ETF: Bond ETFs, yields and junk status

In ETF Blog, Latest by Kristia van Heerden

With a wider variety of local, global and US Treasury bond ETFs than ever before, local investors can tinker with asset class exposure down to the region. The relationship between price and income can be confusing. It gets even worse once you add RSA Retail Savings bonds to the mix. In this post, we explore what bonds are, the relationship between price and yield and how South Africa’s sovereign debt downgrade affected these instruments. 

Bonds

It helps to think of bonds as an IOU from the government. When you buy a fixed interest rate bond or bond ETF, you are lending money to the government in return for a fixed interest rate (also called a coupon) over time. Each bond has a maturity date – the day you will get your money back. Bonds with a longer date to maturity tend to pay more interest than shorter-term bonds, because there’s more risk of something going wrong over a longer period. By the maturity date, you will have the original amount you invested as well as the agreed-upon interest paid over that period, similar to a fixed deposit at a bank. When you buy retail savings bonds, this is exactly what you get.

How bond ETFs differ

The kind of bonds ETFs invest in differ from retail savings bonds. Big institutions and funds buy large amounts of bonds directly from issuing governments. These institutions can sell the bonds to other institutions or individuals in a secondary market. This is important, because once you can sell a bond to someone else, you are no longer bound to the price of the bond set by the government, sometimes called face value. The price can be negotiated between buyer and seller.

Bond ETFs buy these bonds in the secondary market. There are different bonds with different maturity dates and interest rates available in this market. Some are short-term bonds with low interest rates, some are long-term bonds with higher interest rates. When you buy your bond ETF, you aren’t bound by a maturity date the way you would be had you bought a retail savings bond. Some bonds will mature while you hold the ETF. The ETF issuer will replace the matured bonds with new bonds behind the scenes.

Prices down, yield up

In the secondary bond market, bonds can be sold before they reach maturity. They can be sold at face value or above or below face value. If, for example, you worry that the government won’t pay you back by the time your bond reaches maturity, you would be willing to sell it for slightly less just to be rid of it. When you sell the bond at a lower price, the interest the person buying the bond will receive will be higher as a percentage of the value of the bond.

Let’s say the bond you bought has a face value of R1,000 and a coupon of 10%. You will receive R100 per year in coupons, as well as R1,000 at maturity. If you sell the bond for R900, the person who buys the bond will still receive 10% on the face value of the bond and the R1,000 at maturity. The yield is still 10% of R1,000, not 10% of R900. As a percentage of the lower price, the yield is therefore higher when the bond price goes down.

If, on the other hand, there is suddenly a huge demand in the market for your bond and you can think of something better to do with your money, you can sell the bond for more than face value. Your R1,000 bond sold for R1,100 will still pay out 10% on R1,000. By the time the bond reaches maturity, the person who bought the bond from you at a higher rate will only receive R1,000 back. The yield is lower as a percentage of the price that person paid. 

Interest rates up, bond price down

An interest rate hike will negatively affect the price of your bond, because new bonds are issued at the higher interest rate. When an investor buys a bond, they would want a bond with a higher interest rate. If you sell your bond at the lower interest rate, you would have to sell it below face value to compensate for the old interest rate.

What did the downgrade do?

The South African market had been expecting a downgrade to junk status for many years. This status indicates how likely ratings agencies think our government is to meet its debt obligations. That’s a really big deal, since bonds are nothing other than government debt obligations. Investors are far less likely to lend money to a government who might never pay them back. A government with a low credit rating is therefore considered a risky investment. To attract investors who are fearful, the government offers higher reward in the form of a higher interest rate. 

The market was expecting a downgrade to South Africa’s credit rating to affect the bond market in two ways:

  1. Holders of existing bonds would want to get rid of them. A higher supply of bonds in the bond market will drive the bond prices down, creating an opportunity for investors with a higher risk appetite to buy bonds at below face value. As we illustrated above, this will mean higher yields on existing bonds.
  2. The government would have to pay higher interest on new bonds to compensate investors for taking on more risk, also resulting in higher yields.

Both of these things happened in the short term. However, because the  market had been expecting the downgrade for such a long time, the impact was far less severe than it would have been had the downgrade come as a surprise. For a brief window, South Africans could buy retail savings bonds at an interest rate of over 11%. That interest rate has since returned to pre-downgrade levels. Similarly, the performance of local bond ETFs experienced a short-term dip before returning to pre-downgrade levels.

We discuss the impact of the downgrade on bonds in this episode of The Fat Wallet Show.

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