I like to revisit bonds and how they work every so often in this column because they’re different from normal share investing.
With a share, you simply buy it — which gives you ownership in the business and future profits — hope it goes higher, and collect any dividends the board decides to declare. We are technically trading these shares in the secondary market (locally the JSE), and if there are more buyers than sellers, the price goes higher.
Nice and simple.
Bonds are different. You’re buying debt, not ownership, and most often it is government debt (we have a small and illiquid corporate bond market locally). Being debt, this should, in theory, reduce the risk of the investment and equally reduce the potential returns.
It’s how those returns are generated that makes things interesting.
First, it depends on whether you’re buying in the primary or secondary market. The primary market is buying directly from the debt issuer. Here you would buy the bond and, assuming you hold to maturity, you would collect the interest payments along the way. At the end, your initial capital would be returned to you. Locally, this is best illustrated by the RSA retail savings bonds available from the National Treasury.
In the secondary market, bonds trade on an exchange, and here the rule is yield up, price down. So, a couple of weeks ago, when we saw the US 10-year treasuries moving from about 4% to just over 4.5%, that increase in yield meant the price of the bonds was lower due to selling pressure.
In the secondary market, bonds trade on an exchange, and here the rule is yield up, price down
The logic here is that, say you bought a R1,000 bond yielding 10%. The holder of the bond will receive R100 interest per year until maturity, and the face value of the bond is R1,000. But if concerns of a default start to surface, holders may become sellers and could be willing to sell at a lower price of, say, R800. The R100 interest doesn’t change, so the effective yield on the bond when it trades at R800 is now 12.5%. So the price went down and the yield went up. The inverse holds true — if the price rises, the yield lowers.
This means that while, in theory, your capital is safe with bonds unless there is a default, the reality is different in the secondary market. You can lose capital, which is why we’ll often see bond ETFs losing value as yields increase.
Second, in the event of a government default, you’re in trouble. However, there have been few government debt defaults over the past decades. In a corporate default, you’re in the queue ahead of shareholders but behind secured creditors and the South African Revenue Service (Sars), and you’ll likely incur a loss on the capital and stop receiving interest payments.
A final important point is that bonds pay interest, and this is considered income by Sars, so it is taxed at your marginal rate once you’ve used your full interest exemption.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.