Fixed income. The dark arts. A land where everything you know about equities is almost useless. Welcome to the world of investing in debt.
Don’t let that daunting start put you off. Having said that, you need to pay attention here. Buying a fixed income instrument is nothing like putting your money in Shoprite and forgetting about it for the next decade.
If you remember nothing else, remember this: fixed income isn’t the same as a fixed return.
Right. Let’s get into it.
This isn’t the bond on your house
For most of us, a bond is something we pay off on our homes. Effectively, what you’ve done as a home buyer is issue a debt instrument to a bank, secured by your home and based on your affordability. The bank is taking a view on you as a debt payer, hoping to earn income from you over the period of the debt instrument.
A bond on your house is a floating rate instrument, as the repayments change when the prime rate changes. Even though the bank will offer to fix your interest rate, it’s only ever for a short period of time. This isn’t a fixed income instrument, as the finance costs fluctuate with the prevailing level of interest rates.
So, as we move forward with this understanding of bonds, you need to block your current frame of reference for a “bond” from your mind.
Yes, you are investing in the government
Just like when you needed to finance your home and you asked a bank for money, the government needs to finance its ongoing fiscal spending. When there’s a fiscal deficit (the government spends more than it earns), then there’s an even greater need for money to be raised.
This is why the government issues government bonds of various tenures. Your home loan is probably structured as giving you 20 or 25 years until it gets paid back in full. The government issues bonds that mature over various time periods, or tenures. Another key difference is that your home loan is amortising i.e. you pay back capital and interest, whereas bonds only pay the interest until maturity.
The most commonly used bond for valuations of equity instruments is 10 years. Why? Because the 10-year government bond rate is called the “risk-free rate” in finance circles. Is it risk-free? Absolutely not. Is it the closest thing to risk-free that any country has? Yes, it is. And for that reason, we use that rate to price risky assets like equities.
If you’ve been reading about US Treasury yields in the past year, then you’ve been reading about government bond pricing in the US. The US 10-year rate is currently around 4.5%. The South African 10-year rate is around 10.1%. This means there is a “spread” of 560 basis points between the US and South African rates, reflecting the risk of investing in the US vs. investing in South Africa.
This, by the way, is a big part of why a South African company will typically trade at a lower valuation multiple than a US counterpart doing a similar thing. It all comes down to relative risk and the starting point for an equity valuation, being the “risk-free rate” in each country. Here you are, learning something about equity valuations by reading about bonds. How’s that for a nice surprise?
Why would you invest in bonds?
Conventional wisdom suggests that a portfolio with a mix of bonds and equities is the way to go in terms of achieving attractive risk-weighted returns over time. It’s easier to understand this with an analogy.
Think of it as a family of children, with a couple of crazy kids who give the parents regular heart attacks, along with some well-behaved kids who don’t cause much stress. Life is made more colourful and balanced by having both kinds of kids running around.
Sometimes, the crazy kids (equities, in case you missed the analogy) dish up a surprisingly steady year with little drama and only good times. People celebrate this and tell their friends that having kids is a terrific idea. In the years where those kids cause strain, tired parents expected it anyway and they recognise that having kids is a long-term decision.
Now, onto the well-behaved kids, or the bonds in the family. When they do the right things, this is the baseline expectation and they don’t get any gold stars. But when the wheels fall off and they do something rebellious, it’s an absolute crisis. The parents are in shock. Not only do they have the crazy kids to worry about, but now the class captain is also doing wild things. They question everything that they thought they knew about parenting.
Because bonds pay fixed income, they are thought of as a steadier investment with limited upside. Investors make the mistake of believing that there is also limited downside, or that the bonds will never steal the keys to the car and go on an uninsurable joyride with friends. In a long period of steady prevailing rates, that’s largely true. But when we see sharp rises (or falls) in interest rates, as we’ve seen in the post-pandemic period, those “stable” kids can make the family rebel look like a Sunday School teacher.
Fixed income isn’t the same as a fixed return
Now that we’ve set the scene, it’s important to understand why bonds are different to equities.
A bond cannot grow its cash flows or make strategic decisions that improve its situation. A bond is nothing more than an IOU; a piece of paper that promises to pay you a coupon of x rand for y number of years.
When a bond is issued for the very first time, the coupon rate and the yield are the same thing. If the coupon on a R100 bond is R10 and the market is happy to buy that instrument, then the starting yield is 10%. The coupon rate is also 10%.
