Changes to the prudential investment regulation 28 of the Pensions Funds Act mean that all investors with long-term savings in retirement annuity (RA) funds, preservation funds and investment-linked living annuities where there is investor choice need to understand bonds and broader debt markets.
Between now and the end of the year, I will be explaining the consequences of the changes to regulation 28 for individuals invested in RAs and preservation funds.
The most important change that affects individuals requires regulation 28 to be applied at individual level and not at fund level.
The basis of regulation 28 is that it sets limits on how much may be invested in different asset classes – such as 75 percent in listed shares – or in sub-sectors of an asset class or in any one security, such as a share or a bond.
The point of regulation 28 is to reduce your exposure to risk by diversifying your investments.
Previously, the requirement for the limits to be set at fund level meant that you could have, say, 100 percent of your RA savings invested in offshore shares if the fund itself had sufficient capacity to allow you to do so.
Two things about this worried the government:
* It could be unfair on others if some investors had taken up all the access, particularly to offshore investments, leaving others with no access or limited access; and
* Regulation 28 became a meaningless exercise if it was applied only at fund level.
The consequence of both factors was that anyone with an imbalance was not being protected by the diversity-of-investment requirements.
This week’s column is a simple guide to how the bond market works.
A bond is a debt instrument “issued” by borrowers such as governments, parastatals (such as Eskom) and companies that need large sums of money to finance substantial projects.
The sums involved are usually so large that banks do not have the resources to provide the money as loans. So the borrowers, in effect, seek pools of wealthy investors prepared to lend them money. The money is normally required for long periods, which can range up to about 30 years. Most of these investors are institutional investors, such as life assurance com-panies and retirement funds.
Individuals, who do not generally have the large amounts (normally a minimum of R1 million) required to buy a bond, can access bonds through pooled investment portfolios, such as collective investment schemes (unit trust funds and exchange traded funds) and life assurance portfolios.
A borrower issues its bonds in what is called the primary market. But this does not mean that a primary investor has to hold onto a bond until it matures, say in 30 years’ time.
The bond can be traded in the secondary market, either on an exchange, such as the JSE, or in over-the-counter trades directly between buyers and sellers.
A vanilla (basic) bond will have:
* A face value – the amount being borrowed;
* A coupon – the interest that will be paid and when it will be paid (normally every six months); and
* A maturity date – when the bond capital will be repaid.
The interest rate is determined by how keen investors are to lend money to the entity. This is affected by things such as the presumed risk of the loan, the duration of the loan and prevailing interest rates. In South Africa, the Johannesburg Interbank Agreed Rate (Jibar) is normally taken as the benchmark on which the interest rate is set.
The interest rate will be at a premium (higher than Jibar) if the perceived risk and duration of the loan is for a long period, or at a discount (lower than Jibar) for shorter terms and perceived low risk.
The difference between the benchmark rate and the actual rate is called the margin.
Bonds, however, come in many different forms. They can have floating interest rates, where the interest paid is linked to, say, the inflation rate or prevailing interest rates.
A bond may also pay no interest at all – it could be issued at a discount to the face value. In other words, a bond of R100 million could be sold to investors for R90 million, with the investors receiving R100 million on maturity.
When bonds are sold and bought on the secondary market, they are not necessarily sold at the price that was paid on the primary market. A bond could sell at a discount or a premium to its face value.
There are a number of reasons for this, including:
* Current interest rates. Say the coupon was 10 percent when the bond was sold initially in the primary market, but five years on the prevailing interest rate is 15 percent. As a result, the bond-holder (investor/lender) is losing out by five percent a year. The bond-holder will want to sell the bond to receive an interest rate that is closer to the prevailing rate.
* Risk. If the perceived risk of a bond has increased or decreased, this will affect the price of the bond. The closer a bond is to maturity, the lower its perceived risk.
On the other hand, perceived risk can be heightened by an anticipated default. Take Greece, for instance: if you held a Greek government bond today, you would not be expecting to get back your money. In fact, you would be prepared to sell it at a significant loss to ensure that you did not lose all your money.
It is in the secondary market that bonds get complicated and confusing. If prevailing interest rates rise, the demand for bonds with lower coupons will drop. This will be reflected in the price of the bond, which will now sell at a discount to its face value to make up the difference between the lower coupon and the higher prevailing interest rate.
So when interest rates rise, the prices of bonds fall (sold at a discount). When interest rates come down, the prices of bonds go up (sold at a premium).
A bond’s price will fluctuate on an almost daily basis throughout its life in response to a number of variables, such as prevailing interest rate, duration to maturity and perceived and actual risk.
This is where the term “yield”, which is used in newspaper reports on bonds, comes in. A yield is what you will earn (the return) from a bond, combining the coupon and the price of a bond.
Most yields are calculated on the basis of what you would receive if you held the bond until maturity. This known as the yield to maturity (YTM). If you buy and hold a bond to maturity, the yield will be at “par”, with the yield equal to the interest rate (coupon). So if you buy a R1-million bond with a 10-percent coupon (R100 000) at its par value, the yield is 10 percent (R100 000 divided by R1 million).
If the price falls to R900 000, the yield will rise to 11.1 percent (the R100 000 coupon divided by the price of R900 000, expressed as a percentage). Conversely, if the bond goes up in price to R1.2 million, the yield will shrink to 8.33 percent (R100 000 divided by R1.2 million).
The yield, particularly the YTM, allows you to compare bonds with different coupons and maturity dates. The higher the yield you can achieve, the better off you are. If you are on a low yield, you can make up the difference by selling your bond.
Bonds are considered to have a lower risk than equities because their prices do not fluctuate as much as those of equities.
HOW TO ACCESS BONDS
Most people cannot afford to invest directly in bonds, because you need at least a R1 million to do so. The exception is RSA Retail Bonds, but a retail bond is more akin to a bank deposit than a traditional bond issued by a government and traded on the bond market.
Introduced in 2004 to encourage banks to offer savers more competitive interest rates, RSA Retail Bonds guarantee your capital, as well as the interest rate, which is regularly reset on new investments based on what is happening in the traditional bond markets.
RSA Retail Bonds cannot be traded, with the result that the yield is always equal to the interest rate.
RSA Retail Bonds come in two categories, based on lump sum investments aimed at providing an income flow. The categories are:
* The fixed-rate bond, which has an investment term of two, three or five years, and where the interest rate is fixed for the investment period; and
* The inflation-linked bond, which has an investment term of three, five or 10 years. The floating interest rate is adjusted for inflation twice a year.
A third variation is scheduled to be introduced next year. The top-up bond will be aimed at the savings market. Top-up bonds will have a minimum initial investment of R500, and you will be able to add to your savings at any time – the minimum top-up will be R100.
Details of another new retail bond, the pension-providing Annuity Retail Bond, are due to be released next year. A National Treasury team is working on the terms and conditions of the Annuity Retail Bond.
You can buy RSA Retail Bonds at the Post Office and Pick n Pay outlets or directly from the National Treasury (www.rsaretailbonds.gov.za).
Unfortunately, you cannot buy RSA Retail Bonds through products offered by the financial services sector, so you cannot include a retail bond in your retirement annuity.
The choice for most people, who cannot afford to buy a bond on a stock exchange, is to invest in bonds through a collective investment scheme – either a unit trust fund or an exchange traded fund (ETF).
Bonds crop up in a number of unit trust categories, including most fixed-interest funds and flexible funds.
If you invest in a prudential unit trust fund, it will already be compliant with regulation 28, no matter whether the fund is in the low-, medium- or high-equity sub-sectors.
Very few retirement product providers offer investors ETFs, which track various indices, although their number is growing.