Education around the basics of wealth creation and preservation is like a good, solid diet packed with healthy food staples, it can help you enjoy healthy finances for years and create a strong foundation for building your future.
Bonds are a healthy part of any portfolio or ‘diet’, and most people think they understand them. Today, we want to talk about an aspect of investing in bonds most people misunderstand or simply don’t know about – interest rate risk.
In today’s highly uncertain market, bonds remain an attractive option. Not subject to having the sudden market-related dips (or spokes) that equities do, it’s a lower risk option for preserving or growing your money in most environments.
Sounds great, right? Potentially.
Most bonds pay a fixed rate of interest over a defined period of time.
What many investors don’t understand about bonds is that the rate is set according to prevailing market interest rates at the time of issuing the bond, but the market interest rates that occur afterwards during the period of the bond may not be even remotely similar to the ‘weather conditions’ when you first took out the bond.
What this means for your money is that, should interest rates rise, your bond’s value will lessen. Should interest rates fall, the reverse will happen – your bond is now worth more. Because this is directly related to inflation (interest rates rising are usually due to CPI itself rising above what’s been predicted for it), a good way to understand this is inflation. If inflation increases, even though you have the same notes and coins in your wallet, that money is effectively worth less. If inflation decreases, slowly your money will be worth more in relation to the rest of the market (price of eggs etc.). It is not the notes or rands themselves that have changed if the inflation rises, it’s the market.
This is interest rate risk, and it’s a vital element which affects how much return you’ll get once a bond matures.
It is seldom that we truly know what is going to happen to the market in the next two to three years with absolute certainty, but in the case of interest rate risk, it seems that we do. South Africa will be hiking rates for the foreseeable future, as announced at the end of last year when the Reserve Bank’s Monetary Policy Committee (MPC) said it would raise the repurchase rate quite significantly to 6.75% per year as of November 2018.
What does this mean for our bonds? Well, if you look at the above in SA in isolation, it means that a bond’s value will lessen if interest rates rise (which they have) and will continue to do so if interest rates continue to climb (which it looks like they will).
A word of warning – any investment in any form should be underpinned by knowledge. Choosing to put money into a bond of any kind is no exception. Taking interest rate risk by investing in a certain bond without knowing every aspect inside and out is like getting onto a horse and expecting to ride it when you don’t know how a horse moves.
However, if you only ever invest in things you already understand, where will that leave you? Your money may grow, but your own horizons and understanding won’t.
Consider this a call to adventure – not to invest in bonds necessarily, but rather for us to chat about things you don’t fully understand, perhaps interest rate risk being one thing, and start an exciting new chapter in your financial awareness and confidence!