You have a friend, called Otieno who needs a loan for his butchery. You don’t have time yourself to run that kind of business but you believe there is opportunity in the meat industry and you figure out that you might as well benefit in some way from the returns of this business. So you lend Otieno Ksh.100,000 payable in three years which he will use to refurbish his butchery.
However you can’t lend Otieno Ksh.100,000, wait three years and only get back Ksh.100,000. That would be unfair to you because you could have done something else with the money i.e. there is an opportunity cost to lending Otieno the money.
So Otieno agrees to pay you interest of 10% p.a. to compensate you for this opportunity cost. Because of the nature of how money goes in and out of his business he can’t pay you every month. At the same time it is not fair on you to have to wait till the end of the year or end of three years to get your return.
Otieno therefore agrees to pay you interest every six months or semi- annually. In a year you would be earning Ksh.10,000 (10% of Ksh.100,000). If he is paying interest every six months that will translate to you earning Ksh.5,000 every half year for three years.
The last payment at the end of three years will be the final interest of Ksh.5,000 plus you will get back the initial capital invested of Ksh.100,000; which is a total of Ksh.105,000.
That's how Treasury Bonds work. This is an area that a lot of people would like to invest in it but think it is very complicated. I agree the way information is displayed about Bonds, it's not very user friendly. However our scenario above with Otieno is exactly how most bonds work only that Otieno is the government.
The government borrows from us to finance certain expenditures like infrastructure, development etc. The loan that we give the government is referred to as a Bond. Depending on the intended use of the funds, bonds can be issued from 1 year to 30 years. This is known as the tenor of the bond. The interest rate a bond will earn is referred to as the coupon.
If you invested in a three year bond with a coupon rate of 10%, the payments to you will be paid semi – annually in the exact same way as when you invested in Otieno’s business.
Now Otieno can decide to raise Ksh.1,000,000 for his business from various investors. Some will give 100,000; others 50,000; and others 200,000 depending on their ability at the time. All Otieno is interested in is getting to a total amount of Ksh.1 million. Whether you put in Ksh.50,000 or Ksh.200,000 you will all earn an interest rate of 10% p.a. on your money.
In the same way the government can opt to raise even Ksh.15 billion from various investors but the minimum they will take from any one investor is actually Ksh.50,000. So as long as you have Ksh.50,000 you can invest in a bond.
Bonds, contrary to popular belief are not only for the wealthy or for institutions. If you put in Ksh.50,000 and someone else Ksh.50 million you will earn pretty much the same coupon (or interest rate) on your money. Many people look at the Ksh.15 billion the government is trying to raise and instantly think their money is too little.
*Written By*: Justine Nyachieo
Business Man & Mentor
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