Why we’re buying bonds.
When I started my business in 2001, clients could earn 5% on sterling cash and not much less from dollar money market funds.
Since the global financial crises of 2008, reserve banks in all the major economies dropped interest rates to stimulate growth and avoid financial collapse in the financial and property sectors. This resulted in booming stock markets and many investors who previously received meaningful interest from bonds and money market where also enticed to buying shares which could pay a dividend higher than what they were receiving from deposits and bonds.
Since the middle of 2021 prices inflation stared to rise for the first time in over a decade. At first it was thought to be “transitory” – the result of short-term oil price shocks, but the Fed and other central banks soon realised that tight labour markets and structurally constrained supply of goods and services in various areas of the global economy meant that inflation was going to be somewhat sticky and needed to be dealt with. Reserves banks in the west have had a united front in their determination to bring inflation (especially core inflation) back to acceptable levels, which is below 2% per annum. To do this they have raised rates and will probably keep them elevated until inflation shows signed of abating.
My view is that reserve banks are not in no way going to capitulate on reigning in inflation and therefore will keep rates up maybe for a bit longer. For me, the important consequence is that you can expect the level of core inflation (excluding volatile prices or fuel and food) to be back down to between 2- 3% pa in the next 3 years. This means that investors should be happy if they are able to earn interest of above 5% per annum on a 5-year instrument because they will receive a real return of 2-3 % which is a decent positive yield.
The best way for investors to take advantage of the current high interest rates and the likelihood of lower inflation in the future is through the global bond markets. Bonds, which are essentially debt instruments issued by international companies or by governments or parastatals. Unlike in South Africa, there are markets for accessing bonds for private investors, which gives them the opportunity of buying an instrument which have incredibly unique characteristics. Different to buying shares, some of the characteristics are unique to direct bond investments and can’t always be achieved by investing in a bond fund for example.
The global bond market has some idiosyncrasies, and one needs to be fairly aware of some of the finer details. I was fortunate enough to run a direct bond portfolio for an offshore trust in the early 2000’s when bond yields where attractive. We did this very successfully until the opportunity set dried-up totally with interest rates pulling right back to below 1% and at best 2% after 2008 and bond investing non-sensical from a return point of view.
The opportunity investors have today is to buy a debt instrument which gives them unique payoffs. Bonds are issued and backed by solid multinational companies rated in many cases higher than SA government debt. Unlike with dividends, the company is contractually bound to make good on the either annual or bi-annual fixed interest payments. So, the investor can count on receiving a fixed interest payment. The second unique advantage of holding a direct bond is that at maturity the issuing company pays you back the principle in full. So, in essence when you buy a direct bond you as the investor know how much you will receive annually, and how much you’re getting back at maturity. This is quite different from equity investing and of course returns are lower for bond investors because they are taking less risk. It is also different for bond-fund investors because the bond portfolio is traded, making the amount you get back (the NAV or price of the bond fund) variable.
So, what is the risk?
The risk is that inflation goes higher which will means that bonds yields will also go up and you as a direct bond investor will be “locked-in” to your interest payment (your yield). In real terms then you might find yourself earning less than inflation and /or less than current interest rates. Your loss is the foregone opportunity costs of being able to have earned a higher rate and /or the fact that you might end up earning a negative real interest rate. This not necessary that terrible unless inflation soars.
How do you get around this?
By buying bonds that mature soon; in a year or two – so that if things go the other way, you will be out fairly soon. Investing in direct bonds give you as an investor the option to choose a bond with a maturity date that suits you. Personally, I feel that inflation will come down and we are therefore advising clients to consider buying slightly longer dated bonds to take advantage of the current elevated interest rates. Investment grade bonds are paying between 6 – 7% per annum in dollars. This rate can be locked-in on a bond that only matures in 5 years’ time.
What else could go wrong investing in direct bonds?
One of the biggest risks with direct bonds is what is called credit risk. This is the risk the issuer, a company or government goes bust or in the case of a government bond defaults. This can mean that you don’t get your capital back. The credit rating of a bond is important, and this is why we are Zaina Wealth for the most part will only buy bonds that have been rated at investment grade by one of the internationally recognised credit rating agencies. We also tend to buy bonds issued by different entities and as far as possible in different sectors.
What drawbacks and pitfalls are there to bond investing?
Firstly, most bonds issued require a minimum investment amount of $100,000. For investors with less than $50,000 the options and choice become more limited. The coupon payment received is taxed as income, but investing in the right bond can help mitigate this significantly. Getting the right advice and having someone like Zaina Wealth can help you to select and manage a portfolio of bonds is important, so that you are made aware of these and other idiosyncrasies.
Some other advantages include being able to sell a bond before at matures. On of the most over-looked benefits is that by purchasing the bonds through the correct structure and involving the right parties to come alongside you, you can bring the costs of owning the bonds in-line with the returns. The characteristically lower yet certain returns of bonds, compared to equities, need to be coupled with a costing structure that ensure the investor receives the loins share of the interest receipts. In many collective fixed income and bonds structures such as funds, a large chuck of the yield is eaten away by high asset management fees and other fees and charges.