“Coming to terms” with your bond allocation

Why it's worth considering bonds as part of your investment portfolio

Glen Wattrus CFP®

Glen Wattrus CFP®

Private Wealth Manager

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“Coming to terms” with your bond allocation

Many of you reading this will already have retired and will, most likely, have a fair portion of your living annuity allocated to bonds as a form of income provision. Depending on your risk profile and the capital available to generate income, and particularly the amount of income required, will determine the percentage allocation to this particular asset class.

Before I unpack the meaning of some of the terms specific to bonds, I’d first like to give an overview of the reasons for including bonds in a portfolio.

In South Africa, the vast majority of bonds included in retirement portfolios will be more conventional Government Bonds, though there may be some allocation to inflation-linked and, to a lesser extent, Corporate Bonds. The preference for Government Bonds would include the fact that there is a constant need to raise capital by the Government and their ability to "print more money" to meet their obligations in terms of the coupon (broadly speaking, the interest payable) of the bond. There is, however, a fine line between issuing too many bonds to raise capital and the negative effect that has on the capital value of other similar assets already in circulation. To attract capital, the issuer needs to offer a lucrative rate, but it also needs to have assets or income-generating ability to meet its obligations. If the Government prints too much money, this introduces inflation into the economy, driving up interest rates which, in turn, has a negative effect on the capital value of the bond.

Let us now look at some of the terms used in the bond market to ensure that your eyes don’t glaze over when your advisor uses them to explain what has happened to your portfolio since your last meeting:

Yield to maturity (TYM) is the overall interest generated by the bond that an investor could expect to receive when the bond is bought at market price and held to maturity, at which stage the capital would be returned by the issuer. Knowing what the yield to maturity is will be an essential part of determining whether a fund manager would include the particular bond in their portfolio by comparing that yield to others that are available. Ideally, an investor would want to buy a bond at a lower price than that at which it was originally issued in order to increase earnings. Taking into account previous paragraphs, too many bonds being issued (amongst other factors) would drive down capital prices, resulting in the secondary purchaser enjoying a higher yield.

Coupon is the name given to the interest (paid twice annually) that the investor receives from the bond during the course of its existence until maturity. This coupon does not change during the term of the bond.

Average duration is one of the most critical factors in determining what bonds to include in a portfolio. There is a perception that bonds are lower-risk assets as the coupon payable through the term is a known factor. This does not, however, imply that bonds are risk-free. Ideally, a fund manager would prefer to hold a portfolio of bonds with a shorter average duration. The average duration of a bond will determine the expected gain or loss of the underlying capital of a bond when interest rates are hiked or lowered. This would explain why there is a potential movement in the value of your annuity’s capital, even if you are drawing significantly less than the coupon being generated. Simply put, if the average duration of an income-generating unit trust in your portfolio is 3.3, it would indicate that every 1% move in interest rates would have a corresponding 3.3% gain (in the event of lower interest rates) or loss (in the event of a rate hike) of the capital value. Given that we have been in a rising interest rate environment for the past few years, it illustrates the stagnating value of the holdings you have faced and the corresponding disappointment of not seeing an uptick at the scheduled review dates. Just when you reach breaking point, rates begin to drop when inflation is brought under control and portfolios then react positively to this cycle of the economy.

An inverted yield curve occurs where longer-dated bonds have lower yields than shorter-dated instruments of the same credit risk profile and is usually seen as an expectation that a recession will occur sometime in the future as there is a likelihood of lower interest rates ahead, expressing general pessimism around economic prospects.

These are some of the more common terms that will be applicable to your portfolio. For more information on bonds or to discuss how they may impact your financial strategy, please don't hesitate to reach out and contact your NFB advisor

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