Bonds don't have as high a profile as shares or cash but they can form an important part of your investment portfolio. They are a relatively defensive asset class and your risk of losing money is lower than the risk you face, for example, in shares. This week, as part of our series on how to manage your money, we tell you about investing in bonds.
Bonds are long-term IOUs issued by governments and companies in which the issuer promises to pay the lender (or investor) his or her capital back at the end of a specified term (when the bond matures). The investor is paid interest, usually twice a year.
Government bonds are considered less risky than corporate bonds because of the government's ability to repay your capital and interest, partly because the government can raise taxes, print money or do both.
Companies raise money by issuing bonds as an alternative to issuing shares. In other words, you lend money to companies when you buy corporate bonds, becoming a creditor. With corporate bonds, you take some risk because the company may not be able to repay the credit at the end of the bond term.
The bond market is divided into the primary market and the secondary market. Bonds are issued on the primary market. Here, government and companies hold auctions at which investors (predominantly institutional investors) bid for the newly issued bonds.
The secondary market is where bonds are traded daily and where they can be accessed by ordinary investors, such as individuals, or institutional investors such as retirement funds.
When you invest in bonds, you take the following risks:
- Interest rates will change;
- The longer the term of the bond, the more susceptible your investment will be to interest rate fluctuations.
There are rating agencies that judge the default risk of companies. Each agency has a slightly different way of assessing and rating bond issuers. The ratings indicate the company's ability to meet its debt obligations and range from AAA (the safest investment) to D (the lowest rating, denoting a higher-risk investment).
Bond issuers that have lower ratings tend to offer you higher interest rates as compensation for the increased risk.
You can also invest in inflation-linked bonds, where the interest rate on the bond rises and falls in tandem with the consumer price index (CPI).
You can access the bond market through a broker. The minimum investment is around R250 000, depending on the broker's requirements. You can find bond brokers or traders at www.bondtraders.co.za, which is the website of the Bond Traders Association.
There are other ways for you to get exposure to bonds - indirectly through pension funds or endowment policies or more directly through unit trust funds or RSA retail bonds (see below).
Principals and coupons
The amount for which a bond is issued is called the principal. It is a set amount that will be paid back to the holder when the bond matures and is also known as the nominal value, or face value.
The interest earned on the bond is also set at the time the bond is issued. Let's say, for example, that you buy a five-year bond with a face value of R100 at an interest rate of 11 percent a year. The principal is R100, and this amount is repaid to you after five years when the bond reaches maturity. The interest on the bond, in this case 11 percent, is also known as its coupon.
The price of the bond on the secondary market depends on how interest rates are expected to move in the future.
Bond prices fluctuate continuously because the market's perception of future inflation and the direction of interest rates varies. Therefore a bond with a face value of R100 can be sold for more or less than R100.
When the prevailing interest rates are lower than the bond's coupon rate, or when there are strong indications that they will fall, it becomes attractive to hold the bond, so its price will rise, and vice versa.
So, if you trade the bond before the maturity date, you may be paid more or less than the principal, depending on demand.
In the media, the market value of the bond is expressed as a yield. For example, the yield on a government bond known as the R153 was 6.335 percent on Wednesday this week.
A bond's yield to maturity is a combination of its current price and its coupon. There is an inverse relationship between the bond's price and its yield.
If the bond's yield to maturity falls below the coupon rate at which the bond was issued, its price will rise and it will trade at a premium to its principal. If its yield rises above the coupon rate, the price of the bond will fall and it will trade at a discount to its principal. In our example of the R100 bond, the coupon rate is 11 percent. If prevailing rates were to rise to 11.5 percent, the coupon rate would not change. But if the bond was traded on the secondary market, the yield may rise to 11.5 percent and the price of the bond may drop to R98.10. This is because the bond has become less valuable in an environment where investors can earn higher interest elsewhere.
