Understanding Asset Classes, Part 2: What are bonds, and what do they mean for me?

In this series, we take a look at the main asset classes - groupings of similar types of investments, which are accessible to the investing public - explaining what they are, how they produce returns and how each one can benefit investors. In Part 1 we discussed the most well-known asset class - equities (also called stocks or shares). Now, we drill down into bonds.

What are bonds?
When you buy a bond issued by a government or company, you are lending money to that entity so it can raise funds to finance spending. It is therefore a form of loan. Bonds issued by governments are called government bonds, sovereign bonds or gilts. When a government spends more on health, education, infrastructure etc. than it receives in taxes, it needs to borrow the difference by issuing bonds.

Bonds issued by companies are called corporate or credit bonds. Bondholders lend money in return for regular interest payments plus a final repayment after a certain period (typically one year or more). Government bonds and many corporate bonds are listed and traded on public exchanges, so they are priced daily and can be bought and sold by investors easily.

What are the benefits of investing in bonds?
Because investors earn interest as a regular income (usually paid out quarterly), individuals who require a high level of income, plus medium- to long-term capital appreciation with relatively low risk, would benefit from investing in bonds or in unit trust funds that hold bonds. Inflation-linked bonds are distinguished by the fact that the interest rate they pay is linked to the prevailing inflation rate, and adjusts as that rate moves up or down. These bonds therefore provide investors with some degree of protection against rising inflation.

How do bond prices move and how risky are they?
Bonds are generally affected by changes in interest rates. Their price falls as interest rates rise, because the fixed interest rate they pay becomes lower, and therefore less attractive, than the latest rates offered for an equivalent risk level. The opposite is true with a fall in interest rates: when the central bank cuts rates, the existing fixed interest rate paid by the bond becomes more attractive compared to any new bonds issued, and the price therefore rises.

Bonds come with repayment or credit risk, which is the risk of a bondholder not being repaid when the bond matures (or even misses an interest payment). This can be measured by the issuer’s credit rating, which grades the likelihood of being able to repay the debt over time. This is assessed by credit rating agencies, and investment managers like Prudential conduct their own rigorous credit analysis.

Because bond prices (and yields) historically have moved less sharply than equities, and they deliver a regular fixed income over time, they are usually regarded as a safer investment option than equities. Also, companies are required to repay their bondholders before making any payments to shareholders, should they experience financial difficulties.

So to reduce portfolio risk, you should consider balancing your investments across both bonds and equities in order to spread (or diversify) these risks.
Prudential offers investors three multi-asset unit trusts with bond and equity components:

• Prudential Balanced Fund
• Prudential Inflation Plus Fund
• Prudential Enhanced Income Fund

and one with a bond focus:

• Prudential High Yield Bond Fund

This last fund aims to maximise income while securing steady capital growth by investing in a diversified portfolio of high-yield bonds. The fund invests in a combination of South African government, semi-government and corporate bonds, and other interest-bearing securities. The performance objective is to maximise total returns above the BEASSA All Bond Index.

In the next part of this series we will be looking at listed property, how it produces returns and how it can benefit you as an investor.

If you aren't already investing with us, contact your financial adviser or our Client Services team on 0860 105 775 or at info@prudential.co.za.