Bonds: an investor's nirvana or nemesis?

Time of article published Sep 13, 2003

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With investors desperately trying to improve the cash flow or income and yield on their investments, many are casting covetous eyes at the historical returns that bond investors have achieved over the past two to three years.

The million dollar question, as always, is whether this trend will continue. Of course investing is never without risk and bonds have already given back some of their gains. Yields on government bonds have weakened by 10 to 20 percent since the lows they reached in the second quarter.

Bond prices generally fall when interest rates rise and vice-versa so the still favourable outlook for inflation is supportive of bonds, but higher-than-expected wage settlements have put a damper on this. Nevertheless, it seems the Reserve Bank will comfortably achieve its inflation targets by year end and next year's inflation rate could be substantially below the bank's target of six percent.

Another cause for concern would be a sharp increase in the supply of bonds, as the government is forced to raise funds to cover a larger-than-expected budget deficit resulting from lower-than-budgeted revenues.

The chief culprit for this is the rand, the strength of which has decimated the earnings of exporters and damaged the profitability of mines.

Bond investors must also be concerned that the precipitous drop in interest rates in the United States seems to have come to a halt. The yield on 10-year US treasuries is in fact 20 percent weaker than its recent best levels. With growth prospects improving and interest rates bottoming out, US bonds also seem more vulnerable.

Local bonds strengthened considerably this week in anticipation of a one percentage point cut in interest rates, which the Reserve Bank duly delivered on Wednesday. Even so, we can expect at least one, but hopefully two, further cuts in the repo rate before the end of the year, which would obviously be supportive of bond returns.

So, what bonds should investors be looking at and what are the risks?

Government bonds are the safest and are the benchmark against which other bonds are measured. By using the yield on government stock over a suitable term as a base line and making various adjustments, one arrives at the risk-free rate of return, which is used in many bond valuation models.

Of course bonds issued by companies potentially yield a greater return as the risk on these bonds is generally higher than on government bonds. Of vital importance are the terms of the issue, which set out when interest and capital will be paid to you and where you rank among creditors if the company defaults on any of the promised payments.

If the company fails, only a portion of your capital may be returned, while if the financial position of the company deteriorates, the returns on your bonds will be negatively affected.

To assess the quality of a company's bonds, you need to be able to read annual financial statements, assess the outlook for the company and rate the company's sensitivity or vulnerability, which is a complex exercise. These are the same skills required to assess any share investment, so if you decide to invest in bonds, particularly those issued by a company, you really should consult your investment adviser. Don't try this at home.

In a nutshell, international interest rates may have bottomed out, and while domestic rates are still falling, rising interest rates in the major economies will at the very least severely curtail the Reserve Bank's manoeuvrability.

Bonds have had a magnificent run and at current levels are pricing in a lot of good news, so valuations are perhaps a bit stretched for the time being.

The flip side of this coin is that, as the yields on cash and near-cash investments tend towards zero, some stalwart dividend-paying stocks are starting to look quite juicy.

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