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7 Sep 2012. Should I be getting my government bond exposure from SA retail bonds or bond Exchange Traded Products (this article doesn't look at Bond Collective Investment Schemes, which are also an option)? If you're asking this question I hope you are an advanced investor, as a decision to increase bond exposure indicates that you are advanced enough to be making asset allocation decisions (or perhaps you just trying to match some fixed liability). This article doesn't comment on the wisdom of investing more in bonds at the moment, but merely compares some of the options.

Basis on which to compare bond options

Bond portfolios may be compared inter alia based on (1) fixed or inflation-linked, (2) security, (3) duration, (4) liquidity, (5) fees, including trading costs, & (6) skill of manager.

Fixed or inflation-linked

Some bonds have payments which increase in line with inflation, and therefore offer a measure of protection against increases in inflation. Fixed-rate bonds offer a stream of future payments which are fixed in monetary terms. Which you prefer, will depend on your reason for wanting to invest in bonds in the first place (e.g. if you want bond exposure because your view is that inflation is going to rise above market expectations, then you'll like the inflation-linked bonds).

Security

Bonds backed by the South African government are generally considered to offer the highest amount of security amongst ZAR-denominated bonds, and those backed by companies have varying levels of security, with yields generally but not always increasing as security decreases.

Duration of instruments

Generally speaking the longer the duration of the portfolio, the more volatile you can expect the return to be for the same change in rates across the yield curve. The duration that appeals to you depends on why you're investing in bonds in the first place:

• If you're investing in bonds in order to try and create a rough match for the movement in annuity rates (e.g. somebody who is about to retire), then a longer duration may be attractive to you.

• You may be a very advanced investor, with a view that a specific part of the yield curve is going to outperform (more advanced than me, as I don't have a strong opinion on this).

• Or perhaps you rate a certain manager's ability to be able to shift durations at the right time and outperform.

• Or perhaps you would like to have a slightly longer duration than the money market, as the yield curve is upward sloping and you would like to lock in a slightly higher return.

• Or perhaps you're investing in bonds because you expect long-term rates to fall, so like the longer duration as it would give the maximum upside (and are willing to take on the risk of capital losses if rates rise).

• Or perhaps you're trying to diversify your portfolio with a bit in bonds, have a view that the long-end and short-end are a bit overpriced, and are wanting to invest in that part of the curve which is currently offering the best rates.

Liquidity

Self explanatory.

Fees

Fees are one of the few things which are certain in investments, so some emphasis can be placed on what you're giving up in terms of fees by investing in the various options. Also, bear in mind trading costs, which will be more for managers who are trading a lot.

Skill of manager

I left this till last, as it is extremely difficult to rate the skill of a bond manager. Merely to untie that part of past performance which was due to credit risk is a big exercise in itself.

Comparing Government inflation-linked bond options

On 7 September 2012 you could achieve a lagged real yield on RSA retail inflation linked bonds of 2.25% for a 10 year term, 1.25% for a 5-year term and 1.00% for a 3-year term. This compares with the following estimated rates obtainable on conventional government inflation-linked bonds:

• R197 1.5%

• R202 2.1%

• R210 1.8%

Considering that estimated TERs of 0.31% are payable on the Newfunds ILBI and 0.44% on the RMB Inflation-X, it is clear that the expected return of the 10-year RSA retail inflation linked bond has a greater expected return than the Absa Newfunds ILBI & RMB Inflation-X ETFs. The ETFs have better liquidity, so at the moment one would only choose the Absa Newfunds ILBI or RMB Inflation-X over retail inflation linked bonds if liquidity is a very important factor.

* This excludes fees involved in purchasing the ETFs (e.g. broker fees if you're going that route).

Comparing Government fixed-rate bond options

On 7 September 2012 you could achieve a rate on RSA retail fixed rate bonds of 7.00% for a 5 year term, 6.50% for a 3-year term and 6.00% for a 2-year term. According to the business day, the yield on 6 September 2012 for the GOVI was 6.9%. This means that after subtracting the expense ratios of the Absa & Investec ETFs (0.21% and 0.34% respectively), the expected net return on the RSA Retail fixed bonds 5-year term is higher than for the GOVI ETF trackers (if you add in the fact that you can restart the RSA Retail bonds after 12 months, the expected return is even higher for longer-term investors). The only reason one would currently invest in the GOVI ETF trackers over the RSA Retail Bonds Fixed rate product is if you prize liquidity highly (as the trackers are traded).

* This excludes fees involved in purchasing the ETFs (e.g. broker fees if you're going that route).

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