Bonds are considered an important asset class for investors, as they are seen as a diversifier to traditional equity markets. Bonds are also considered as less risky than the stock market, providing a fixed and predictable income stream for the investor in the form of coupons (known as yield). The government, corporates and state-owned enterprises (SOEs) issue bonds when they want investors to lend them money. From the capital received, these institutions can then fund their operations.
The Secondary Market
Bonds are debt instruments with a predetermined period after which the bond issuer promises to pay back the capital lent, paying interest in the form of coupons to investors in the interim. A 20-year government bond with a coupon of 10% means you lend the government R1 million today, and receive R1 million back at maturity in 20 years. You also earn 10% of the R1 million in interest each year until then. Typically, the longer it takes to pay back the capital amount (the longer the maturity), the more sensitive the price of the bond is to changes in the market’s rate of interest (as newly issued bonds are sold at a higher coupon rate).
Interest rate sensitivity is measured by a bond’s duration. Because there are bonds with different maturities, yields and duration, this then attracts different types of investors who want to trade in and out of these debt instruments, creating a very active secondary market. The different available risk profiles mean there is also a market where an investor can buy into one product that gives them exposure to a diversified index of debt instruments.
The ETF market has made it easier for investors to get exposure to bonds, easily and cost-effectively, with Satrix being one the biggest bond fund providers in South Africa (with access in both ETF and unit trust form).
Many believe - wrongly - that bonds carry no risk as the maturity date and income paid are fixed. In reality, bond investing carries risk as most would not hold bonds to maturity (few invest in a 20-year bond for 20 years) – and because the interest paid is fixed (say 10%), the value of the instrument varies as market interest rates move up and down.
If market rates at a similar maturity were to increase to 14%, that would mean the investor would need to sell the R1 million bond at a lower price (say R950 000) in order to compensate the holder for a lower-than-market coupon. The opposite also holds true, i.e., if market interest rates fall, investors earn a capital gain. This means there is a capital and an interest component to bonds, with only the latter being fixed and known.
Taken together, the difference between the price paid and capital received at maturity (capital gain) and the coupons received until maturity – add up to a bond’s yield to maturity. A key measure derived from traded bond coupons then is the yield curve, which depicts the different maturity dates of existing bonds with their yields if held to maturity. This is an important graph in the investment world, as it shows what the implied interest rates in the markets are at different time frames.
Another key determinant in the yield required by investors to lend out money, is counter-party risk (risk of non-repayment of debt). Since governments can print money to cover their debts, their issued bonds tend to be less risky than corporate bonds and institutional issuers with lower creditworthiness.
Bond funds usually appeal to investors who are looking for a defensive asset class which holds the potential for capital growth and provides a hedge to inflation with the yields it provides. The Satrix SA Bond ETF, which tracks SA government bonds, had a 7.9% return in the last 12 months to June 2023, and had a distribution yield of 13.1% - showing strong defensive numbers during an environment of volatile equity markets and high inflation rates that reached 7.8% in July last year.
What Are the Risks
The South African bond market is the busiest and most liquid bond market in Africa, and because most of these debt instruments trade in the secondary market, there are risks of capital loss on your investment in the short term. The primary aim for bond investors is to earn a reasonable rate on their yield in the fixed term on the bond so that when market interest rates rise, the bonds they would be holding as an investor will potentially have a lower yield than newly issued bonds, therefore losing capital value (where existing bond holdings are marked down in price). There are times when inflation rises at a rapid pace, and this leaves investors holding bonds that pay lower yields that are not keeping up with the pace of inflation – resulting in lower real returns.
Apart from inflation and interest rates, the credit risk behind these instruments plays a big role in determining their valuation and how much interest they pay. In a country like South Africa where there are political issues, load shedding and rising government debt levels, the credit ratings for sovereign debt worsens and this requires the government to pay higher interest on newly issued debt to compensate for the risk investors take when lending money to the government.
Satrix Bond Exposure
Buying bonds directly is not feasible for most investors as these instruments have minimum investment amounts often exceeding R1 million. Satrix provides investors with an easy and low-cost way of investing in this asset class. For exposure to bonds issued by the SA Government – the Satrix GOVI ETF and the Satrix Local Bond Unit Trust funds are available to investors.
To invest in inflation-linked bonds, investors can use the Satrix ILBI ETF. Another way to invest in bonds is through the Satrix Balanced funds, which provide a mix of assets including shares, bonds and other offshore asset classes. For global bond exposure, investors can utilise the Satrix Global Bond ETFwhich tracks the Bloomberg Barclays Global Aggregate Index.
Satrix Investments (Pty) Ltd is an approved FSP in terms of the Financial Advisory and Intermediary Services Act (FAIS). The information does not constitute advice as contemplated in FAIS. Use or rely on this information at your own risk. Consult your Financial Adviser before making an investment decision.
While every effort has been made to ensure the reasonableness and accuracy of the information contained in this document (“the information”), the FSP, its shareholders, subsidiaries, clients, agents, officers and employees do not make any representations or warranties regarding the accuracy or suitability of the information and shall not be held responsible and disclaims all liability for any loss, liability and damage whatsoever suffered as a result of or which may be attributable, directly or indirectly, to any use of or reliance upon the information.