Demystifying the value of bonds in your portfolio

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By Josh MacRae *

After absorbing uninterrupted interest rate hikes going as far back as November 2021, South African consumers will be glad that the hiking cycle has been paused. We might yet see some more, but with the repo rate having climbed from 3.5% in September 2021 to 8.25%, many households will be glad for a break.

Investors, too, will be eyeing the domestic and global inflation reports for confirmation that it might be time to switch to growth assets.

This recent rate hiking cycle is also a timely reminder for investors that boom and bust cycles are to be expected. Most successful investors adapt their strategy according to the current environment, knowing fully that they’ll have to adjust again when conditions change.

Let’s look, for instance, at the case of bonds as a component in your investment strategy.

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The case for bonds

Bonds are fixed-income instruments that pay regular interest payments and coupons and return the principal at maturity. They are often considered low-risk or defensive investments that can provide steady income and preserve capital.

This is not to say they are immune from market fluctuations and interest rate changes. Both the bond price and the coupon rate change over the life of a bond, which is usually a few years to 10 or more years.

SA Government bonds have become especially popular over the last while because they’ve offered 10% or more yields. In an environment of low economic growth and lacklustre returns from the JSE, these higher returns for less risk have attracted strong interest from investors looking for predictable income.

This predictability comes from the way bonds work. When buying a bond, you’re effectively lending money to the SA Government that it promises to pay back in full at the end of the bond term while paying you interest or ‘coupons’ every month (or year).

This arrangement is ideal for investors, possibly already in retirement, looking for predictable investment income to fund their lifestyle. And when the coupon value on recent Government bonds is 10% or above, this can be a very appealing proposition.

Bonds and interest rates

Under typical conditions, newly issued bonds will have a higher coupon rate in response to rising interest rates. As a result, the market price of existing bonds with lower coupon rates tends to fall because investors prefer the new bonds offering higher returns.

And when interest rates fall, newly issued bonds will have a lower coupon rate, making existing bonds with higher coupon rates more attractive. As a result, their market price will rise.

These are important factors to consider when considering your investments’ current and future value. However, it’s debatable whether you should be doing that. You might feel justified in doing so if interest rates change dramatically over a short period. Your instinct would be to ditch the low-coupon bonds in favour of new bonds with a higher coupon rate.

However, by holding your bond to maturity, you will not be subject to this interest rate risk.

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What if interest rates start falling

With an eye on the next 12 months, it would be fair to expect interest rates to moderate as inflation falls within the targeted range. We might have already witnessed the slowing of rate hikes in July when the SARB held steady, and the US Fed hiked by only 25 basis points, as inflation figures have started coming down.

Under normal circumstances, lower inflation should translate into higher spending and corporate profits. As a result, equity markets should outperform the returns offered by bonds.

However, SA Government bonds have been offering superb yields lately that offer a compelling reason to include them in your portfolio for diversification and wealth preservation.

As of July 2023, the R2030 SA Government Bond yield, which matures in 2030, is around 10.32%, much higher than the inflation rate of 4.9% and the repo rate of 8.25%. If you buy this bond, you can lock in a real return of more than 4% per year for the next seven years, assuming that inflation and interest rates remain stable.

I believe that bonds offer an incredible opportunity to lock in inflation-beating returns, which are much less volatile than equity and offer potential returns significantly higher than cash.

There are several ways to include Government and corporate bonds in your portfolio. I suggest speaking to your financial advisor to determine the best mix and type of bonds you can add to your portfolio.

* Josh McRae is a Financial Advisor at Brenthurst Granger Bay, Cape Town, under the direct supervision of Brian Butchart.

Brenthurst Wealth Management