This article first appeared in Personal Finance Magazine, 4th quarter 2017

It’s very likely that you are indirectly invested in government and corporate bonds, one of the four mainstream asset classes for investors (the others are listed shares, listed property and cash). 

Retirement funds and endowment policies will certainly have bonds in their portfolios, as will almost any unit trusts that are not purely equity-based. 

So what are bonds, why are they an important asset class, and how do they work?

Most financial instruments, including shares, bonds and derivatives, are based on simple concepts. The instruments have become complex only through taking on a life of their own. In the case of bonds, the underlying concept is a simple promise, as in “my word is my bond”.

The promise is that you will repay the money I have lent to you – in other words, it’s an IOU. The conditions attached to this promise include the term of the bond – for how long the money is borrowed, with a date by which it must be repaid – and the cost to the borrower, which would normally be in the form of interest, paid at regular intervals over the term.

Say you (Mr A) lend R1 000 to a friend (Mr B), who needs it to start a business. You agree that he will pay back the money after five years and will pay you interest at six percent a year. Each year, he is bound to pay you R60 in interest, and, at the end of the five years, he must return your R1 000. Essentially, you are investing in your friend, at a return of six percent a year. 

What’s so complicated about that, you may ask?

Say that, when Mr B borrows from you, the bank savings rate on such an amount is five percent. By investing in Mr B instead of putting the money in the bank, you are earning a higher return (six percent). But what if, soon after lending to your friend, the bank ups its interest rate on a R1 000 deposit to seven percent? 

You can’t renege on your agreement with Mr B. Your contract, or “bond”, is that he pays you the six percent-a-year interest and pays back your R1 000 only after five years. 

What if you could “transfer” the agreement to someone else? You decide to “sell” this bond to Mr C at a slightly discounted price of R950. Mr C would score, because he is receiving R60 a year from Mr B on only R950, which works out to a slightly higher annual return of 6.3 percent (he hasn’t heard about the better bank rate), plus he gets R1 000 (just over five percent more than he paid for the bond) at the end of the five-year term.

You get R950, which you are now free to invest in the bank. At the higher rate of seven percent, you will still be earning a better return in rand terms, of R66.50 a year, although your capital will have dropped by five percent. Meanwhile, your friend, Mr B, is still in possession of the R1 000 and paying the six percent interest, but now to Mr C.

What is the case when the reverse happens and the bank rate goes down to four percent? You might be tempted by an offer by Mr C to sell your bond to him for the higher price of R1 100. You will make an immediate R100 and Mr C will be happy, because he will be getting R60 a year on R1 100, a return of 5.4 percent, which is still better than he’d get at the bank.

ALSO READ: Asset classes: what they mean and why they matter

This example demonstrates an important feature of bonds, which, like shares, are traded on a secondary market: when a bond’s price drops, typically on the back of rising prevailing interest rates, the bond’s return on investment, or yield, rises. When its price rises, on the back of falling interest rates, its yield drops.

So there are two ways you can make money on bonds: on price, by trading them over the short term (buying low and selling high), and on yield, which would be more of a long-term investment.

(Note that the equity market works in much the same way, with a lower share price usually translating into a higher yield. However, the yield on a share, which is the dividend the company pays to shareholders, is subject to a number of variables, the main one being the company’s profitability.)

On a bond, the capital amount to be repaid to the lender is known as the principal. The interest rate on the bond is the coupon. And then there is its expiry date, on which the principal must be repaid.

Issuers and users
Bonds are issued by governments to raise money as an alternative to increasing taxes on the populace. They are also issued by corporations as an alternative to issuing shares or borrowing from lenders such as banks. They are issued for large amounts (R1 million, for example), so they are not directly accessible to most individual investors. However, they are used extensively by institutional investors, such as life assurance companies and retirement funds, which is why, whether you like it or not, you are probably indirectly invested in them.

Bonds can be higher- or lower-risk, depending on the issuer, but overall, as an asset class, they are less risky and their prices less volatile and more predictable than equities. That said, they do not offer the same levels of returns over the long term.

You get short-term bonds, with a duration of a year or less, and long-term bonds, which, in the case of government bonds (also known as sovereign bonds, treasury bonds, or simply treasuries), can be up to 30 years.

To make things a bit more complicated, the interest rate on the bond may be not be fixed for the term of the bond. A bond may have a floating rate, linked, for example, to the inflation rate, or it may have no interest rate at all, but offer a discount to the initial buyer (who, for example, may buy a R1-million bond for R900 000).

There are three main factors that determine the coupon when the bond is issued: 

1. The prevailing interest rate charged by banks, which, in turn, is linked to the repo rate set by the South African Reserve Bank and the inflation rate. In South Africa, the Johannesburg Interbank Agreed Rate (Jibar) is normally taken as the benchmark on which the interest rate is set. The difference between the benchmark rate and the actual rate is known as the margin.

