You hear terms like upfront interest when investing in discounted instruments like treasury bills in emerging markets like Nigeria. This is not true technically. Your interest is not paid upfront. Only a portion of your money is invested while the balance is returned to you less charges.
Discounted instruments are money market instruments that are issued at a value less than the face value. You are buying at a discount. You have to wait till maturity to realize the face value. The difference between the face value and discounted value is your interest or profit.
Let’s illustrate by assuming you are buying one million naira worth 364 days tenor treasury bills at 15%. You will be required to deposit the complete face value of N1,000,000 with your broker. The summary of your transaction is as shown below:
Face Value: N1,000,000
Discounted Value: N850,000
Discount Rate: 15%
Value Date: 15th June 2017
Maturity Date: 14th June 2017
Tenor: 364 Days
Upfront Interest: N150,000
Custodian Fee (0.100%):
Commission (0.125%):
VAT 5% on Custodian Fee:
(NB: This is for illustration purposes. The minimum subscription for primary market auction is N50Million)
Assuming there are no fees and commissions, N150,000 will be credited back to your account. Your money is simply being returned to you. It is not your interest. You actually invested N850,000.
Your money back
The straightforward thing to do would have been simply to calculate the commissions/fees plus N850,000 to come up with the total amount you ought to pay. It should be clear to you how much you are actually investing.
The challenge with this ambiguity is that many investors are not growing their money. Using the example above, you walk away with the impression you invested N1Million in treasury bills whereas you only invested N850,000. You are paid the ‘upfront interest’ which you may end up spending. You end with the same N1Million at maturity.
If you knew right from the start you are investing N850,000 in treasury bills, it becomes clear you need to wait one year for your money to grow to become N1Million. It becomes easier to roll over your investment at maturity. That means waiting another year for your N1Million to grow to become N1,176,470. Consequently, at each maturity, your portfolio is growing bigger. The temptation to consume your interest is virtually eliminated.
When you are aware you invested N850,000, liquidating your investment before maturity (re-discounting) seems more straightforward. If you thought you actually invested N1Million, it may seem like you are losing money when you re-discount.
You may be wondering what difference it makes. When you really understand what is going on, you will adopt the right strategies to achieve your financial goals.
