Government bonds are a debt-based investment where the investor loans money to the government. The government uses this money to funds its projects and developments. Investors get an interest on the amount of money they issued to the government, this interest is either fixed or linked to the inflation rate.
Government bonds are considered to be one of the safest investment assets. This is because the government is not likely to ever default on its loan. Government bonds don’t have the same yield as corporate bonds, corporate bonds are not as safe as government bonds. Corporate bonds offer a higher yield compared to government bonds because their risk is generally greater.
Let’s look at the two bond products that are currently offered by the government in South Africa.
Fixed Retail Savings bond
Fixed Retail Savings bonds have a fixed interest rate, they consist of bonds with 2-year, 3-year and 5-year terms.
The average interest rate differs for each of these terms, 2-year investments yield a 5% return, 3-year investments yield a 6% return and 5-year investments yield a 7.75% return. These are the rates for October 2020.
It’s very important to note that these rates fluctuate and change each and every month. For example, on January 2020 the rates were 7.25%, 7.50% and 8.25% respectively. The interest rates for October are on the lower end, it’s not likely that you will get an interest rate that is lower for your investments.
Fixed Rate Retail Savings Bonds earn a market-related fixed interest rate, which is priced off the current government bond yield curve. This simply means that factors of supply and demand affect the interest rate. High demand for bonds lowers the interest rate, the high demand is usually caused by some economic activity elsewhere.
Inflation Linked Retail Savings Bond
These bonds are linked to the inflation, they offer lower interest rates on paper but they are very good if you want to invest long term. With the fixed retail bonds; the interest rate might be 5% on your principal amount but inflation might rise by 4% each year, meaning that in reality you only make a gain of 1%. This government bond ensures that your interest rate is adjusted for inflation.
Inflation will eventually eat into your money, especially if you are investing on a long-term period like 5 years. With this bond you get paid semi-annually, this means you get paid twice per year at a fixed rate that has been adjusted for inflation.
Unlike the fixed retail savings bond, with this option you are allowed to invest for 3 years, 5 years and 10 years. The interest rate on October 2020 is 3,50%, 4,50% and 5% respectively. This is the highest they have been in over a decade.
How much do government bonds cost?
The minimum amount of money that you can invest in a Retail Savings Bond is R1 000 but it must not exceed R5 million. This amount is very low and can be afforded by most South Africans, R1 000 will not yield a lot of money. With R10 000 you can expect to make R14 620 after 5 years on a Fixed Retail Savings Bond.
Tax on government bonds
Interest on Retail Savings Bonds is treated as income; therefore, you will have to pay income tax. Depending on the personal circumstances and age group of an investor, investors may be entitled to the tax exemption of a portion of or all of the interest. More information here.
Advantages and disadvantages
The main advantage of government bonds over corporate bonds is that they are very secure. Way more secure than corporate bonds and most other investment assets.
The main disadvantage of government bonds is that they have a very low yield. Another disadvantage is that government bonds can lose value on the open market if interest rate or inflation expectations arise. Bonds can be vulnerable if the government that issues them enters a fiscal crisis that raises doubts about whether debt obligations will be honoured.
Government bonds are safe and great for new investors that don’t have that much experience with investing. This was a guide on how government bonds work in South Africa. Do you have any thoughts or questions? Comment below.