When governments or companies in South Africa need to borrow money, they often turn to the bond market instead of relying solely on bank loans or lines of credit. While individuals typically approach banks for borrowing needs, governments rarely do so. Larger companies, including some mid-size businesses, often choose to issue bonds to raise funds.
Banks earn profits by lending money and charging borrowers interest based on their creditworthiness. Banks assess the risk of default and set interest rates accordingly. Even though all loans carry some level of default risk, U.S. treasuries are generally considered low-risk and serve as a benchmark for “risk-free capital.” While there is a possibility that the U.S. government may face challenges in meeting its obligations in the future, it is not anticipated during the life of the treasuries. Short-term instruments like treasury bills are considered to have even lower default risk compared to longer-term treasury bonds.
Bonds carry varying levels of default risk, which affects the interest rates they offer. Corporate bonds generally have higher risk compared to government bonds and, therefore, offer higher interest rates. It is important to note that the risk profile of bonds depends on the specific government or company issuing them. Different countries may have different levels of risk associated with their bonds.
Individual investors in South Africa have the opportunity to participate in the bond market and lend money to governments and corporations. By purchasing bonds, they can earn interest over time without needing to be involved in the banking business. The bond market provides the necessary infrastructure to facilitate these transactions.
Bonds are Publicly Traded Debt
What sets bonds apart from privately financed borrowing, such as bank loans, is that bonds are securitized and traded on the open market. When seeking a loan from a bank, individuals typically have limited options available within the closed market of private lending.
While some privately sourced borrowing is securitized among financial institutions, it remains within the private market. However, when bonds are issued, they enter the public market and remain there until they mature.
Although bonds are publicly traded, they are not traded on exchanges like stocks. Instead, bond trading takes place over the counter, where dealers trade bonds among themselves. Individual investors can buy bonds through dealers who have access to this network. In the past, buying bonds through dealers was the primary way for individuals to invest in them. However, now many individual investors participate in the bond market through mutual funds and exchange-traded funds (ETFs).
ETFs provide individuals with the opportunity to trade bonds on an exchange, but they are typically structured for diversified holdings rather than trading individual bonds directly.
Individual investors can also access certain government bonds through contract for difference (CFD) brokers. These brokers handle the positions and trade the actual treasuries as required to manage the trades placed with them. CFD brokers may offer different pricing spreads, and some provide competitive access to these markets with ease.
Another option available to individual investors is trading bond futures. However, futures trading tends to require a higher level of expertise and may not be suitable for most investors.
The Defining Characteristics of Bonds
Bonds, including corporate bonds, can have various features that may be complex for individual investors to understand. However, individual investors typically do not purchase corporate bonds individually, as they usually require large investment amounts. Those who do invest in corporate bonds at that scale typically receive guidance from advisors.
At its core, a bond has three main characteristics: price, interest rate (coupon rate), and maturity date.
Bonds are initially issued at a specific price, known as the par value. After issuance, as bonds are traded in the secondary market, their price can fluctuate similarly to the price of stocks.
Unlike stocks, bonds represent a debt obligation to the bondholder rather than ownership in a company. The bondholder lends money, which will be repaid over time with interest.
The price of a bond can fluctuate, but the interest rate is fixed or floating based on a spread with an interest rate benchmark. The maturity date is also fixed. Therefore, the only element that can change for a bond is its price.
When obtaining a loan from a bank, the price remains fixed as the principal amount borrowed. The interest rate and maturity date also remain constant, unless the loan is paid off early. However, if the bank decides to sell the loan to another lender, the loan’s value may change depending on prevailing interest rates. For example, if a borrower has a fixed rate loan at 7% while banks are now lending at 6%, other lenders may be willing to pay more for that loan to benefit from the higher interest rate.
Similarly, with bonds, investors may be willing to pay more or less for bonds based on the difference between the bond’s interest rate and current interest rates.
The price of bonds can fluctuate above or below the par value due to changes in interest rates and normal supply and demand factors. The demand for bonds by investors at any given time influences prices, leading to fluctuations even when interest rates remain unchanged. These price fluctuations can occur in real-time as demand changes.
Bonds Therefore Offer Both the Potential for Capital Gains and Interest
The value of bonds incorporates expectations for future interest rate changes. However, not all factors are priced in, particularly fluctuations in supply and demand.
Speculating on bonds is possible, with individuals buying and selling them based on technical analysis or other factors unrelated to interest rates. However, others may choose to hold bonds long-term, with less concern about short-term price fluctuations, especially if they have no intention of selling before maturity.
| Benefits of Bonds | Characteristics of Bonds |
| Risks of Bonds | Bonds as Investments |
| Bonds for Diversification | Bonds vs. Stocks |
| Corporate vs. Government Bonds | Trading Bonds |
| Bonds and Liquidity | Bond Funds |
The liquidity of the bond market is enhanced by regular trading among investors and institutions, providing opportunities for individuals to participate. Bonds are initially issued to financial institutions, and individuals typically access the bond market through intermediaries such as brokers or investment funds.
For investors with trading strategies, pricing becomes important if they intend to sell their bonds. Capital gains or losses depend on the purchase and sale prices, in addition to the interest earned during the holding period. Zero coupon bonds, which do not pay regular interest, rely solely on capital gains for returns and may offer tax advantages. Certain government bonds may also provide tax-exempt status to incentivize investment.
Bonds offer a range of investment and trading strategies, from short-term positions to long-term income generation. Compared to stocks, bonds generally exhibit lower volatility and greater stability. However, for those holding bonds for income, the focus is primarily on regular interest payments rather than price fluctuations.
The popularity of bonds stems from their ability to supplement income through interest payments, although their utility extends beyond income generation. With a larger market size than stocks, bonds continue to be a significant component of the financial world.
