In the first two posts in this series, we investigated dividend-hugging ETFs and listed property ETFs. While both of these are worth consideration when investing for income, both are listed instruments, which introduces volatility to your investments. This makes them more appropriate for investors with a longer investment horizon. For those nearing financial independence, debt instruments offer a way to store cash at guaranteed rates. These instruments protect your capital investment and pay a fixed rate for a set period.
Debt instruments are far less volatile than equity and property. Their returns are guaranteed, but they limit the amount of money you can make. While there’s always a degree of risk in every investment, these instruments are considered a better option for investors nearing the end of their investment term.
South African ETF investors are spoiled for choice when it comes to debt instruments with fixed-rate and inflation-linked South African bond ETFs, a growing number of international bond products and even a preference share ETF. All of these products work on the same premise: when a government or company wants to borrow money without giving up ownership, they issue a debt instrument. These instruments return your capital amount, plus interest paid over the duration of your loan.
Before investing, it’s worth bearing in mind that interest is taxed differently than dividends. Each individual is entitled to a R23,500 interest exemption every year. Any additional interest is charged at your income tax rate. In local bond ETFs, your interest is automatically reinvested into the ETF. However, you are still liable for the tax.
Explains Mike Brown of etfSA.co.za, “The tax treatment for any bond return ETF in South Africa is effectively that of a roll-up fund. Any income is automatically invested on behalf of the investor, but they are deemed to have received the interest (in the case of a bond ETF) and will be taxed on that interest. They receive a tax certificate at the end of the tax year, showing the value of this deemed interest income.”
In the ETF space, there are three main debt instrument categories to consider. Inflation-linked bond and fixed-income bond ETFs invest in local and international government debt. Preference shares are a great way to rake in those dividends.
Inflation-linked bond ETFs
Real world inflation-linked bonds pay out a percentage above inflation for every term and return your initial investment when the bond expires. While ordinary bonds don’t gain value over time, the inflation-linked bond ETFs re-invest income and take on new bonds when existing holdings expire. This means you don’t receive your coupons in cash, but the value of your ETF increases with the value of the coupons received over time. More coupons buy more bonds, which results in the lovely snowball effect we in the business like to call compounding.
Fixed-income bond ETFs
Fixed-income bonds pay out a fixed percentage of interest, regardless of the inflation rate. These bonds are great for investors who want to accurately predict the returns they will receive over time. You can work out at the beginning of your investment term exactly how much interest you’ll receive in addition to your principal investment. In the case of fixed-income bond ETFs, the returns are once again reinvested into the ETF.
Preference shares are issued by listed companies who want to raise capital without diluting ownership. They are the love child of bonds and shares. Importantly, dividends are fixed at a percentage of the prime lending rate, like inflation-linked bonds. The dividend amount is generally higher than dividends paid to ordinary shareholders. Income from preference shares are taxed at the 20% dividend withholding tax rate.
Preference shareholders are paid out first in a liquidation event, making these instruments safer than ordinary shares. However, since preference shares are debt instruments, holders aren’t part-owners of the company and therefore don’t have voting rights. In the ETF environment, this is moot, since ETF shareholders don’t have voting rights.
Unlike the bond ETFs, whose coupons are automatically reinvested in the ETF, the preference share ETF pays out dividends quarterly. Retired investors who want to receive hard cash from their investments would do well to consider this ETF.
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