How government securities work

Brokers trading at the stock market in Kampala recently. PHOTO BY ERONIE KAMUKAMA

What you need to know:

Many people always want to invest in different income-generating ventures, but few think of government Treasury bills or bonds. Could this be that there is a general lack of knowledge about these two? Mark Kamugisha demystifies what these bills and bonds are.

The government has to undertake a lot of work and this work costs money.
While it raises funds through taxes and other means, this may not always cover its needs. If one thinks of the government as a household, it has an income (taxes), it has expenditures (salaries and so on) and from time to time its needs to borrow.

The government borrows by issuing securities known as Treasury Bills (T-bills) and Treasury Bonds (T-bonds). These securities act like an I.O.U (I Owe You). People hand over their Shillings and receive a promise from government to pay them back.

T-bill or T-bond auctions are referred to as the Primary Market because it is the first time the securities are being traded. Thereafter, any trades (purchases or sales) are undertaken in what is known as the Secondary Market.

Treasury bills
T-bills are known as discount instruments. This is because they are securities that one purchases at a discount to its value. An example is a 1 year T-bill where government promises to pay you back Shs1m in one year. Purchasing this security will cost you less than Shs1m. If you are expecting a 13 per cent return (or yield) then it will cost approximately Shs885,250. If you expect a 20 per cent return, then it will cost even less, approximately Shs833,750.

As you can see the greater the expected return the cheaper the initial cost. Treasury bills can be bought in maturities of 91 days, 182 days and 364 days. This means that 91, 182 or 364 days after giving government your money, they will pay you back. Treasury bills are auctioned every two weeks by Bank of Uganda (BoU) and bids can be made through commercial banks. The returns on offer for T-bills are determined by market forces and these include: Availability of cash, expectations around the Central Bank Rate and appetite from investors, amongst other factors.

Treasury bonds
Longer term investors are better suited to investing in Treasury bonds. T-bonds are issued with maturities of 2 years, 3 years, 5 years, 10 years and 15 years.

However, unlike T-bills, T-bonds will pay you income whilst you own them. T-bonds in Uganda pay what are known as coupons. These are payments made to bond holders every six months until the maturity date. Coupons are fixed per cent payments that do not change.

At the maturity date, government will pay back your principal. This is why bonds are known as fixed income securities.

Treasury bonds are auctioned monthly by BoU and applications can be made via commercial banks. The same factors affecting interest rates for T-bills also apply to T-bonds. Whilst T-bills are generally purchased at less than their value – it is not the case for T-bonds. T-bonds can be bought at a premium or discount to their face value.

Roughly, we can state that T-bonds trade at a premium (cost more than face value) if the purchase yield is higher than the coupon rate. Alternately, T-bonds trade at a discount if the purchase yield is lower than the coupon rate (costs less than face value).

Fixed income securities provide a known income stream that is fixed and does not vary. This is the reward. However, the down side to a fixed income investment is that it may be adversely affected by inflation. Inflation is a real risk to bond holders because it reduces the purchasing power of their Shillings. Imagine holding a bond from 2017 all the way to its maturity in 2032. The prices of goods and services may be very different in 2032 compared to 2017.

Bonds as stated earlier are effectively a promise to pay you back later. What if the borrower is unable to pay you back? When a borrower cannot meet their obligations, it is known as a default. While governments are generally good borrowers, they have been known to fail to pay back their obligations. This has been witnessed in Russia, Argentina and other countries.

Technically, a government can just print the money it needs to pay everybody back. However, this can cause a lot of problems with many further unintended consequences. Printing money can lead to hyper-inflation (the rapid loss in the purchasing).

BoU appointed six commercial banks to be primary dealers who are mandated and obligated to show buying and selling prices in government securities. As with any asset, the value of your bonds and bills will fluctuate. This presents you with market risk. You may sell your security at a lower price than you paid for it. Or you could sell it at a higher price than you paid for it.

How do I invest?
The good news is that it is relatively simple to invest in Uganda Government Securities. All the details are available on the BoU website. In short, you will need an account with a local commercial bank, a TIN, a CSD account and of course some money.

Step 1, open a bank account. Step 2, obtain a CSD account with BoU to hold your securities, this is done with the help of your bank. Step 3, fill in bid application forms for auctions or approach your friendly securities dealer for a quotation.

The minimum amount that one can purchase from an auction is Shs100,000. All bids up to and including a volume of Shs200 million will automatically be awarded at the average yield from the auction. If you bid for more than Shs200 million you will be a competitive bidder and must be able to input the price at which you are prepared to buy. In competitive bidding you are not guaranteed to be awarded any securities.

Why invest
Backed by the government they present little risk as the government is highly likely to pay you back. The income is stable and known, and little effort is required to get paid.