Before we get started, let’s quickly run through the basics. When reading articles or listening to fund managers getting into the swing of things, some of the terminology used may be confusing. Below are the key terms you may have come across when looking into bonds.
- This is the date the bond expires and when you as an investor will receive your capital back from the government.
- A 10-year government bond bought today will reach maturity in 2030.
- This is the fixed amount you will receive each payment period from government.
- This is the measurement of the coupon you receive in relation to price you paid for the bond.
- Easiest way to calculate yield is to divide the coupon you receive by the purchase price.
(R10 coupon ÷ R100 purchase price = 10% yield)
- This is the amount you paid for the bond and how much you will get back at maturity.
By now, we have become all too familiar with market instability. The continuous equity market uncertainty added to us now finding ourselves in a low interest rate environment means that even investors who had previously found solace in cash and fixed interest investments are finding it increasingly difficult to generate real returns – what a time to be alive! At the end of the day, real returns are vital to ensure our money grows quicker than inflation can eat away at our buying power. Given the above circumstances and extreme market conditions brought about by the global Covid-19 pandemic, government bonds have become very attractive for investors looking for more certainty as well as those looking to capitalize on extreme market movements brought about by global uncertainty.
What is a government bond?
Essentially, a government bond serves as a borrowing mechanism that allows a government to support state spending and its obligations. It is a debt instrument whereby investors (such as individuals or unit trust fund managers) lend money to the government and in return for that loaned money, receive interest. The same way we borrow from a bank to purchase a home and are obligated to repay the loan amount and interest, so does a government have to pay back investors through interest and the loan value. The beauty of a government bond is that it is virtually risk free as the debt is backed by national treasury – think of yourself, or the bond holder, as a mini Eskom or SAA.
How do bonds work?
When you or a unit trust fund manager purchase a government bond, you are simply lending government an amount of money for an agreed upon period of time. In return, government agrees to pay you a set level of interest at set intervals. For example, if you purchase a government bond for R100 (face value) at an interest rate of 10% per annum (yield) over 5 years (term/maturity), government is obligated to pay you R10 per year (the coupon) for 5-years as well as your initial R100 back in year 5. You give the government R100 and after 5-years you have R150.
Government bonds, for simplistic purposes, can be differentiated by two aspects 1) the term of the bond and 2) the interest (or yield) of the bond. Generally speaking, the longer the term of the bond (1-year, 5-year, 10-year, etc.) the higher the yield you will receive, to compensate you for taking on a longer investment term.
These bonds are termed “vanilla bonds” as they are the simplest to understand. These vanilla bonds are what you will most likely encounter when you come across advertising to invest in an RSA Retail Savings Bond.
The beauty of these vanilla bonds is that you as the investor get a degree of certainty. You know what you are going to get at each period (like the R10 each year in the example we used) as well as the capital value you will get back when the term of the bond has been reached.
Why Invest in government Bonds?
Well, to put it simply, you invest in a government bond for the ability go to sleep at night knowing exactly how much money you are going to get from your investment. This is what low risk investors get excited about. When the correct investment decision is made, say buying a government bond yielding 10% when inflation is 4%, the real returns of 6% (beating inflation) can be very appealing.
The beauty of this asset class is that it is accessible held by many unit trusts who use bond opportunities as a form of reducing risk in a portfolio and generating a portion of the returns from a steady, reliable source.
I hope this short write up has helped you with understanding the basics of how bonds work. Bonds undoubtably get more complex in nature and while investing in bonds directly is possible, we prefer to make use of professional fund managers, e.g. the Allan Gray Bond Fund, to make those investment decisions for us. We do have a healthy bond allocation where necessary in our portfolio’s, so we take care of ensuring you have exposure to the entire market to deliver on our promise of independent and diversified advice.