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What are bonds and how do you buy them?
Diversify your investments with little risk by choosing bonds.
When you’re ready to take your savings to the next level and invest it, you’ve got options. There are mutual funds, stocks and other securities, but these types of investments can be daunting to new investors and returns can fluctuate wildly. Instead, consider investing in bonds, where your money will be kept out of reach while it grows at a steady rate.
What are bonds?
A bond is a low-risk investment where you’re lending money to either the government or a company at a fixed interest rate for a predetermined period of time. You’ll receive interest payments on your investment on a regular basis, with the principal amount paid back to you at the end of the term. Before deciding to invest in bonds, you should carefully compare your options, as some will pose more risk than others.
Case study: How do bonds work?
Maria has been transferring her spare cash into her savings account for the last two years, but is now starting to seriously think about her retirement. She decided to invest in a treasury bond, which will pay her interest twice a year on the investment. This is a low-risk option for her savings that will pay her the full investment back in 30 years when she’s closer to retirement.
By choosing a government-issued bond for her savings, Maria is able to diversify her investment portfolio while keeping a percentage of her money in her savings account where she can still add to the balance, earn interest and withdraw those funds as needed. The interest earned on her government bond will be added to this account, where it will then earn more interest.
Types of bonds
You have a few different options when investing in bonds. Each choice has its own risk and return potential, making it important that you compare your options carefully before deciding on any one product:
There are different types of government bonds, such as treasury bonds and municipal bonds, which are used to generate money for cash flow, financing debt, funding capital investments and more. These bonds are issued by the government so they are typically low-risk, but often have lower interest rates than other options.
These types of bonds are issued by the South African government through the Treasury. The only drawback is that the government requires a minimum investment bond of R10 million to invest directly into a government bond. However, there are a few more accessible investment options that are linked to the government bond yield.
Municipal bonds are issued by cities and local governments. While all of these bonds are used to finance capital expenditures, the specific purpose and repayment plan will vary depending on the type of bond that is issued. The South African government established six municipal bonds named COJ 01 through COJ 06 in 2004. Although, the Domestic Medium Term Note program has allowed cities to issue new bonds, and so the available bonds may vary from one area to the next.
So far, only four large metros – Johannesburg, Cape Town, Tshwane and Ekurhuleni – have sold bonds to date, however the Treasury is working on policy changes that will allow medium and smaller towns to start issuing bonds and broaden access to markets.
This type of bond is usually a part of a public offer, where a company will issue a prospectus that informs consumers about the offering and allows them to make a direct investment. This is different from buying shares, where you are a part owner and your investment is affected by the cash flow of the business. With corporate bonds, you are a creditor and your return is limited only to the agreed-upon interest payments and the return of your principal investment. They usually have a higher investment rate than government bonds but are also riskier — if the company fails, they may default on the debt.
Are bonds safe?
Government bonds are considered to be very safe, but there are bond options that can carry a high level of risk if you aren’t careful. Bonds are typically less volatile than other types of investments, such as shares, but it’s still possible to lose money with government-issued bonds. Bonds do come with a credit rating, but you will need to consult with a licensed financial advisor in order to access that type of information.
Pros and cons of bonds
Like any investment, bonds have their own set of pros and cons:
- Steady, fixed-income investment
- Higher yield than savings accounts
- Could provide tax benefits
- May offer regular interest payments
- Help fund causes you want to support
- Less risky than stocks
- Clear risk ratings
- High minimum investment (Usually R1,000)
- Broker fees if you want to buy or sell on the secondary market
- Less liquidity if you need access to cash
- Lower returns than stocks and other investments
- Bond prices fall when interest rates increase
- Risk of issuer defaulting
How are bonds valued?
A bond’s capital value can increase or even decrease before the maturity date based on the current interest rates. The amount of interest accrued since the last payment will also have an effect on the value of a bond. If interest rates drop, you’ll see an increase in the value of your bonds, whereas if they rise, the value of your bonds will drop as a result. These fluctuations are only relevant if you’ve invested in floating rate bonds as opposed to fixed-rate bonds because the interest varies in line with the benchmark interest rate. This investment has the potential to earn higher returns but there is also a risk of lower returns if the interest rate drops.
How do I choose a bond to invest in?
If you are interested in diversifying your investments with bonds, you’ll first need to decide which type of bond is right for your financial strategy:
|Type of bond||Issued by||Risk||Reward||Purpose||Taxes|
|Treasury bonds||Government||Very low||Very low||Finance government debt, capital expenditures, etc.||Very low|
|Municipal bonds||Cities, local government||Low-medium||Low-medium||Finance municipal purchases and public projects||Tax-exempt|
|Corporate bonds||Companies||High||High||Finance growth, debt, capital expenditures, research||Taxable on interest income|
If you’d like to diversify your investment even further, you can invest in something called a bond fund. A bond fund is a mutual fund or ETF that is comprised of multiple bonds with varying risk levels, maturity dates and yields. This provides instant diversification and allows investors to participate in multiple bonds without paying for individual transaction fees. Instead, you’ll pay an annual expense ratio which also gives you access to a professional portfolio manager that will do all the research, analysis and management for you.
How to buy bonds
Now that you’ve decided which type of bond you’d like to buy, there are a few ways to make an initial purchase.
If you’re looking to buy new-issue bonds, you can purchase them on the primary market, which is usually directly from the issuer.
You can purchase RSA Retail Bonds directly from the government on a website called RSA Retail Savings Bonds, which allows you to avoid transaction fees from brokers, or you can buy bonds from any bank or broker who is part of the South African Bond Exchange. Unit trusts can generally be bought directly from a unit trust management company.
Municipal bonds are generally offered for a short period of time through a single bank or group of banks. A prospectus or offering document would be issued, highlighting the different maturities and yields. During the offering period, you would put in a request to purchase with the investment representative at the specified bank.
Some SA government bonds and corporate bonds are available to the public through the South African Bond Exchange. That said, most of them are sold to large institutions and banks which sell them in the secondary market.
The secondary market is where you’ll find investors and other institutions looking to resell existing bonds. This is done through brokers, which are a third party that allow you to purchase bonds from another entity on your own or with the help of an investment representative. You’ll specify which bonds you’d like to purchase and the broker will search for another person selling them, then purchase them for you, often with a markup to cover commission.
Brokers can also help you resell bonds before they reach maturity. Once you’ve purchased a bond, you can choose to hold it until maturity or sell it on the secondary market. You’re not required to pick one or the other, so there’s nothing stopping you from collecting interest then reselling the bond if its value increases.
Bonds can be a prudent way to keep your money safe over a long period of time and are a great way to diversify your portfolio. Splitting your savings between a traditional savings account and a government or corporate bond can help you earn interest on your money without taking on too much risk. Assess your financial situation and compare your investing options to determine whether buying a bond is right for you.
Picture: Getty Images
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