31 Aug SA bond returns – a permanent capital loss?
To understand SA bond returns, we need to recognise that bonds are usually used as a hedge for equities when diversifying an investment portfolio. This is because in general, when market volatility leads to equity values falling, bonds will maintain their value.
What happened to SA bond returns in March, then?
In March 2020 there was a period of extreme sell-off and market panic. Investors scrambled to make predictions about the long-term effects of the coronavirus pandemic on global stock markets and adjust their holdings accordingly. Under such conditions, asset class returns converge, and in South Africa, both our equities and our bonds lost value. The equity return for SA in the first quarter was -21.4% (JSE All Share Index). The SA bond return, however, was -8.7% (All Bond Index).
A quick recap about bonds
A bond is a type of loan where the borrower promises to repay the lender their capital after a fixed period. Regular interest payments are paid until then. Borrowers are typically governments, large corporations or banks. Lenders may sell the bond to third parties in the secondary bond market.
Bond interest yields outperform those on the money market while being less volatile than equities over the long term. So, asset managers include bonds in balanced portfolios to improve diversification.
If bond prices fall, is that bad news for bond investors?
Not necessarily. The market price of a bond fluctuates over the life of the bond. This in turn results in a fluctuation of the bond returns. However, there is good news! By holding the bond to maturity, you will still receive interest and capital repayments regardless of the bond value.
So, even with negative returns on the bond portion of your portfolio, this is not necessarily a permanent capital loss. The bond will continue to pay the interest and capital due. Only if the bond is sold at the lower market value will the result be a permanent capital loss.
Are bonds a risk-free investment overall?
No investment is entirely risk-free! If it were, you might as well hold your money in cash. This is because the bond return would pay the same effective interest rate as the money market.
Here are some of the risks associated specifically with bonds:
- Default risk. The borrower is unable to repay the bond
- Mark-to-market risk. The lender is forced to sell the bond at an inopportune time in the market for a lower price
- Inflation risk. Inflation increases over the bond term and erodes the real return of the bond
Is buying bonds still useful in investment terms?
While bonds are not risk-free, they can certainly add value over time and improve diversification within a well-balanced portfolio.