Understanding Bonds and Interest rates

As an investor, you will most definitely hear a lot about government bonds and interest rates on your investment journey. Understanding these concepts may help you to identify opportunities during times of uncertainty.

Government bonds are tools used by governments to borrow money from investors to fund new projects. Interest rates are the main tool used to control money supply.

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Here’s some more information on interest rates, government bonds and their effect on inflation.

Interest rate

Central banks use interest rates to control the supply of money into the economy by regulating the interest paid on “borrowed money”. When interest rates rise, the cost of borrowing increases and inflation slows. A cut in rates allows more money into the economy as borrowing costs decrease. An interest rate cut also tends to result in higher inflation.

Government bonds .

Buying bonds

When a government buys bonds, it effectively exchanges the bonds for money. This money is then introduced into the economy. And as money enters the economy, we are likely to see demand-driven inflation.

Selling Bonds

When governments sell bonds, the supply of money in the economy is reduced. With less money in the economy, demand decreases over time and inflation slows.

Considering the basics of supply and demand, when bond demand lags, bond prices fall.

While bonds may not be directly tradable through the stock market, bond ETFs expose investors to the bond market with more liquidity and transparency. Bond ETFs are available on the EasyEquities ZAR and TFSA platforms.

These bond ETFs include, but are not limited to:

Satrix Global Aggregate Bond Feeder Portfolio

1nvest Global Government Bond Index Feeder ETF

Ashburton World Government Bond ETF

Inflation is the biggest threat to the future cash flow of bonds. When inflation rises, bond prices fall while yield increases.

What is a bond yield?

In short, bond yield is the return on investment that bond holders receive over a certain period of time.

Bond yield = (coupon payment / bond price) x 100

Coupon payment is the expected payment from a bond.

When interest rates rise, bond prices fall while yields increase. This is because bonds are expected to pay more to cover for the rate hikes. A lag in demand reduces the price of bonds.

The direction of inflation is a good indicator for your investment choices.

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