DINEO TSAMELA: Sorting the junk from true value in the world of bond markets
We recently touched on retail bonds — how and why household investors use them when constructing their portfolio. There are two types of bond investors: retail and wholesale.
Most of the buyers of bonds fall in the wholesale category and include financial institutions and pension funds with big amounts of capital to invest in this particular asset class.
Bonds are a method of finance used by governments and businesses to raise money for long-term projects. Bonds issued by businesses are known as corporate bonds while state bonds are sovereign bonds. In South Africa, the government issues around 90% of all South African bonds.
Bonds have a specific term: a year, five years, 30 years, and so on. The term depends on the issuer's capital needs.
Bonds are first issued in the primary market. Investors don't have to hold the bonds they purchase to maturity. They can sell them on the secondary market, where bond prices are determined by supply and demand.
Most South African bonds pay out interest twice a year. This payment is known as a coupon and is usually a fixed rate. The principal amount will be due on the bond's maturity date.
To illustrate: if the principal amount is R10,000 and the coupon rate is 15%, then the annual coupon paid out will be R1,500, which will be paid in two instalments through the year. R10,000 will also have to be paid at the end of the repayment period.
But not all bonds pay coupons, and these are called "zero-rate coupons". The benefit investors receive lies in the difference between the issue price and the principal amount that will be repaid at the end of the bond's term.
There are also fixed-rate bonds and floating-rate bonds. Fixed-rate bonds have a fixed coupon rate while floating-rate bonds do not. The floating rate can be pegged to a benchmark rate such as the prime rate.
For example, inflation-linked bonds are pegged to the consumer price index, which fluctuates. Coupon rates for South Africa's inflation-linked bonds are decided at an open market auction. This rate will remain fixed for the bond term. The capital value is adjusted for inflationary movements.
When investors are looking to buy bonds, they will assess the bond's credit risk. Ratings agencies have different measures to determine the credit worthiness of a particular bond holder.
A credit rating reflects the quality of a bond — that is, the issuer's financial security and their ability to repay outstanding debts, namely coupons and principal amounts to bond investors.
Bonds are rated investment grade or non-investment grade. Investment-grade bonds are considered very likely to honour their debt obligations.
Non-investment grade, or junk, bonds tend to have higher yields. This is to compensate investors for the risk they're taking as it's possible the bond issuer will not meet its obligations.
Yield and interest rates are important to both bond issuers and investors, and both play a role in bond volatility. Given that bonds are considered fixed-income assets, it may come as a surprise that investors must consider volatility.
However, the longer the bond term, the more volatile it will be in the secondary market. It's easier to predict short-term movement, but there's no way of predicting the state that a bond issuer will be in in 30 years. Interest rate movements, informed by economic factors, contribute to this volatility. Higher interest will eat away at the present value of the returns as well as the capital or principal expected at maturity, leading to investors losing their money.
That's why bond investors must keep a close eye on these three factors: the bond credit grade, time until maturity and inflation numbers — current and expected.