Bonds as an investment vehicle
Bonds – the thing that sounds like James Bond – but has nothing to do with him.
If you like playing the loan shark with a bigger change of getting your money, then bond are for you. With Bonds, you can borrow money to companies. A company might want to expand, pay off existing debt (what?!) or strategically invest in something – and they need money for it. Bonds are like an IOU (I owe you) note from the debtor – they owe you the money and promise to repay it within a set term. Bonds normally have a maturity date connected to them. This means that the money will be borrowed for, e.g. 5 years with an annual interest rate of 3% – which will be payable quarterly, annually or whatever is stipulated in the contract.
Governments issue bonds – you’re basically investing in them with the prospect of earning interest on the money that you lent them.
On the free market, once the bond has been bought, it can be traded / sold to other people. As example, Person A bought a bond for R 1 000 that matures in 5 years at a 10% coupon. Next year you sell this to person B at R 1 100, because they will still get 4 years of interest at a very good rate – which makes up for the R 100 they pay more for the bond.
Terms and definitions
Bonds have some terms you might want to take note of:
- Principal: The initial money you borrow to the lender
- Coupon: The interest rate that is offered by the lender
- Credit Quality: A rating which indicates the chance of the lender getting their money at the set due date(s)
Types of bond investment strategies
Many funds – such as mutual funds (funds of funds, funds and ETFs and pension funds) invest in bonds, as this tends to be fairly secure. The following strategies can be looked at for investing in bonds:
- Passive, or “buy and hold” – If you are looking for a stable outcome and want to know the yield you will be getting, then buying and holding the stock indefinitely is for you. This strategy assumes that bonds are safe and the lender will not default on their debts.
- Index matching, or “quasi-passive” – If you want to link your investment to an index fund (ETF) to spread your risk, you can do so with a bond portfolio. Bonds will be bought as the index dictates. It will rebalance depending on the risks encountered. Note to take into account the fees for buying and selling!
- Immunization, or “quasi-active” – The bond is kept for a predefined amount of time, and sold after this time. all outside factors are ignored in this strategy. This is often done when you know that you will need the money at a specific time in the future.
- Dedicated and active – Many people want to maximise the returns of their portfolio. They will, in turn, buy and sell bonds when they anticipate bad things will happen or when the bond becomes worth more than what they bought it for in the first place. These include interest rate anticipation, valuation, and spread exploitation, timing, and multiple interest rate scenarios.
The pros and cons
As with all asset classes, shares have some interesting pros and cons.
- Liquidity! If you’ve ever wanted to get rid of your asset to get money, this is the thing!
- Passive predictable income (stability): If you’re looking for something quite stable, this is for you. Bonds tend to be more stable with regards to income than shares
- Your money is prioritised: If the company goes bankrupt, you will get your money first – before the share holders get theirs. You might not get your full money back, but you will get more than the shareholders!
- As an asset class, they tend to be lower volatility and more predictable compared to shares
- Bonds tend to not perform as good as stocks in the long run
- Predictable returns – this means your investment cannot grow more than the expected outcome
Quick tax overview
Bond proceeds are seen as interest
Local and government bonds
The SA Government has a RSA (Retail Savings Bond) initiative where you are able to invest in government bonds.
Many local companies also issue bonds
Local bonds are taxed at your income tax rate (meaning if you are filthy rich, that will be at 45 %, and if you’re earning a salary that is taxable, 18 %).
If you are younger than 65, the first R 23 800 is exempt of tax.
If you are older than 65, the first R 34 500 is exempt of tax
If you received R 100 total ‘interest’ in a year, you will pay no tax, as this is within the exemption amount.
If you’re in the 18 % tax bracket, under 65, and you received R 23 900 total ‘interest’ in a year from local bonds, you will pay tax only on R 100, as this is falls outside the exemption amount:
R 23 900 – R 23 800 (Gain minus the exclusion)
= R 100 (Taxable gain)
R 100 x (18 / 100)
= R 18 payable in tax
Foreign bonds are taxed like foreign interest.
This means that foreign bonds are taxed at your income tax rate (18-45%). As an added bonus, there’s no exclusion rate – you’re taxed on everything!
If you’re in the 18 % tax bracket, under 65, and you received R 100 from foreign bonds ‘interest’ in a year, you will pay tax on the full R 100:
R 100 x (18 / 100)
= R 18 payable in tax
Ways to invest
As mentioned before, it’s become really convenient over the last few years to invest in stocks.
Brokers and financial advisors
You sort of need knowledge about what to invest in. This is where stock brokers come in. There’s loads of brokers that would be more than willing to take your money and take a profit from your full investment capital.
If you want to ask them for advice (at an hourly rate) and then invest in an online platform, this is highly recommended. If you want to invest through a broker – make sure that the fees are justified by the returns.
Invest in Bond ETFs directly through online brokers
Though you would like to get away from fees, this is likely not to happen. Certain companies allow you to invest online and don’t take the huge chunk of an ‘advisory’ fee.
One that I have mentioned is EasyEquities – they really do a great job in setting out the fees so that you know exactly what you will be paying. Clarity is one of the most important things when it comes to fees.
Government Retail Bonds
If you want to invest in Government retail bonds, many supermarkets have stalls with information on how to get started on this. Just walk into your local Pick n Pay and as at the money counter about the option.
The bottom line
Bonds are boring – or so the saying goes.
If you invested R 1 in bonds in 2000, it would be worth a mere R 6 today. In shares it would on average be worth R 16.
As a diversification tool, it’s cool to invest some money in bonds – to offset the risk of shares.
Many people see this as a pivot when disaster strikes, as was seen in 2008 with the financial crisis, as this is a more stable vehicle than stocks.
Spread your risk and invest some money in other asset classes.