If you are looking for a savings vehicle that returns at least your original investment amount plus inflation, you might be in the market for bonds. Some bonds protect spending power by offering returns linked to inflation. Others offer a guaranteed income, regardless of market events or inflation. This asset class offers investors a degree of certainty over the types of returns they can expect in the future. South African investors can choose between five bond ETFs, including inflation-linked bonds, global bonds and T-Bills.
HINT: We explain how bonds work and the relationship between bond price and yield in this article. We also discuss bonds in this podcast, and this one.
Bonds allow us to lend money to governments and corporations. We agree to let others use our money for a fixed period. In return, they agree to pay us interest (called “coupons” in the case of bonds, because why would the financial world make anything simple?). Bonds give us security and control that the stock market simply can’t offer. By the end of the investment period, we are guaranteed our money back and we receive income the entire time our money is invested. While the security of a bond investment is attractive, you will never be pleasantly surprised by a bond and you are locked into your investment period.
Bond ETFs offer some benefits that ordinary bonds do not. For one, they can be traded like ordinary shares, unaffected by the date of maturity of the bonds within the index. Most bond ETFs reinvest income received from the bonds instead of paying coupons to the investor. Although you will not receive regular cash payments the way ordinary bond holders would, this strategy increases the value of your bond holdings over time. Bond ETFs, with the exception of RBM’s DCCUSD, can be bought within the tax-free investment environment.
If you are in a high tax bracket, use bond ETFs with caution. Income from bonds is considered interest income, not dividends. The income you receive from bonds is added to your annual income and taxed at your marginal rate.
Inflation-linked bond ETFs
As the name implies, the performance of these bonds and ETFs are linked to inflation. When the bonds mature, investors receive their principal investment amount plus inflation for the investment period. The coupon payments are also linked to inflation, expressed as inflation plus a percentage. Within some of these ETFs, these coupons are reinvested in more bonds, increasing the underlying value of the index over time.
Inflation-linked bonds offer an ideal solution for investors who want to protect their spending power without taking on market risk.
Ashburton inflation ETF (ASHINF)
The Ashburton inflation ETF tracks the South African Government Inflation-Linked Bond Index. Unlike its brethren, this ETF doesn’t reinvest the coupons automatically. Investors in the Ashburton inflation ETF can look forward to a cash payment every quarter. Consider buying this ETF within the tax-free investment environment to avoid paying tax on the coupons. Your principal investment amount will also increase with inflation, protecting your buying power over time.
This ETF tracks the The Barclays/Absa South African Government Inflation-Linked Bond Index. The NewFunds ILBI ETF reinvests the coupons on your behalf, increasing the net asset value of each unit of the ETF over time. Nearly 50% of this ETF is invested in bonds with a maturity date of greater than 12 years. Read more about this product here.
Satrix SA Government inflation-linked bond (STXILB)
This ETF tracks the S&P South Africa Sovereign Inflation-Linked Bond 1+ Year Index. Like the NewFunds ILBI, it reinvests all income on your behalf, increasing the value of your ETF over time. Over half of the ETF is invested in long-term bonds, allowing you access to higher yields without locking you in for the full term.
Free radicals
Inflation-linked bonds aren’t the only game in town. Investors who want a guaranteed return, regardless of the inflationary environment or market conditions, can opt for the NewFunds Govi. This ETF tracks the South African Government Bond Total Return Index. The bonds return a fixed coupon, expressed as a percentage. The coupon amount depends on the maturity band of the bond. These coupons are reinvested in the ETF monthly.
You can also widen your bond net to include investments in developed market bonds. The Ashburton World Government Bond ETF invests in the FTSE World Government Bond Index (WGBI). This ETF pays quarterly coupons, which means you can look forward to cash in your account every three months. While this ETF can include investments in emerging markets, the majority of this ETF is invested in the American and European economies, offering exposure to more stable economies.
If you’re not feeling optimistic about the South African government’s ability to honour its debt obligations, you can also invest in US treasury bonds, thanks to the RMB DCCUSD franken-ETF. While listed and traded as an ETF, this product doesn’t actually track an index. We explain how it all works here.
ETF blog
At Just One Lap, we are big fans of passive investment using ETFs. In this weekly blog, we discuss ETFs on the local market and the factors you need to consider when choosing an ETF. If you have wondered how one ETF differs from another, this is where you can find out. We explain which index each ETF tracks, what type of portfolio could benefit from holding each ETF, and how the costs will affect your bottom line.