I must pay back the money I borrowed. Option C is equity financing.

Read about Option C below

Understanding Stocks — minus the maths
A simplified explanation would be a stock is similar to a pizza. When you and nine of your friends contribute equally to buy a pizza.

Option B is today’s story.

BONDS

When companies ask for money from the public, they issue bonds. Bonds are instruments — papers representing loans an investor gives (to a company or government).

WHAT HAPPENS WHEN YOU BUY BONDS

When you buy bonds, you borrow money from whoever you are lending it to.

When you lend people money, they pay interest, just like when you borrow from a bank. Here, however, the company or government sets the interest it would pay and how it would pay you, and there is no collateral. The company does not give collateral. You buy bonds from a company or government with good faith, i.e. you believe they would pay back the loans and interest.

THE PROSPECTUS

The bakery says, “Hello guys, please, I need $1,000,000 for expansion. I need you to lend me money. You buy a 5-year bond with a minimum subscription of $10,000 at $1000 per unit. I pay you 5% interest per annum. Payment is semi-annually ”.

When a government or company wants to issue bonds, it releases a legal document that states everything you need to know about the bond. It could be dense or a summary. Here are the essential features  you should know:

Conditions and timing of the interest payment: The how and when the interest would be paid is clearly stated. Like in the case of the bakery above, 5% interest would be paid, and the bakery would pay the amount twice a year, i.e. 2.5% interest every six months.

Amount of bonds issued: This states the number of bonds. However, it isn’t written in some cases; it is said in monetary value. Like $1,000,000 bonds at $1000 per unit which means 1000 units are issued.

The minimum number of bonds that can be purchased: This is the lowest amount you can buy. Like in the example above, “minimum subscription of $10,000 at $1000 per unit”, so the lowest unit of bonds you can buy is 10.

Maturity date: This is when the money you lent the government or company is returned. This is the date your agreement comes to an end. In the example above, the maturity date is five years after the issuance date.

Options for call and call protection: Sometimes, the government or company might decide to return your money, which means your interest payment won’t hold again. Like someone cancelling your date, It kinda hurt. So, in the prospectus, you get to know whether they could call the bonds or you are protected; i.e. they can’t call the bonds until at least a certain time has passed.

Credit rating: Nobody wants to borrow money from a person, company or government that would default (won’t pay their loans back). A credit rating shows the credibility of the bond issuer. There are different rating organizations that rate companies and governments. The issuer’s credit quality is one of the most significant features to look for in the prospectus.

A higher credit rating means a corporate bond is less likely to default.

SUKUK

Sukuk is the Islamic equivalent of bonds. Sukuk are sharia compliant, i.e. they abide by all the Islamic laws.

Unlike bonds, Sukuk represents asset ownership and not a debt obligation.

Sukuk Prpspectus by the Federal Government of Nigeria

In essence, it means you own part of an asset. The return you get (profit) is based on the performance of the asset. The assets must also be sharia-compliant,i.e. free from interest, alcohol, porn, pork and weaponry.

The Sukuk is rated based on the asset, unlike bonds.

TREASURY BILLS

Also referred to as T-bills, these are short-term bonds issued by the government, backed by the treasury or central bank as the case may be. T-bills provide short-term funding for the government and are usually issued in denominations of $1000 (US). They are referred to as short-term bonds because their maturity date is typically a year or less.

T-bills are sold at a discount and redeemed at par value.

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Photo by Annie Spratt / Unsplash

CONCLUSION

All these instruments are called fixed income — as the name implies, you get a fixed amount over a period. Government bonds, government Sukuk and T-bills are considered “risk-free” because the risk of default for the government is very low, almost impossible — because the government can always print money to give back to the investors.

Except for Sukuk, all other instruments are debt obligations.

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