2. The risk of the issuer (corporation or government) defaulting on the debt: the higher the risk, the higher the interest rate must be to attract investors. This risk may be reflected in the entity’s credit rating, as determined by rating agencies such and Standard & Poor’s and Moody’s. Government debt is generally lower risk than corporate debt, and big “blue-chip” corporations lower risk than smaller ones.

3. The duration of the bond: short-term bonds typically have lower rates than long-term bonds.

There are differences in the way bonds and equities are traded on the secondary market. In South Africa, equities trade openly - and almost instantaneously - on the JSE, making it a highly liquid market. With bonds, the JSE Debt Market is the primary market, on which registered primary dealers bid for bonds issued by the government or the corporate sector. There is a less opaque secondary market in which these dealers trade with institutional investors, reporting transaction to the JSE within 30 minutes of a trade. Corporate bonds are generally less liquid than government bonds.

The price of a bond is affected by the following, among other things:

  • Expected interest rates. If interest rates are expected to rise, investors will want to sell the bond and put their money in the bank or buy a bond with a higher yield.
  • The credit risk of the issuer. If a ratings agency downgrades a country or corporation, the price will drop as investors sell off their investments.
  • Exchange rate fluctuations. A large portion of the bond market is held by foreign investors. A rise or fall in the value of the rand against major foreign currencies may see a surge of interest from these investors or a flight to relative safety.
  • Advantages of bonds
So what are the positive features of bonds for investors, and why should you hold them in addition to shares in your portfolio?

  • There is less risk of losing your money. If, in the case of corporate bonds, the issuer goes into liquidation, bond holders have a better chance of getting their money back (or more of their money back) than shareholders. Shareholders partly own the company, whereas bond holders form part of a company’s creditors. Creditors are higher in the pecking order when it comes to the liquidation and distribution of assets.
  • Bonds are less volatile than shares or property as an asset class, making them suitable for conservative investors.
  • Significantly, bond prices on the secondary market do not correlate with the rise and fall of share prices, making them useful in managing risk in a portfolio. Typically, share prices drop in a weakening economy. To stimulate the economy, the government will lower interest rates, which will cause bond prices to rise. In a booming economy, inflation will tend to rise, along with share prices. To dampen inflation and cool the economy, the government will increase interest rates, which will cause bond prices to fall.


SHOULD YOU HAVE BONDS IN YOUR PORTFOLIO?

By Mark Dunley-Owen

Bonds are boring, or so the saying goes. A better interpretation is that bond returns are less volatile than equity returns, most of the time. This is positive for investors who value stability, such as retirees. It is negative for investors with long time horizons, because higher-risk investments such as equities typically outperform over the long term. One rand invested in 2000 would be worth about R11 today if it had been invested in the FTSE/JSE All Share Index (Alsi) versus about R6 in the JSE All Bond Index (Albi).

Boring or not, the diversification benefits of bonds make them relevant to many investors, because they tend to perform well when equities perform poorly, and vice versa. It is thus prudent to maintain some bond exposure within a diversified investment portfolio, and vary this according to your objectives and your view on relative risk and return.

Regarding the current investment climate for bonds, we at Allan Gray caution against making broad assumptions about the future, such as macro-economic forecasts, because these are seldom correct or indicative of investment performance. Instead, we spend our time thinking about key variables that we believe will impact long-term bond returns: long-term inflation and the real (after-inflation) return required to make South African bonds attractive to investors.

South Africa’s inflation has remained remarkably stable over the past 20 years, moving between four percent and eight percent. It is currently towards the low end of this range, and is expected to remain there for the foreseeable future. This may prove optimistic if the rand remains weak and global inflation gradually increases, because many of South Africa’s costs are imported.

The required real return from bonds is difficult to predict, but there currently appears to be a dichotomy between the real return investors are expecting from South African bonds and the underlying risks to which they are exposed. The real 10-year government bond yield was 3.5 percent at the end of August. This is low relative to similar points in history, which suggests investors are relatively comfortable about South African risks today. This is surprising, given the downgrade to junk status, as well as the country’s weak underlying fundamentals.

A possible explanation is that investors are looking forward to improved fundamentals. We are more cautious and believe it is unlikely that South Africa’s fundamentals will improve sufficiently to justify current bond yields.

We thus believe there are upside risks to South Africa’s long-term inflation and real yields. If we are right, future bond returns are likely to be disappointing.

Mark Dunley-Owen is one of the portfolio managers of the Allan Gray Stable Fund and the portfolio manager of the Allan Gray Bond Fund.

- PERSONAL FINANCE ONLINE