Bonds are regularly traded on the Bond Exchange. Its website, www.bondexchange.co.za, shows the yields of the various bonds.
Tax on returns
Like most other investments, you will pay tax on the interest you earn from bonds. However, each year you are exempt up from paying tax on interest earned up to a certain amount. The ceiling this year is R21 000 if you are under 65 and R30 000 if you are 65 or older.
Any interest you earn above this ceiling is added to your general income and you are taxed on it at your marginal rate of tax.
You will be sent tax certificates showing the interest you earned. You have to declare this amount on your tax return.
You will also pay capital gains tax (CGT) on gains made when you sell your investments. The first R17 500 of your gains in a tax year is exempt from CGT.
RETAIL BONDS ARE AN EASILY ACCESSIBLE OPTION
There are two types of RSA Retail Savings Bonds: fixed-rate and inflation-linked.
- Fixed-rate bonds.
The maturity periods for fixed-rate bonds are two, three and five years and the interest rate is fixed for the investment period. The interest rates are based on the yields on government bonds and are reviewed every month.
If the interest rates applied to retail bonds change, the new rates apply only to new investments and not to existing ones. The current fixed rates on retail bonds are 9.5 percent for two years, 9.75 percent for three years and 10.25 percent for five years.
The interest can be paid to your bank account at the end of March and September, or you can have your interest reinvested in the bond. If you are 60 years of age or older, you can arrange to receive your interest payments monthly.
- Inflation-linked bonds.
These bonds pay a floating rate of interest that is set above the inflation rate. This floating rate is adjusted every six months in line with inflation as measured by the consumer price index (8.5 percent in March).
Inflation-linked bonds have a three-year, five-year or 10-year maturity period. The current floating interest rates are 2.5 percent (three years), 2.75 percent (five years) and three percent (10 years) a year above inflation.
Investment criteria
The minimum investment amount for a fixed-rate or inflation-linked retail bond is R1 000 and the maximum is R1 million.
Early withdrawals are allowed after a year but incur a penalty in the form of lost interest. If you make an early withdrawal, it will take four to five working days before you receive your money if the term to maturity is more than a year and up to four weeks if the term to maturity is less than a year.
You cannot borrow against the money you invest in a retail bond or use the bond as security for a loan.
You cannot sell or cede ownership of your investment to anyone else.
RSA Retail Savings Bonds are available from your local post office and Pick n Pay, Boxer and Score stores. Or you can call 012 315 5888 or go to www.rsaretailbonds.gov.za
POOL RESOURCES BY BUYING INTO A UNIT TRUST
When you invest in unit trust funds, your money is pooled with that of other investors. If you can't afford to buy bonds directly, you can still enjoy the benefits of the bond market by buying bond unit trusts.
Bond unit trust funds invest in bonds, fixed deposits and other interest-bearing securities. They may invest in short, intermediate and/or long-dated securities. The investment is usually actively managed and changes to reflect the fund manager's assessment of interest rate trends. These funds offer the potential for capital growth, together with a regular, high level of income. Their benchmark is the BEASSA All Bond Index.
Other unit trust funds that invest in bonds include income funds and fixed-interest varied specialist funds. However, these funds don't invest exclusively in bonds. Income funds invest in both bonds and shorter-term fixed-interest instruments typically used by money market funds. Fund managers will switch between these as their view on the interest rate cycle changes. The fixed-interest varied specialist funds invest in bonds, money market instruments and sometimes other asset classes such as property or even equities, switching between them depending on the outlook for these classes.
The monthly minimum investment amounts for bond and income funds is between R200 and R1 000. Bond funds accept lump sums of between R1 000 and R30 000, depending on the fund, while income funds accept lump sums between R1 000 and R15 000.
The initial charges on bond funds range between 0.75 and 1.25 percent, and annual charges range between 0.4 and 1.25 percent.
There are two ways a fund manager can make money from bonds - from the bond issuer's interest payments and from possible capital gains when he or she trades the bonds.