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By Danine van Zyl*
Many investors do not fully understand what bonds are, how to invest in it or what value it can add to an overall investment strategy. If used effectively, it can make a healthy contribution in a comprehensive strategy and be of value to investors who need to generate income and preserve investment capital.
A bond is a fixed income security that promises to pay a stream of annual of semi-annual payments for a given number of years and to repay the loan amounts at the maturity dates. The bond issuer borrows money from the bond holder to acquire money for capital expansion or to finance a specific project.
Bonds are issued by companies, public corporations, and governments. Bonds are capital market debt instruments and have durations ranging from several months up to 30 years.
In South Africa, the JSE has regulated the debt market since 2009 and there are over 1,800 listed bonds currently trading on the JSE.
Types of bonds
The most well-known types of traded bonds are government bonds, municipal bonds, and corporate bonds.
Government bonds are issued by the South African government denominated in the country’s own currency, namely Rand. Government bonds are usually referred to as risk free because the government can raise taxes or create additional currency in order to redeem the bond at maturity. A sustainable and robust bond market is reliant on a developed and well-functioning government bond market.
Municipal bonds are issued by South African municipalities to generate income with which to fund capital expenditure on, for example the construction of schools, bridges, and other essential infrastructure. The Johannesburg Metropolitan Municipality was the first local entity to launch public listed bonds in 2004.
Corporate bonds are issued by private companies to obtain dept financing for projects or capital business expansion. The corporate bond market comprises a much smaller percentage of the nominal value in issue compared to the government bond market. Compared to government bonds, corporate bonds have a higher general risk of default. The risk depends upon the specific corporation issuing the bond, the current market conditions, and government bonds to which the corporate bond issuer is compared as well as the rating of the corporate. Corporate bond holders are sometimes compensated for this risk by receiving a higher yield than Government bonds.
Bonds are included in different types of funds, but a larger allocation of bonds will be included in a lower risk type of fund such as an Income fund. Fund managers include different types of bonds within their funds to ensure diversification in issuer, duration, and currency.
What are the risks?
Interest rate risk – the risk to which a portfolio or institution is exposed due to the uncertainty of future interest rates. Due to the interest rate sensitivity of bond prices, if rates rise, then the present value of a bond will fall. Interest rate risk thus refers to the effect of changes in the prevailing market rate on the return of a bond and comprises of price and investment risk.
Credit risk – the risk that the credit worthiness of a bond issuer will deteriorate, increasing the required return on that bond and decreasing its value. Credit risk as such comprises of default, credit spread and downgrade risk.
Liquidity risk – the risk in bonds is because of the difficulty of selling securities quickly at an attractive price. This only applies to the investor who is looking to sell his/her bonds before its maturity date. Investors who keep the bond until maturity will receive the principle of the bond plus interest on their face value.
When investing in bonds, many advisors include options like income funds in portfolios, where appropriate. A popular fund used is the Mi-Plan IP Enhanced Income fund, which has outperformed the JSE successfully and provided greater returns than equity over the past five years, and with much less volatility.
The performance of bonds over the past five years.
The MI-Plan IP Enhanced Income fund is a typical income fund that is used in the fixed income space. The fund currently comprises of Government bonds (18%), Corporate bonds (58%) and cash and cash equivalents (24%). The modified duration of the securities is 0,96%. The fund’s superior performance compared to the JSE over the past five years is illustrated graphically below:
The performance of bonds during the recent market correction
In March 2020 South Africa experienced the sharpest correction in our bond market in recent times. Despite of this downturn, investors were still able to receive a positive return for the year to date.
The return received from bonds is taxed as interest in the hands of the investor. For investors who are 65 years old or younger the first R23 800 is tax free and for those older than 65 the tax-free amount is R34 500. Any interest above these amounts will be taxed according to the individual’s marginal tax rate. Within different types of investment vehicles, tax implications may vary. For example, investors who invest in bonds through an Income fund in a Tax-Free Savings account, or Retirement Annuities no tax will be payable on the interest earned.
Bonds should be considered as part of investment portfolios given the excellent risk adjusted returns and lower volatility compared to other asset classes such as SA equities. The percentage asset allocation to bonds will depend on the investor’s specific risk profile, income requirements and financial objectives.
Read more about Investment Planning.
- Danine van Zyl is a financial advisor at Brenthurst Wealth.