Exploring The Benefits Of Bond Issuance In Nigeria

LAGOS, Nigeria, Capital Markets in Africa: Tax Savings Benefit Issuers of bonds enjoy some tax benefits from the deductible nature of the interest on bonds. On one hand this lowers the issuers’ taxes. On the other hand, dividends paid to equity holders are not tax-deductible and must come from income after-tax. Tax savings, therefore, help further reduce a company’s debt financing cost.

Cheaper Cost Source of Funding

Debt is generally cheaper than equity, because debt is less risky from the investor’s viewpoint. In an event of liquidation, the creditor will rank higher than the shareholder in the priority of claims and bondholders are paid before equity. Therefore this makes debt a less risky investment than equity and hence bondholders demand lower rate of returns than shareholders. Capital market sources of debt tend to be cheaper than direct lending like bank loans because it is a more efficient source of debt. Therefore, by introducing debt in its capital structure through bond issuances, the Issuer’s Weighted Average Cost of Capital (WACC) will reduce up to its optimal capital structure or credit capacity. A further introduction of debt in its capital structure beyond this optimal point will cause the Issuer’s cost of funds to increase as a result of potential credit risk of a highly geared firm.

Increases the Market Value of the Issuer

As a result of the afore-mentioned point, bond issuances increase the market value of the Issuer. The value of a firm is the sum of its discounted future cashflows and there is an inverse relationship between a firm’s value and its cost of capital; the lower the cost of capital, the higher the present value of its future cashflows and the higher the market value of the firm. As such, as the Issuer’s cost of funds or WACC reduces as a result of introducing debt in its capital structure up to its optimal point, the firm’s future cashflows are less discounted and thus the firm’s value is much higher.

Less Accountability Requirements

Issuing bonds as opposed to issuing additional equity saves the Issuer the bottlenecks of greater regulatory requirements, disclosure and accountability and scrutiny. Compared to bondholders, shareholders have more onerous requirements as they are the true owners of the Company and management are obliged to accord them all the rights of a principal as stipulated in a typical Principal-Agent relationship. Bond holders are not entitled to such rights even though they have other monitoring mechanisms like bond covenants.

Information Signalling

Bond Issuance announcement is an opportunity for Managers to signal the future cashflow prospect of their firms. Companies will only issue bonds when they are confident that cashflow from the proceeds utilization is sufficient to pay the interest and repay the principal of the bond. As such, the market will take an announcement by a firm to issue bonds as a positive signal of the firm’s future cashflow and thus may react positively to the bond issuance. Based on information asymmetry that exist between managers and investors, when the firm’s asset-in-place is undervalued, managers have the propensity to issue bonds to finance investment or pass up on the investment opportunity by waiting until shares are appropriately valued, rather than use equity to finance such investment opportunities.

Currently, considering the market has seen more of bearish trend and how much of value companies listed on the NSE have shed in the last couple of months, some companies may be undervalued. As such, it may not be appropriate to issue equity as the shares of the Company will be inappropriately priced. Whereas, issuing debt with adequate credit enhancement may be a better option for the Issuer.

by Chuks Izu, Associate, Dunn Loren Merrifield Limited, Nigeria

Contributor Profile: Chuks is a seasoned Financial Markets Analyst with broad experience in fixed income, money markets & FX markets as well as portfolio management & investment advisory. He currently works as an Associate; Asset Management/Investment Research at Dunn Loren Merrifield. He pioneered the setting up & management of DLM research portal on Thomson Reuters platform, whilst overseeing the domestic platform: A portal currently used by domestic & international risk  managers, traders, portfolio/fund managers, regulators, financial consultants & reporters, students amongst others to access qualitative & quantitative reports on the Nigerian financial markets.

Chuks graduated from the prestigious Ahmadu Bello University, Zaria in 2007 where he bagged a BSc in Economics with 2nd Class Upper Division. He equally gained an MSc in Economics from the prominent University of Lagos, Akoka in 2015. Chuks has attended several courses at FDHL Training Institute on Fundamentals of Financial Markets, Gilts Game (Bonds with simulation) and Zerocs (Money Market/Treasury bills with simulation).

This article features in INTO AFRICA August 2016 edition which focuses on the Bond Markets in Africa.