Bond returns explained

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Global bonds have been a topic of interest over the past year. They have been unusually volatile and are reflecting a potentially higher interest rate environment for the next few years.

Bonds are often misunderstood as their returns are driven by their inversely related interest rates and capital values. In this newsletter, we provide a simple explanation of bonds, their current drivers, and our outlook for the bond market.

Some background on Bonds

One method governments and companies employ to raise capital is by borrowing money from the public. This is done by selling bonds, which require regular interest payments and a specific capital pay-back period, such as 2, 5, 10 or 30 years.

When you buy bonds directly from the government or a company, you are expected to hold the bond for the full term. However, investors can buy and sell their bonds on a market called the secondary market for bonds. When buying or selling on the secondary market, you can sell your bond at a price either lower or higher than you paid for it, i.e. at a profit or a loss.

This is where fund managers will generally trade with different bonds, which make up a key component of diversified investment portfolios. The chart below shows an example of how bonds form part of a diversified or balanced investment portfolio.

There are three main types of corporate and government bonds:

  • Fixed-rate bonds – these bonds provide unchanging regular interest payments. The interest payments are predetermined.
  • Inflation-linked bonds – these bonds provide interest payments that adjust with inflation.
  • Zero coupon bonds – these bonds do not provide a regular interest payment while you hold the bond. In this case, you would generally receive a larger payment at the end of the term than what was invested.

The relationship between bond prices and interest rates

Bonds not only provide the investor with regular interest payments while holding them, but they also have a price (or market value) that can change over time. The interest payments plus the change in the price of the bond (combined) result in the overall return investors receive.

Bond prices fluctuate according to the perceived risk of whether the capital value will be repaid or whether there is a better investment opportunity. i.e., when interest rates increase, economic growth slows and the risk of capital repayment increases resulting in bond prices declining, and vice versa.

The relationship between the price of the bond and the interest rate is that they move in opposite directions. Bond interest payments generally remain fixed, but the implied interest rate fluctuates as the capital value changes based on the market’s perceived risk of the bond. When investors feel bonds are becoming riskier, they pay a lower price, but receive the same amount of interest resulting in a higher interest rate for the capital outlay. When bonds look more attractive and less risky, the opposite will occur, prices will increase resulting in a lower interest rate.

A way to think about bonds is that if you pay R100 for a bond that pays R10 of interest per annum, your interest rate / yield is 10%. But if the value of the bond declines, to say R90 due to perceived higher risks as the economy slows, you will still receive R10 of interest, but the interest rate /yield will increase to 11.1% (10/90).

Some myths about bonds

Bonds are a good asset class to hold in your investment but there are myths that need debunking them.

  • Bonds are only for conservative investors.

Although bonds are considered less risky than equities, the price of bonds can vary, and fund managers can get good returns from trading bonds.

  • Bonds are not liquid.

Although purchasing retail bonds directly from the government are illiquid, most bonds are traded on public exchanges like equities. For instance, you can buy bonds in unit trust funds where you can invest and sell the fund/s in a few days.

  • Stay away from Junk bonds.

Junk bonds are considered riskier, with investors demanding a higher yield for this risk. Investors often achieve good returns from the higher yields that compensate for the higher risk.

The current environment

Because bonds are traded on a regular basis, the returns are extremely reactive to the economic environment. Since the end of COVID, bond interest rates have been increasing as inflation started to rise. This is because higher inflation results in higher interest rates, which slows economic growth and increases the risk of capital default thus reducing bond prices.

The chart below shows how global bond prices have been decreasing since Jan 2021 (in red). Bond prices decreasing have been accompanied by rising rates as seen by the US’s 10-year government bond yield (in blue), and the South African 10-year government bond yield (in green).

As can be seen, where bond prices decrease, interest rates increase and vice-versa.

Bonds are looking attractive

Global bond markets have performed poorly over the past 2.5 years as inflation has risen and interest rates have increased (e.g., USA’s 10-year bond interest rate is 5.01% p.a. and South Africa’s 10-year rate is 9.48% per annum).

But as it appears that inflation has peaked, interest rates are likely to start declining next year, which should drive a recovery in bond values and returns.

Although we expect a bumpy market environment in the short term, investors should expect good returns from bonds in the medium term.

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