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Compounding returns tell in time

Dec 14 2010 09:36
Despite growing interest in corporate bonds, the bond market in South Africa is still dominated by Government gilts. There are a number in issue spanning different maturity dates and offering different fixed and inflation-linked rates.

For investors, exposure to bonds is necessary diversification in a portfolio.

Yet many investors are probably unaware just what their exposure to gilts is. They’ll probably have that exposure through a balanced or multi-managed fund – without being sure just how much of the portfolio comprises bonds.

Apart from providing shelter in turbulent times, gilts are good diversification because the instruments react to the same macro-economic factors as equities in different ways.

Share prices typically rise when interest rates drop, promising increased corporate and public spending. When interest rates fall bond yields will rise, meaning the bond’s price is becoming cheaper.

However, individual retail investors specifically looking at investing in bonds – such as the benchmark R207, the 10-year government bond – should be prepared to hold it to maturity. Short-term movements in the price of the bond then become of little concern.

The investor is holding the bond to receive the capital payment returned at maturity and collects interest payments, normally declared twice a year, along the way. A few percentage points above inflation may not seem much, but if the R207 is held for 10 years the interest payments compound and that can result in a significant return.

Harder to read is the other macro economic factor affecting bonds – the expected rate of inflation.

Under normal circumstances that shouldn’t be difficult to read over the short term. But then there are structural increases in inflation, as we’re starting to see, from Eskom price hikes and above inflation wage settlements. Rising inflation will decimate bond returns.

But, once again, that won’t affect the investor holding the bond to maturity. Sensible bond investment management will have gilts of different maturity dates in the portfolio.

Regular interest payments can therefore be structured. The only investment decision then is when to buy bonds. When interest rates fall and yields rise, as they are now, is usually a good time.

 - Finweek

bonds  |  investing
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