By Mildred Moss, ContributorIN recent times, there has been growing interest in bonds specifically government bonds as an increasing number of Jamaicans are holding these securities as part of their investment portfolio. This development is attributed to several factors, namely, lower rates on bank and money market accounts, negative returns on global equity markets and sustained aversion to the Jamaica Stock Exchange since the crash in the early nineties. Bonds also offer a hedge against devaluation, as well as tax benefits for Jamaican investors.
In my profession, some investors tell me that they would never purchase bonds for their portfolio. And sometimes I'll encounter experienced investors who admit to not fully understanding bonds. However, the basics of bonds are quite easy to figure out. This article is the first in a series designed to help you do just that and to understand why bonds can be a worthwhile addition to a portfolio.
WHAT ARE BONDS?
Let us begin by asking a simple question: What are bonds? A bond is an IOU in which you, the investor, agree to loan money to a company or government or other known entity called the Issuer in exchange for a specified rate of interest over a fixed period of time. Its opposite is a stock, which represents ownership in an entity and is worth only what someone else is willing to pay for it.
When to Buy Bonds vs Stocks
One of the fundamental decisions every investor makes is whether to own or to loan. Imagine years ago, Sandals mogul, Gordon "Butch" Stewart approached you for money to say build a hotel. You are offered a choice of lending him the money with a promise to pay you back with interest after 10 years or giving him the money in exchange for shares of stock in his company... but with no promises that you will ever get back your investment. With hindsight, we all know the right choice: a stake in what has become the most successful chain of All-Inclusive resorts in the Caribbean. Therefore, if your priority is to make as much money as you can because you believe in a company's prospects, you should buy the stock. However, if the offer were made by former Sandals rival, Ciboney, a Bond or IOU would have been the better choice. Why? Because Ciboney would have been required to honour the promise to repay the face value or principal of the bond on its specified maturity date, as well as interest payments twice a year in the meantime. On the other hand, investors in Ciboney stocks would have ended up owning "property" that they could not sell. Therefore, if your priority is to be repaid with interest and to minimise the risk of losing your principal you should consider buying a bond.
WHO ISSUES BONDS AND WHY?
Issuers of bonds may be classified as: supranational agencies, such as the World Bank; national governments, such as the Government of Jamaica (GOJ); provisional or state governments; and corporates, such as JPSCo. We have given you an example of the reason that a corporate entity might borrow via a bond issue. Now, let us take a closer look at government borrowing.
GOVERNMENT BONDS
When a Government runs a deficit because current revenue from taxes is not sufficient to meet all expenditures, its spending is financed at least in part through borrowing. Large sums of money are required annually for capital expenditures on schools, hospitals, roads, etc. and the practice has developed whereby governments or their agencies borrow money to finance these capital projects. Taxes are then levied in subsequent years to pay the principal and interest on such borrowings, since the assets for which they have borrowed are expected to last for many years, and to benefit both present and future generations. Bonds issued by the Jamaican Government are backed by the full faith and credit of the Government, irrespective of the party that is in power. And since the Government exercises broad taxation powers to make bond interest and principal payments, these securities are deemed to be of a higher credit quality than the securities of any other Jamaican borrower. As such, GOJ bonds are the standard by which all other local bonds are measured. It should be noted, however, that Government debt of J$495B or 133 per cent of GDP and government deficit of J$14B or 3.8 per cent of GDP are problems in and of themselves. Increased Government debt such as that resulting from the issuing of bonds will not be repaid in the foreseeable future. Instead when government bonds mature they are refunded by selling new bonds to raise money to repay them.
Note, too, that interest payment so called debt service already consumes 50 per cent of Government revenues. As both debt and debt servicing increase more rapidly than production, the increase is clearly not sustainable and will be eventually stopped by a crisis, if not by deliberate restraints on Government deficits.
Mildred Moss is Chief Operating Officer of Sterling Asset Management Ltd.