The coupon rate is the fixed income component. It never changes, unless it’s an inflation-linked bond or an instrument with some more exotic structuring – but let’s ignore those for now. The R100 is the face value of the bond and the R10 is the coupon, so the coupon rate is always 10%. But here’s the thing: the bond won’t necessarily trade at R100 in the market. In fact, you can almost be sure that the price is going to fluctuate over time based on a number of factors.
This brings us to a critically important concept: the return on the bond is only fixed if you hold it to maturity. If you buy a bond today on a yield of 10% and you hold it until the capital is repaid to you, then your return is 10% per annum unless you face the very unlikely situation of the bond issuer defaulting on the debt. In government bonds, that is almost unheard of (but not completely impossible). To achieve that fixed return though, you might need to hold the instrument until the government pays you back, which can be 10 years (or more).
What happens if you don’t want to hold to maturity? In this (common) scenario, you are now far from the realm of a fixed return. Welcome to bond investing, or bond trading if you have a short-term outlook.
You are now exposed to (1) interest rates and (2) country risk. As with all things in finance, more risk also means the potential for higher returns.
Rates go up, bonds go down. And vice versa.
The traded price of a bond has an inverse relationship with the yield at which it trades.
For example, if the face value is R100 and the coupon is R10, then the market is willing to pay R100 if a yield of 10% is acceptable. If things get riskier out there or if there are improved yield opportunities elsewhere (e.g. US Treasury yields increase), then the market might demand a 12% return from this bond. The coupon is still R10 (fixed income, remember?) and so the only way to achieve that return is for the traded price to differ from the face value. In this case, R10 / 12% = R83.33.
In other words, the bond will trade at a discount of 16.67% to face value, in order to juice the yield up from 10% to 12%. If you bought the bond back when a yield of 10% was acceptable, then you just lost 16.67% of your capital if you sell the instrument. If you keep it, you’ll still get the return of 10% per year because the bond is eventually redeemed at fair value, not market value. But you might not be happy with 10%, because the market is clearly demanding 12%. Conversely, if you buy at a 12% yield and the market moves back to being happy with a 10% yield, then you’ve just locked in a potential capital gain from R83.33 up to R100. Or, a gain of 20%! Take that, equities.
The important thing to understand here is that bonds can deliver substantial swings in their traded value, depending on what happens with interest rates and the risk factors of the country issuing the bonds. When a bond moves from investment grade into junk status, the required rate of return spikes and the bond trades far below face value. When a country improves from junk status to investment grade, the bond increases substantially in value.
Bonds aren’t necessarily less risky than equities. They are just different, which takes us right back to the conventional wisdom of how a stock-and-bonds portfolio gives diversification.
Both types of kids, remember?
As you learn about bonds, watch out for “duration”
As you’ve now seen, bonds are sensitive to changes in interest rates. Going into detail about bond duration and interest rate curves is a CFA-level topic. Luckily, there’s a simple rule of thumb that will help you make an informed decision about how much capital to allocate to bonds and to which tenures.
The longer the tenure and the lower the coupon rate, the more sensitive the bond is to changes in interest rates. Shorter-dated bonds generally offer lower yields, but arguably less risk. Longer-dated bonds have higher yields, but they have higher risk as well.
Like in stocks, there are risky and less-risky approaches
This is exciting stuff, isn’t it? If you’ve made it this far, it’s because you are intellectually curious and you want to learn as much as possible about investing. This is a brilliant approach to be taking.
EasyEquities has now made it possible to invest directly in government bonds of varying tenures. For all the reasons given above, this can be a lucrative strategy if you get your timing right in terms of where interest rates are headed. Just please don’t equate fixed income with fixed returns, as that is only true if you hold to maturity.
The best way to think of these bonds is to view them in the same light as single stock exposures in your portfolio. Be careful with position sizing and dip your toes in while you learn.
For broader exposure to fixed income, you can consider bond ETFs. Also available on the EasyEquities platform, these give you diversified exposure in the same way that equity ETFs do. They also frequently include corporate debt as well, as you are investing in the debt of large corporates alongside our government. The ETF manager also buys instruments of various tenures, doing a lot of the hard work for you.
Fixed income investing is a major part of our financial ecosystem. As a retail investor, you can take part in it as well. Be curious, read as much as possible and take position sizes that are appropriate for your risk appetite and portfolio. As with stocks, the most sensible approach may well be a mix of ETFs and specific bond exposures.
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