Jacques Magliolo
If you’re in the enviable position to have enough money to invest in unit trusts, chances are you’ve been encouraged to invest part of your portfolio in bonds.
But bonds appear to be complicated, jargon-laden creatures with names like the “benchmark” R150. Actually, they are simply loans.
For instance, if the South African government needs R5-billion to build a railway network, it can raise the money by issuing bonds. The government calls this bond issue Track100 (T100). Its specifies that each bond issue (tranche) has a face value of R100, with a maturity date in 2020 and carrying a coupon rate of 15% a year.
This means you can buy bonds at R100 each, earn interest (coupon) of 15% a year for 22 years, after which the state will buy back the bond for R100 each.
The bond issue allows the government to raise funds without digging into tax income. To entice investors, it can provide incentives. For example, the T100 bond could be offered for R90, which is a discount rate of 10% or R10. On maturity, the owner of the bond would still receive the full R100.
Since you are lending money, an important factor is the bond issuer’s credit-worthiness. Bonds are rated by credit rating agencies, like Moody’s and Standard & Poor’s. The highest ranking given to and issuer with the best credit is a AAA and the lowest ranking, D, is given to issuers who have defaulted on their loans.
Like shares, bonds, also known as “gilts”, can be traded on the open market via the Bond Market Association of South Africa.
Short-term bonds, which mature in two to five years, are the least risky, while intermediate-term bonds (maturities of five to 10 years) experience larger price fluctuations.
Bonds offer a steady income that will outperform bank accounts or money- market funds in the long term and protect against declines in the stock market.
Individual investors tend to get exposure to the bond market through gilt unit trusts or through options, since direct investment is often very expensive.
Bonds are affected by unpredictable economic indicators such as the recent interest rate hikes and falls. Whenever interest rates go up, the yield on existing bonds goes up, but the value of the bond goes down.
Yield is measured by dividing the interest amount by the price of the bond, so if the price goes up, that ratio is lower. Yields rise when prices drop because bonds pay a fixed amount of interest with every payment.
The relative value of that interest goes down if you pay more for the bond and goes up if you pay less. For example, if you pay R110 for the bond, compared to R100, and receive R15 interest, your interest rate is 13,6%, compared to 15%.
Since the bond market is sensitive to interest rate fluctuations, its performance is regarded as a barometer for financial markets’ sentiments towards the economy.
ENDS