Lowdown on retail savings bonds | Fin24
 
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Helena Wasserman

Lowdown on retail savings bonds

Oct 22 2010 11:03
THERE is danger everywhere for those who have to make investment decisions.
 
Shares look shaky as the strong rand hurts some of the biggest companies on the SA bourse. Local companies that may benefit – in particular retailers – are looking expensive.

Apart from that, global markets are still unstable and there are real fears about a double-dip recession in the US.

Cash and fixed-income investments, which guarantee that you won’t lose any money, are not without their perils. South Africans have piled into these kinds of investments – in particular money market funds – in an effort to protect themselves against volatility.
 
However, there is growing concern that investors are now overexposed to assets which won't protect them against inflation. Electricity price hikes and big wage increases look set to bump up inflation, and your money will have to grow much harder to ensure your spending power isn't eroded.
 
According to Prudential Portfolio Managers, the consensus is for inflation to rise from the fourth quarter onwards, hitting 5.85% in 2012.

For those who shun equities, the relatively high interest rates earned on government's RSA retail savings bonds may make them a "lesser evil", particularly compared to bank deposits, but the long-term risks cannot be ignored.
 
How do retail savings bonds work?

Your investment in these bonds, which are backed by government and were created in 2004, is guaranteed. There are a number of options.
 
You can earn a fixed interest rate per year and invest for a minimum period of two (8%), three (8.25%) or five years (8.5%).
 
Or you can get a rate linked to inflation, with a percentage above the consumer inflation rate (currently 3.5%) being paid out. For an investment of three years, you will earn 2.25% (plus the consumer price index rate), compared to 2.5% for five years and 3% for 10 years.

Interest is paid out every six months and you will receive the money – plus, after the fixed period, your whole initial investment – automatically in your bank account. You can also choose to reinvest the interest.

You can buy bonds online, at Pick n Pay, Score or Boxer stores or from a post office branch. The minimum investment is R1 000.

Pros and cons

The upside:

There are no charges or commission on an investment in a savings bond.

The interest rate is attractive. RSA bonds are generating up to 8.50% per year, while money market funds average around 6.60% at the moment. On a fixed banking deposit over two years, Absa is currently offering between 4.3% and 5.3%.
 
The downside:

If you want to withdraw money before the end of the investment term, you will pay penalties.
 
Say you invested R10 000 in a five-year fixed interest rate (10%) bond in May 2004. Interest is paid out every six months.

In October 2007, you urgently needed the money and withdrew the whole amount. After penalties, you will only receive R9 583 of your initial investment back. (Although you would have earned R3 356 in interest payments.)

If access to capital is important then money market unit trusts would be a better option than RSA bonds, says Craig Gradidge of Gradidge-Mahura Investments.

Money market investors can access capital without penalty and within 24 hours.

There are also other risks. If interest rates were to turn sharply in the short term and start moving higher, investors in RSA retail bonds could find themselves earning a lower rate of interest because they are locked in at the rate for the term of the bond, says Gradidge.

Under these same circumstances, money market funds would start to earn the higher rate within a much shorter time.
 
Then there is "reinvestment risk" – something many investors are facing at the moment. This is the risk that an investor will have to reinvest their capital at a rate lower rate than the one they were earning before maturity.
 
But the main risk associated with RSA retail bonds is that of inflation, especially for those investors that take monthly income, says Gradidge.
 
While capital is guaranteed, over time the purchasing power of the income generated by retail savings bonds will be eroded.

At 7.2% average inflation over a 10-year period, purchasing power halves.
 
"The best protection against inflation is capital growth, and RSA retail bonds do not offer that."
 
The inflation-linked bond rates offer some degree of protection, but the low rate (2.25% to 3.00%, depending on term) effectively makes these bonds attractive only to those that have saved sufficiently for their income, he adds.
 
You also have to commit your money for three to 10 years in these bonds.

- Fin24

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