PICK OF THE MONTH

Gaining access to government bonds is not always easy for retail investors, as the minimum denominations are just too large for the average investor to afford

Extraordinary times — these are probably two words that you have come across fairly frequently by now.

Market volatility over the past month has been unprecedented.

The market has fallen harder and faster than at any other time in history, while central banks around the world have made more moves to boost their economies than ever.

Investors have had to scramble for safety — something that has been hard to find. Therefore the pick of the month is in pursuit of this aim as well. IM’s choice is the NewFunds government inflation-linked bond index (Ilbi) exchange traded fund (ETF), which tracks the index of all the bonds that are issued by the SA government.

Gaining access to government bonds is not always easy for retail investors, as the minimum denominations, or smallest bonds that can be bought, are just too large for the average investor to afford. An ETF that offers a wide spread of government bonds makes it a lot easier.

The NewFunds Ilbi ETF not only invests in the various government bonds; it reinvests all the coupon payments, or interest payments, that the bonds earn back into the ETF.

Moreover, the interest that is earned and reinvested is linked to the consumer price index, so that investors enjoy an inflation-linked return.

This ETF is not likely ever to “shoot the lights out”.

However, it does offer stability in a sea of chaos.

Though the potential longterm returns of government bonds do not match the potential returns of normal equity investments, these bonds are considered to be risk-free investments, as the government can usually pay them with the backing of the central bank. This makes the NewFunds Ilbi one of the few safe investments available to investors in extraordinarily volatile times.

The ETF consists of 10 inflation-linked bonds, which have various maturities, so it offers some diversification.

About 37% of the index consists of bonds with maturities of between three and seven years, while about 25% have maturities of seven to 12 years. The maturities of approximately 37% are longer than 12 years.

As is true with all index tracking ETFs, the NewFunds Ilbi ETF buys the underlying government bonds in the same weightings as the index it is tracking.

As the interest earned on these bonds is reinvested, the return profile is increased by compound interest over time.

The drawback of investing in this ETF is that when the market finally bounces back and the bull market returns, it will not enjoy the same rally as equity investments normally would. On the other hand, the bonus is that during the bad times, such as we have been experiencing, the ETF will not suffer below-inflation returns.

In other words, there will be no capital loss.

Usually this type of investment forms a building block in a portfolio used to reduce the portfolio’s overall volatility.

Asset managers might increase or decrease their allocations to investments such as these as part of an active management strategy in order to either heighten or lower the overall risk the portfolio is exposed too.

Thus, this ETF can be added to a portfolio to smooth out the volatility or can simply be purchased to act as a vehicle for safeguarding capital during difficult times.

Another potential downside to investing in the NewFunds Ilbi ETF is that it does add a layer of complexity to your tax return.

As the interest earned is reinvested, it needs to be declared as income.

Interest earned from bonds are added to total annual income and thus increases your marginal tax rate (usually interest earned on cash is added to interest income and is taxed differently).

When the ETF is eventually sold, capital gains tax becomes payable as well, because the interest was reinvested.

There are many resources available to investors to help them with their tax returns, though; most of them can easily be found on the internet.

Alternatively, the help of a tax practitioner can be sought, which is usually a wise thing to do when preparing tax returns in any case. ●