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The low-down on government bonds

What about investing in debt?

Debt is traded via bonds in the bond market. This is one of those dark mysterious places the average investor knows little about, except that the troubles in Greece and other EU countries is directly linked to their government bonds. But we shouldn’t be afraid of bonds as the concept is easy enough to grasp.

Bonds are issued by corporates, governments and state-owned enterprises (SOEs) and we’ll focus on the latter two. When a government realises it needs more money, it can raise taxes (which it’ll often do), but it can also pop off to the bond market and raise money there.

In short, the government is borrowing money from investors to fund its spending habits.

This debt is in the form of a bond with a maturity date when the principle debt must be repaid. There is also an interest rate that has to be paid regularly over the life of the bond. Both are guaranteed by the issuer – be it a government, an SOE or company.

In the case of an SOE (such as Sanral and Eskom) the guarantee is actually from the relevant government.

What is critical is the perceived ability of the issuing government or SOE to make the regular interest payments and the ultimate final payment.

The perceived risk associated with the ability to repay the debt will determine the rate of interest the bond market wants in order to take the risk of buying the bonds.

Currently the US 10-year bonds pays 2.31% interest, while the Greek 10-year bond will give you 12.56%. South Africa pays about 8%.

The different rates are based on the perceived risks. So we see the interest rate on Greek bonds is markedly higher than that of the US or even SA bonds. This risk is monitored by the rating agencies – Standard & Poor’s, Moody’s and Fitch – which continually evaluate the risks and assign a credit rating to each country’s debt. In 2011 the US credit rating was downgraded to AA+ from AAA (negative outlook).

What is important to understand with bonds is that one is making money as the yield (rate) goes down. The logic is that you pay more to achieve the payment, hence falling yields (interest rates) equal profit for the investor.

That said, many buyers of government bonds are looking to hold until expiry and that expiry can be anything from two years to 30 years.

The attraction of investing in government bonds is the safety – and yes, in some cases, that has been blown out the window by the global financial crisis – but SA and US government bonds are not at risk of default.

The other benefit is the diversified nature of bonds in that they typically don’t track equities over time and pay a high rate of interest.

In days gone by it was very expensive and difficult for private investors to gain exposure. But these days there are a number of exchange-traded funds (ETFs), such as NFGOVI from Absa and the CPI-linked RMBINF from RMB and NFILBI again from Absa (all three qualify for the tax-free savings accounts).

The RSA Government Retail Bond is another easy way to get exposure to SA government bonds. This retail bond has zero fees and pays a decent (albeit taxable) income.

These bonds are bought directly from government (via the Post Office) and have a number of different durations and rates. Importantly, these have to be held until maturity – there are penalties for early exits. The ETFs can be traded like any other ETF via a stock broker or ETF platform.

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