The launch in May of the government's new RSA Retail Bonds to encourage savings by ordinary individuals is a good move. I suspect, however, that instead of a proper bond, the government is going to offer a product that is more akin to a bank term deposit.
If interest rates on the government's retail bonds are going to be similar to those offered by banks on term deposits, there will be little reason for investors to switch to these investments. I think, the government will have to make their bonds more attractive than term deposits offered by banks, probably through a tax incentive.
In Italy, ordinary investors place their savings primarily in government bonds because interest rates are competitive and they enjoy special tax breaks for investing in bonds.
But we will have to see exactly what the products will look like when they are launched.
South Africans have always been able to invest, both directly and indirectly, in the bond market. (Do not confuse bond investments with your mortgage bond or home loan.)
Most people have bond investments without knowing it, because bonds form a significant component of all retirement fund investments, managed/balanced/asset allocation unit trust funds and endowment policy life assurance investments, where your money is invested across the asset classes of cash, bonds, shares and property.
Bonds are considered less risky than shares, and historically bonds have not provided the same superior returns as shares, over the long term.
However, this conventional wisdom has been turned on its head in recent years, with bonds providing better returns than shares, which have been languishing in the doldrums.
Although bonds have always been directly available to investors, you have needed at least R1 million to invest in them.
Who issues bonds?
Bonds are issued primarily by institutions that cannot raise money on stock markets to finance their capital expenditure (money spent on things such as buildings, roads, infrastructure). The main borrowers on the South African bond market are the government and parastatals, such as Eskom and Telkom.
However, corporates can also borrow on bond markets. The market in corporate bonds tends to be a bit more risky than government bonds, because companies can go bankrupt, leaving the debt unpaid. Bonds are extensively used by financial services companies that provide financial products with guarantees. Bonds make up a large portion of the underlying investments in these products because bonds are considered a secure investment. This is particularly the case with annuity (pension) products, where a life assurance company gives you a guarantee that it will pay you a pension for the rest of your life.
Underlying investments aside, you can invest in bonds by buying unit trust funds that specialise in bonds, particularly those funds in the bond and income categories.
Bonds are also known as gilts, because bond certificates used to be edged with gilt to give the impression that they were risk-free.
Primary market
Normally, bonds are sold first in what is called the primary market. Large institutional investors - such as life assurers, unit trust funds and retirement funds - buy bonds from the institution wanting to borrow money (in other words, they lend it money).
The interest rates - known as the coupon - on bonds are set by the issuer according to demand. If there is little demand for bonds, the institutions issuing bonds have to offer higher interest rates to attract investors. If demand is high, the institutions can offer lower interest rates.
Secondary market
Once a bond has been bought in the primary market, it can be traded (bought and sold) in what is called the secondary market. Bonds are traded in the secondary market for many reasons, but the main one is changes, or anticipated changes, in interest rates.
Bonds bought and sold in the secondary market are interest-earning and capital growth investments, because their underlying value can increase or decrease. The coupon states that you will be paid a fixed rate of interest, normally every six months.
But when traded on the secondary market, the price of a bond does not only depend on its face value and coupon. It also depends on where investors see interest rates moving in the future.
Interest rates
Bonds are strange things in that when interest rates are high no one wants to invest in them. Governments and other borrowers have to offer high interest rates (higher coupons) to attract investors to lend them money.
In terms of the secondary market, this means a bond that was issued at a low interest rate a few years previously can be bought at a discount when interest rates rise (for example, the face value of the bond may be R1 million, but you can buy it for R980 000) because investors can get a better deal by owning the newly issued bonds at the higher interest coupon rate.
In other words, when interest rates are high, bonds are sold at a discount to their original value, because investors want to get a better and safer return elsewhere.
Interest rates on bonds are pushed lower when many investors want to buy bonds. When interest rates start dropping, the price of the bond starts rising because investors want to lend money to the institution. By selling when interest rates are dropping, you can make a profit on your capital.
So you can make money from the interest paid as well as from an increase in the value of the bonds. If you buy a bond cheaply and sell it when it is expensive, you will make what is called a capital gain. In other words, your original investment becomes worth more.
If you invest in bonds when they are expensive and sell when they become cheap, you will suffer a capital loss.
Different structures
The bond market is very complex and bond traders spend many years gaining experience in dealing in bonds. The market is made more complex by the many types of bond structures. For example, there are bonds on which no interest is paid (zero-interest bonds) but which are sold in the primary market at a discount to their face value. Then there are bonds whose interest rate is linked to the inflation rate.
Unit trust funds that specialise in the bond market do their best to get a better performance than average coupons offered on bonds. Unit trust bond funds do this by seeking opportunities on bonds that are selling at a higher or lower price than their face value.
The retail bonds about to be sold by the government are, however, very simple investments and differ markedly from traditional bonds, particularly as they cannot be traded in the secondary market. This means their capital value will remain stable.