Managing risk on the local money market
IN our bid to inform the investor on risks associated with the local money market, this week we conclude by considering corporate
bonds and commercial paper.
A company issues bonds in order to finance business ventures. The bond document will specify the interest payment terms such as quarterly, bi-annually, or annually as well as the payment date for the principal amount and its perceived credit rating.
Bonds can be underwritten by investment banks, which will then re-sell these bonds to individual and corporate investors. However, corporate bonds carry a high default risk than state bonds because a firm’s profits tend to fluctuate and at one time may not be able to meet the debt payments. The risk that is attached to a bond is dependent on the primary issuer of the respective bond.
Some institutional investors such as pension funds, insurance firms and banks are compelled by law to have a certain percentage of prescribed assets in their portfolio. This plays a pivotal role in the economy given the quantum managed by pension funds, insurance firms, banks and asset managers.
Assets that are normally granted prescribed status are government stocks, government bonds and quasi government bonds such as NRZ and Noczim bonds.
The market for smaller companies and municipals is very thin and this poses a high liquidity risk on the bonds. The investors in these types of bonds are not really aware of the specific terms of the issuer unlike in Treasury Bills market, where the investors are aware of the terms and the credit worthiness of the issuer. Bonds are prone to interest rate risk which is the uncertainty that hovers on interest rates. The interest rate risks tends to complement liquidity risk.
Bonds can be further classified as callable and non-callable bonds. Callable bonds are subject to the risk that they may be redeemed before maturity. This usually happens when interest rates tumble making it more viable for the issuer to redeem the old bonds and re-issue the same amount with a lower coupon rate.
The holder therefore yields less than what he could have achieved had he held the bonds until maturity. If the interest rates do not fluctuate, the call risk can be done away with by buying new bonds with identical coupon payments.
In order to hedge against risk when trading in bonds, it is necessary to ensure that any position taken is matched outrightly with the investor’s requirements. It is not necessary to have trading limits on counter party if the bond has some or all of the following features; tax exemption, prescribed assets, highly liquid and acceptable as security for overnight accommodation by the central bank.
Commercial paper is an instrument sold to prospective investors through a broker or financial institution.
This is issued by a fairly creditworthy company in order to finance seasonal working capital needs, bridge financing, corporate takeovers and for use in the interest rate swaps market amongst other things.
The basis upon which a company opts to raise finance through the issue of commercial paper is the entity’s high credit rating, which affords the paper a liquid status. A commercial paper is drawn in the form of a promissory note that undertakes to pay a specified amount of money at a specified future date.
The secondary market for commercial paper remains constricted due to the prevailing hyperinflationary conditions where uncertainty and risk still haunts our local investors. Commercial paper is a high-risk instrument because there is a possibility that the issuer will extend or rollover the debt by drawing another paper upon maturity of the initial offer.
All holders of such paper are exposed to risk that comes mainly from the characteristic nature of the security as all debt instruments pose credit risk to the investor. This in turn is associated with default risk, the risk of non-payment by the issuer.
Next week, we will look at various products that are offered by most fund managers in Zimbabwe.
* Elias Mugabe is the finance & risk director of Imperial Asset Management Company and can be contacted on 774341, or email: firstname.lastname@example.org.