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By Suzean Haumann CFP®
Bonds don’t often come up in dinner party conversations as exciting investment strategies or as an investment opportunity ripe for the picking. But maybe they should, especially as we move out of the high-interest-rate world we’ve been living in for the past few years.
Here’s why: From March 2022 to October this year, SA government bonds outperformed domestic equities by about 11%, at roughly half the volatility. This is a return of inflation plus 6.5%, which is what you’d normally expect from equities.
More importantly, we’re at the top of the interest hiking cycle, which means that as rates start to drop so the returns from bonds also start to taper off.
Confusing much? Don’t worry, I’ve put together this explanation of what bonds are, how they work and react in different market conditions, and ultimately why you shouldn’t ignore them.
What are bonds?
When you buy a bond, you’re essentially lending money to an entity like the SA Government when National Treasury issues bonds to raise funds to run the country. Private and listed companies also issue bonds as an alternative way to raise funding, but for the sake of this article we’re referring to government bonds.
The bond issuer essentially commits to paying you a fixed amount for the life of the ‘loan’ – 10 years is a common contract period – and then returning your initial deposit at the end of the term. So, you get regular income (usually monthly) that you can count on.
Simple enough right?
Some of the confusion around bonds is because of the different terms used to explain commonly-understood concepts found in other investment types.
Bond coupon: The amount of money you receive as ‘interest’ payments from your loan to the government.
Bond price: This is the unit cost per bond. Although it can be confusing because this price varies according to a number of factors explained below.
Bond yield: This is essentially the percentage ‘interest’ that you receive. And this can also vary according to different factors.
How Bonds Work
Let’s say you buy a 10-year bond with a R1,000 face value that pays a R100 annual coupon (interest payment). This will give you a yield (interest rate) of 10% for the duration of the bond … as long as you hold onto the bond to maturity.
Because if you don’t then you enter into the more misunderstood characteristics of a bond, which is that the bond yield and price change over the life of that bond. But only if you’re selling before the 10 years are past, or buying in after the start of the 10-year period.
The price change affects only those who are selling out at that point – before the 10 years is up – and for those buying the bonds at that point. However, if you buy and hold a 10-year bond at a 10% yield your income will remain unchanged even as the bond yield changes over its life.
This predictability is one of the reasons that bonds are a popular diversification tool.
Bonds vs equities
An even more important diversification consideration is that bonds tend to increase in value when listed equities are losing value. Which is why bonds are commonly used to hedge against falling stock markets.
The diversification argument is strengthened even further by the fact that bonds are typically less volatile than equities.
However, the stability in bond prices recently has been less consistent, with the trailing 12-month annualised bond market volatility coming in at over 9% by October this year. This is higher than the long-run average of 7.6%, but still at least half of the volatility of equity markets.
What has surprised many has been the relative stability of SA Government bonds despite the economic challenges.
Local is lekker
South African bonds have outperformed developed market bonds in recent years. Despite our high debt-to-GDP ratio (currently above 70%), SARB’s Monetary Policy Committee managed to steer inflation back towards 4.5%. The expectation is that interest rates will steadily come down as long as we remain in the Reserve Bank’s 3 – 6% inflation target band.
This means that the period of long RSA bonds yielding around 13% could end.
Investing in SA bonds now offers the potential for inflation-plus returns. The combination of government guarantees and the possibility of capital appreciation from interest rate cuts presents a compelling opportunity.
**Sources: DFM Global and Rowan Williams-Short (Vunani Capital)
Suzean Haumann is a Certified Financial Planner® professional and head of Brenthurst Wealth TygerValley. You can email her at [email protected].
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