Bonds are equal parts simple and complicated but also an important part of a diverse portfolio, especially for one looking for income.
The simple part is that they are a loan you make to the issuer (government, corporate, state-owned entity and the like) and it pays an agreed return over the period. This payment is called a coupon because in the very old days you literally tore off the coupon part of the bond to claim your income.
The duration of a bond can be a couple of months to the 100-year bonds issued by Argentina, Austria and Mexico. They’re issued because the issuer needs money and while it could go to a bank for a loan, public markets are a viable alternative.
At the issue date the rate is set. If you buy directly from the issuer this is the primary market, and you’ll get your contracted coupon payments and your capital back at the end of the term if you hold for the duration.
This brings in risk in that maybe the issuer can’t afford the payments or to repay the capital and you’ll get a default. This is fairly rare in government bonds, but certainly more frequent in corporate bonds. Hence we have the ratings agencies, which rate the issuer based on their view of its ability to meet its bond obligations. The value is perhaps debatable, but I’ll leave that for another week.
I have mentioned the primary market, but most government bonds (and corporate bonds globally) trade in the secondary market — and now things can get complicated.
Say you bought a R1,000 bond paying a 10% yield. You’ll receive R100 a year in interest. But then there are concerns that maybe the issuer won’t be able to pay, so the R1,000 bond trades lower — at, say, R800. But you still get the R100 a year in interest, so the yield is now 12.5%. In other words, price down, yield up.
The inverse is also true in that if there is increased demand for the bond, buyers will push the price higher to, say, R1,250. But you’re still only getting R100, so the yield is now 8%.
You also get inflation-linked bonds that see the capital increase by the official inflation rate and then a yield that pays out on top of that higher capital. These are great for beating inflation, though they generally offer a lower yield.
It is also important that there is no direct link between bond rates issued by a government vs the central bank’s lending rate (the repo rate locally). Our government yields have been falling while the repo has been unchanged for ages.
On corporate bonds, they’re generally higher risk and, locally, hard to access. In the US there is an active corporate bond market and even corporate junk bond market, with yields on some of the ETFs of more than 10%, but buyer beware.
A last point: remember bonds pay interest. So this is taxable as income above the annual interest exemption.