Get to know the basics of Government Bonds

Basics of government bonds - Afrika Kesho

You can lend the government your money

The South African government needs money to operate. Unfortunately, as you would have seen or heard on the news recently, the South African economy has not been doing all that well. This has been the case for the country because the economic growth levels have been disappointing to say the least, as seen with the technical recession avoidance, and the fact that most state-owned enterprises remain submerged in large sums of debt. As a country, we have also seen many headlines that speak about the shedding of jobs by companies, especially within the
banking industry.

The source of the money needed by our government can come from within South Africa, from citizens and companies that operate within the country, or from external sources that are outside the borders of South Africa, from international banks that lend money to governments and from private citizens of other countries who are able to make investments in South Africa.

The important thing to note about money from within the South Africa by citizens and companies to its government is that it does not come from just charging VAT and other taxes to citizens and companies. The money needed by the government can also come in the form of debt. More specifically, citizens and companies lending money to their government. The instrument of this lending is called a “bond” – the focus of my article series with Afrika Kesho.

The essentials of a bond

What are bonds?

Bonds are a financial instrument that obligates the issuer of the bond (for example, the government) to make fixed payments at regular intervals (e.g. per month, every six months, etc) until a certain date. When a bond matures, the bond’s ‘face value’ (which I’ll explain in a moment) is also repaid. To make things easier to understand, bonds can be thought of as regular loans issued by banks to consumers. In this case however, the citizen can be thought of as the “bank“ and the government can be thought of as the “consumer” who asking for a loan from the bank.

Who can issue bonds?

Institutions ranging from small start-up firms to National Governments issue bonds in order to raise funds. These funds are debt to that institutions and they are used, as an example, to finance government activities and projects.

Bond jargon explain

The most important components of a bond are the face value of the bond, the coupon rate, the yield to maturity, and the term of the bond. All of these components relate to each other, and here are explanations for each of them:

  1. The Face Value or Par Value: This is the price that the bond is initially sold for by the issuer to the public. For example, the government could issue a R1000, 10 year bond, with a yield 5%.
  2. Coupon Rate: The coupon rate is a percentage of the bond’s face value and represents the amount of the coupon payments made to you. Continuing from the example above, the 5% would mean that you would get R50 per year, divided by the number of payments you get from the issuer per year. The coupon payments are made to compensate the bondholder for the inability to use their funds, and to encourage the investor to invest in that particular bond.
  3. The bond price: This is the price that the bond is currently selling for. The bond price can either be priced below the face value, in which case we it a discount bond, or it can be selling at the face value, which case we say it is selling at par, or it can be priced above the face value, in which case it’s called a premium bonds.
  4. Yield to Maturity (YTM): the yield to maturity of a bond is the total amount of money you would if you held a bond until it matured.
  5. The maturity or term of the bond: The maturity of the bond is the amount of time (quoted in years) that the investor will have to wait before the bond’s face value is repaid. It will be at this point that the contract expires and the bondholder is no longer entitled to regular coupon payments. From the example above, 10 years is the term of that bond.

In summary, you lend money to a borrower through a contract known as a ‘bond’, the borrower pays you a portion of the bond’s value at set intervals until the expiry of the bond, at which point, the face value of the bond, as well as the the last coupon payment, are repaid to you.

Now that you understand the basics of how bonds work, next time I’ll be covering the particulars of a government’s inflation-linked bonds.

This article was written by Liso Mdutyana.

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