Understanding Bonds and Where They Fit Into Your Portfolio

Bonds constitute one of the four major investment asset classes – the others being equities (listed shares), listed property, and cash – and an important component of a well-diversified portfolio. They are generally less volatile than equities and produce a more stable return. Importantly, they behave differently from shares: while not always true, they tend to perform well when shares perform poorly.

What are bonds and how do they work?

Bonds are a form of debt instrument that governments and corporations use to raise capital. Essentially, a bond is an IOU: a government or company borrows a sum of money from an investor for a specified term at a certain interest rate. The capital is repaid at the end of the term.

Bonds, which are typically for large amounts – beyond the scope of most individual investors – are issued in tranches and bought by institutional investors such as asset managers, insurance companies and retirement funds. In the period before they mature they are traded on a secondary market like shares. This means their price fluctuates according to the dynamics of supply and demand, which in turn affects the yield to the investor.

A bond’s yield is the interest paid by the issuer expressed as a percentage of its secondary-market price. For example: a bond of R1 million is issued at a fixed interest rate of 8% (known as its “coupon”). If investors find a more attractive return from, say, cash investments, they may sell the bond in favour of cash, causing the bond price to drop and, in turn, causing its yield to rise. A R1 million bond with a coupon of 8% will pay annual interest of R80 000. If the bond is sold on the secondary market for R900 000, the interest payouts, which remain at R80 000, will represent a yield of 8.9% for the new investor. Thus a bond’s yield is inversely proportional to its price.

Types of bonds

Normally when investment experts talk about bonds they refer to fixed-rate government bonds. These can be longer- or shorter-term instruments – for example, in South Africa the National Treasury issues bonds with durations ranging from 10 to 30 years. Long-dated bonds normally have higher coupons than shorter-term bonds because the risks to the investor (borrower) are higher.

Apart from these “vanilla” bonds, there are inflation-linked bonds, which have a floating rate linked to the inflation rate.

Banks and large corporations often issue bonds as an alternative investment to shares. Corporate bonds are higher-risk than government bonds and thus may offer better rates. Funds investing in bonds often hold a mixture of government and corporate instruments.

Returns from bonds

As with equity investments, returns from bonds comprise both income and capital growth. Capital growth is determined by the price of the security on the secondary market. Income in the case of shares is from dividend distributions and in the case of bonds is from interest payments. Whereas dividends paid by companies to shareholders may be relatively low and sometimes erratic, interest payments to bondholders are reliable and constitute a substantial part of a bond’s return.

Investing in bonds

Apart from offering diversification in a long-term growth portfolio, bonds are suitable for investors with a short investment horizon or who are looking for a steady income with low risk of capital loss.

You can invest in a number of ways:

Directly through a stockbroker: SA government bonds trade on the JSE’s bond exchange and can be bought through a stockbroker. However, as mentioned, because of their high barriers to entry only wealthy individuals can go this route.

Collective investments: Among the wide range of unit trusts and exchange-traded funds available to retail investors are funds that exclusively hold bonds and multi-asset funds that have a greater or lesser exposure to bonds, depending on their mandate. A typical “balanced” fund will have about a 60/40 equity-bond split whereas a low-equity multi-asset fund may be predominantly invested in bonds.

Retirement funds: Bonds are an essential holding in retirement funds, which are restricted by law in how much they can invest in higher-risk assets.

References:

• Investing in bonds – FNB

• What is a bond and how can I invest in bonds? – Smart About Money

• A dummy’s guide to bond investments – Personal Finance magazine (4th quarter, 2017)