How to cash in on bonds

As part of a diversified portfolio, you should hold at least some lower-risk bond and cash-equivalent investments. They’re particularly useful in a high interest rate environment

One of the impacts of the past few years of high inflation and the resulting higher interest rates has been returns from usually boring cash, bonds and allied products.

Suddenly a local investor can get a great yield from a bond investment, with the RSA retail savings bonds currently offering 11.25% for the five-year bond. Note that this rate changes monthly, with a new rate announced on the first of every month. And you’re locked in for the period of your investment.

This is an almost equity-like return, but without the risk of capital loss.

Your risk in this case is a default on an interest payment or, worse, a default on the return of capital.

With these bonds the risk is therefore that the government doesn’t pay, which is highly unlikely. First, the retail savings bonds are very small in the life of the National Treasury. But the government could just print more money to pay. (Yes, I know this would be bad for both inflation and our currency.)

Moving away from government bonds, there are also great rates in income funds and even in the money market. But here investors need to be cautious about just chasing yield. Earlier this year Bridge Taxi Finance defaulted on loans; some funds held these assets, which are no longer tradable — so the funds have taken a loss.

Now, we’re never going to be expert enough to fully dig into a fund’s holdings and analyse every position held. But concentration risk is certainly one red flag, as we saw with funds that held about 8% of Bridge Taxi Finance. For a niche bond offering, that is a lot. It would be fine if that level of concentration was held in a government bond, but not in a smaller offering.

Corporate bonds are also higher up the risk scale, especially in a higher interest rate environment. As we see little or no liquidity in these bonds, we have poor price discovery. And defaults are possible, as some businesses simply struggle to cope with their debt burden.

The bigger question is, how exposed should we be to bond or cash-like investments? The classic 60/40 portfolio was always 60% equities and 40% high-quality government bonds.

For me, 40% in bonds seems high. Yes, it reduces volatility — but in the long term equities will give better returns than bonds, and with time on my side I want those higher returns. So don’t get greedy, or scared, and rush all your money into bonds.

An investment in this space is important in building a diverse portfolio, but it’s only one part of that portfolio.

Last, there’s tax. Bonds and cash-like investments pay interest, and after the exemption of R23,800 (or R34,500 if you’re over 65), it is added to your income. This dents the returns, depending on your tax rate, and needs to be considered.