How to invest in the junk era

MYTHBUSTING: HOW STATE DEBT BEGGARS YOUR POCKET Piercing the veil of government debt shows how your pocket is intimately tied to perceptions of risk in global bond markets.

South African bond yields have tracked upward, indicating reduced confidence in our ability to pay our debts, in the wake of Monday’s downgrade, rising from 8.285% to over 9% the next day.

To understand what it means, it’s important to appreciate what government bonds are. Simply put, they are loans to the state. By buying a bond, investors are lending money to the government with the promise that over a set period it will pay them back their initial capital, plus interest. The bond yield is the interest rate that you will receive. The immediate impact of higher bond yields on SA’s finances is therefore obvious. Government will have to pay more interest on debt and take more tax out of your pocket.

Before last week’s upheavals, anyone buying a new 10-year bond would have been paid an annual interest rate of 8.285% by the South African government. Now, the government is having to pay 9.0% on the same instrument.

Perceptions of rising risk are pushing the yields higher.

What is important to remember, however, is that government bonds are very liquid. There is a huge secondary market where they are traded in large volumes.

So bonds South Africa issued 10 days ago at 8.285% can still be bought and sold. And this is why their price also goes up and down.

If you bought a R1 000 10-year bond offering a yield of 8%, every year you would be paid out R80 in interest.

Ten days later, however, risks increase and the same bond is yielding 9%. Anyone buying one then would therefore be earning R90 per year in interest.

Nobody in these circumstances would want to buy a bond that is still only offering 8% per year. If you wanted to sell yours, you would therefore have to drop its price so that its effective rate of interest was at least 9%. That would mean lowering the price to R890, so that the R80 per year it was paying out was above 9%.

This is a simplistic example, since whoever held the bond at maturity would still also get back the R1 000 in initial capital. The change in price would therefore have to take that into account. As the head of Fixed Interest at Sanlam Investment Management, Mokgatla Madisha, explained in to investors on Tuesday: “The 90 basis point increase in yields over the last week has reduced bond portfolio values by about 6.6%”.

This is also reflected in a number of bond unit trusts. Over the last week, a number of these funds have produced sharply negative returns.

Two examples are the Absa Bond Fund, which has lost over 4% in the last seven days, and the Allan Gray Bond Fund, which is 3.5% down.