Should DIY investors even bother with bonds?

Bonds are tradable debt instruments whereby a government, state-owned enterprise or corporate raises debt by selling bonds into the market. 

These instruments have a maturity date and an interest rate (called a coupon). The maturity date will be determined by the issuers’ needs while the coupon rate will be determined by the perceived risk of the bonds, the ability of the issuer to pay the coupon and repay the principle. 

The higher the perceived risk, the higher the rate.

Bonds are usually considered a lower-risk investment and hence offer lower returns than normal shares. 

This is in part because in the event of a bankruptcy, bondholders are paid before shareholders but also because a bond default is a serious issue, much more than profits falling or a dividend being cut.

The average do-it-yourself investor, should not ever consider bonds, although anyone who has any sort of pension investment will be exposed to bonds, with the quantity relative to the risk within the portfolio. 

But the problem is also that there is a stigma attached to them as they are considered boring.

In the past it was also difficult for smaller accounts to invest in these instruments. The bond exchange deals in large amounts, leaving smaller accounts unable to partake.

However, we have had a few local exchange-traded funds (ETFs) issued over local bonds, tracking government and inflation-linked government bonds.

We’re now also seeing two new offshore bond ETFs coming to market. Ashburton has issued an ETF tracking the “Citi World Government Bond Index (WGBI) which invests in fixed-rate, local currency, investment grade sovereign bonds from over 20 developed and emerging market countries”. 

We’re also getting a new Stanlib bond ETF tracking the “FTSE Group-of-7 (G7) Index”. The latter focuses on developed markets only while the former includes a small weighting of emerging-market bonds such as those belonging to South Africa.

These listings got me thinking about bonds, something I have always called boring and never bothered with. But as investors we’re chasing returns and, more importantly, we’re chasing returns that beat inflation. 

Now over time markets beat inflation and the returns from bonds – but with a chunk of volatility as markets rise and fall. Bonds can give stable, predictable returns especially if we consider the local RSA Government Retail Bonds.

These retail bonds have zero fees and are guaranteed by the South African government. They have two styles, the first being a fixed-term option ranging from two, three or five years, currently offering rates of 7% to 8%. 

These rates fluctuate as local rates change, but once you’ve bought your rate is guaranteed until expiry and you can restart at higher rates after one year. But what I liked the look of is the second option, their inflation-linked bonds. 

The 10-year bond offers rates of inflation +3.5% and this looks interesting. They increase the investment amount by inflation every six months and pay out the 3.5% in cash to the holder.

This means your money is going to beat inflation and this is a great way of creating wealth without any risk, although beating inflation by 3.5% is slow, with the stock market likely offering inflation +6% over time.

The problem here is that the interest is taxable, so any significant amount invested will be subject to tax, which destroys any inflation-beating return. 

They’d work great in a tax-free account and you can open one of those. But otherwise a great wealth-creating investment product is of little use if taxes kill the return.

This takes us back to the beginning. DIY investors largely ignore bonds and while their reasons for doing so are varied, the taxes are a good enough reason to steer clear and leave the bonds to your pension or tax-free funds.