Unit trusts vs. bonds. Connie Bruwer from PC Bruwer and Partners gives advice on this important topic.
Question: A reader, Frank, asks how bonds work and how it works within in unit trusts. I also gather from other readers’ queries that there was a little confusion about the concept of bonds vs. unit trusts. It is two different products. Please explain the difference to us, Connie.
Connie: A unit trust, now called collective investment schemes, is a combination of units in a number of asset classes, including, inter alia, cash, shares and property.
A bond is a particular investment instrument that can be recorded in a particular unit trust – or not.
It depends on the particular fund’s composition.
Bonds are investments that provide a steady income, which is an interest income and provides return of your money at the end of the term, for example, 5, 10 or 20 years.
The exact effect is very technical and I would rather answer this question: Do I invest in bonds?
Question: What do you answer our readers, Connie?
Connie: My answer is yes. But first read a bit further.
Bonds are issued by the government and large companies when they want to borrow money. For this loan, they pay you interest at a tied rate if you buy the effect. At maturity you will get your money back.
The current interest rates make bonds attractive for now. If you borrow money from the bank, you pay a high interest rate. It works just the same if you lend money, because that is what you do when you buy bonds.
The price of the coupon (interest rate) is determined by the prevailing interest rate. It is also the determinant of the interest income you receive during the term.
Question: What about risk? How does it work?
Connie: All investments, even cash, have a degree of risk and risk for bonds are considered moderate. Bonds issued by the state, is probably the safest. The government can always create money. They simply raise taxes when they realize they can’t pay their debt.
Companies do not have that “benefit” and it may happen that they cannot refund the money, although the likelihood is slim. South Africa has one of the best developed bond markets in the world and it is well regulated.
The interest risk works both sides and it is a key characteristic of an investment in bonds. If interest rates rise, the capital value of your instrument will reduce. While you still receive the same interest, new bonds investors can get a better interest rate.
Question: Can you explain this in another way?
Connie: Put in another way, if interest rates rises, the value of your investment will become less.
But if interest rates fall – and that’s the reason for my answer above – your investment will increase in value because the interest rate paid for new effects are lower than the rate at which you purchased your unit.
Bonds are liquid and can be traded. You can therefore sell it at a higher capital value than which you bought it if interest rates fall.
Bonds are a negotiable instrument and in the open market investments are also traded, just like shares
Bond’s role in a mutual fund is the same as shares
Question: Do you invest directly in securities or through a mutual fund? Which one would you recommend, Connie?
Connie: Unit Trust, I would say. Simply because knowledgeable people take your buy and sell decisions and in a unit trust your exposure to bonds form part of a more diversified investment. All your eggs are not in one basket – as it should be with a sensible investment.