Bonds are loans to the government, (e.g., bonds issued by the South African government) government-like institutions/parastatals and corporate institutions, in return for an agreed rate of interest. These various institutions issue bonds (borrow from investors) to raise capital for various reasons e.g., infrastructure spend by government, or for companies to finance their operations or new projects.

 How bonds work: 

1. The investor (you) – provides the capital investment. 
2. In return for your capital invested, you receive interest via a regular coupon (interest) payment from the issuer (or borrower). 
3. The issuer promises to repay the loan on a specified maturity date in the future. 

What are the characteristics of a bond? 

• Face-value/par-value – is the principal (or initial capital) that the issuer wants to borrow. This is a fixed amount and does not vary. It is also the amount that the borrower promises to repay on maturity. 
• Maturity date – is the date at which the bond issuer (borrower) agrees to repay the full loan at its face value and is set at the time the bond is first issued. You can hold the bond until maturity or sell the bond before maturity (if there is interest in the market to purchase it).
• Coupons – a bond’s coupon rate is the annual rate of interest paid by the issuer to investors (purchasers of the bond). This is always expressed as a percentage of par (or face-value). For example, a coupon rate of 10% on a R1,000 bond (face-value), means that the issuer will pay the investor a coupon of R100 a year for the full term of the loan until maturity date. Payment intervals may vary e.g., annually, or semi-annually etc. The bond can be issued as a fixed-rate bond where the coupon payable is a fixed percentage of the face-value of the bond e.g. 10% per year; or a floating rate bond where the coupon/interest payment will vary as market interest rates change. 
• Price – The price an investor pays for a bond may be the same as, more than, or less than the face-value of the bond. Bond prices fluctuate with changes in the interest rate in an economy. In general, when interest rates rise, the bond price falls and when interest rates fall, the bond price rises. 
• Duration – Measures how much the price of a bond changes (sensitivity) for every percentage change in the interest rate, e.g., Bond A has a duration of 2 years. For every 1% change in interest rates, there will be a 2% change in the price of the bond. The higher the duration, the more sensitive the price of a bond will be to any changes in the interest rate, and vice-versa.
• Tax implications – The total return on a bond for an investor is made up of the coupons (regular interest payments received while you hold the bond), plus or minus any capital gains or losses realised on the sale of the bond. Coupons are taxed as income at the investor's marginal tax-rate - the tax rate applicable to the individual on every additional rand earned - less any allowable exemptions if applicable. Both the tax rates and income exemptions are determined annually by the South African Revenue Service. There may also be capital gains tax consequences on sale if the price of the bond has increased and is sold at a higher price than you paid for it. 

Why are bonds useful in an investor’s portfolio? 

• Bonds provide investors with a predictable income stream as you are getting regular coupon (interest) payments. 
• Bonds are considered “less-risky” than equity investments in a company as bondholders are usually first in line to receive their investment before shareholders in the event of a liquidation. 
• Bonds can play a useful role in diversifying your investments – this is where you spread your investment risk across different asset classes in your investment portfolio. 

What are the risks of investing in bonds? 

These are some key risks to consider when investing in bonds: 

• Historically, bonds have only returned 1-2% above inflation over the long term. The potential to grow your investments above inflation is thus limited. This is known as inflation risk. 
• Bond prices fluctuate with interest rates in the economy. So, if you are invested in a bond unit trust fund for example, you may experience some capital volatility in your investment (periodic gains or losses) as interest rates change. This is known as interest rate risk. It is important that an investor in bonds has some tolerance for capital volatility in the value of your investment. 
• There is also a risk that the issuer (the borrower, or counterparty) defaults on the bond and will not be able to repay the loan. This is known as credit risk. Governments are generally considered “good credit risk” and corporations are rated on a scale depending on their financial stability.

 If the issuer has a poor credit rating, this means the risk of default is higher. Issuers with a poor credit rating typically pay a higher rate of interest than those with a good credit rating. A bond unit trust fund (with a reputable asset manager) helps to reduce counter-party risk by spreading your investment across a basket of issuers, instead of investing with just one. Investing in a unit trust also means that your investment is very accessible if needed, usually within a day. This benefit of having an expert manage your investment for you in a unit trust fund does come at a cost though. This is an annual management fee payable to the asset manager and is usually expressed as an annual percentage (e.g. 1.0% per annum, plus VAT), and is payable on the full amount of your investment in the fund. (e.g. A fee of 1% on R10,000 invested for one year will result in asset management fees of R100 for that year, all else being equal. Note that this example ignores the fact that while the percentage fee is fixed, the rand amount of the fee will vary as bond prices fluctuate). 

To summarise: 

• Investing in bonds can be useful for investors who wish to earn a predictable stream of income. 
• The capital value or price of a bond can fluctuate over time with changes in the interest rate in an economy. Investors must thus have some tolerance for capital volatility in the value of their investment. 
• Over the long term, bonds have not provided investors with significant returns above inflation. While bonds are a useful building block as part of a diversified portfolio, investing solely in bonds may expose investors to inflation risk over extended periods of time.