Tuesday, 02 April 2013 - 20:00

 

Charts

The Basics of Bonds

Bonds play an important role in investments but, as an asset class, are often misunderstood by retail investors. While they can provide an attractive yield pickup (when compared to cash and equities) there are some risks that investors need to be aware of.

Yield Curve

There is often mention of the bond yield curve.

What is this, and what does it mean?

The yield curve is basically a ‘best fit’ line that shows the annual return that you will receive for investing into a bond with a given maturity date on the condition that you reinvest interest coupons at current rates.

The chart above shows the current yield curve for South African government bonds. The yield curve is currently upward sloping (i.e. investors receive higher yields for taking a longer view) which is normal. It makes sense that investors would generally demand a higher return in exchange for longer terms on their investment (loan to the government). Inverted yield curves (i.e. long term yields below short term yields) are usually an indication that a recession is approaching, or that the economy is in recession. In this environment investors expect that inflation will fall and are therefore willing to accept lower nominal returns in the future, in the expectation that the real return they receive will be sufficient to compensate for the risks involved.

Risks

Bonds are often thought of no or low risk assets. This is only true for certain bonds, and then also only certain definitions of risks.

What are the major risks that bond holders face?

One of the biggest risks for bonds is inflation. As a normal bond essentially promises you a fixed nominal return over a fixed period, any unexpected inflation will eat away at your real (after inflation) return. An example is where an investor buys a 20 year bond yielding 8% (current case in South Africa – see chart above). This investment should, at current inflation, deliver a real return slightly in excess of 2% - which isn’t great, but is at least positive. The risk for this investor is that inflation averages 10% over this period. In this case the investor still receives 8% pa, but will lose purchasing power over the investment period. Conversely, should inflation fall and average 3% over this period, the investor will be rewarded (in real terms).

Default risk is also an important risk, especially for bonds linked to companies (credit bonds). A credit manager made quite a rather poignant statement at a recent meeting, “the probability of a company defaulting increases to 1 (i.e. 100%) as you lengthen the time horizon” – i.e. all companies will eventually default on their obligation given enough time. Investors need to be aware of this risk and ensure that they are being sufficiently compensated for the risk of default. Countries where the government has the ability to print more money and is struggling to pay their debt, will typically speed up the printing press to cover their obligations – governments therefore seldom default on their local currency obligations, but can default where the issue is denominated in another currency (i.e. South Africa issuing USD denominated bonds). Increased money supply typically leads to increased inflation (which affects the purchasing power of your fixed investment) and can lead to hyperinflation (most recently seen in Zimbabwe earlier in this century).

Bonds have their time and place in investment portfolios, but as with other asset classes can either be cheap or expensive – relative to other assets or relative to history. At Seed we believe that locally and globally bonds are currently very expensive as nominal yields are close to all time lows and the real yields are insufficient to compensate for the low starting yield. We therefore have a very low weighting to traditional bonds across our portfolios.

Take care,

Mike Browne

www.seedinvestments.co.za
info@seedinvestments.co.za
021 914 4966

Tue, 02 Apr 2013

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