Page 131 - Profile's Unit Trusts and Collective Investments 2021 issue 2

Understanding Asset Allocation

Why do bond prices fluctuate?
Think of the relationship between bond prices and interest rates as opposite ends of a
pulley. When interest rates fall, bond prices rise. When interest rates rise, bond prices fall.
Let’s say that you buy a bond worth R10 000 paying 10% interest (R1 000 per annum)
until it matures in 20 years time. The bond would have been bought in the expectation that interest
rates would go down.
Now suppose you want to sell the bond after only five years. And suppose that the interest rate
has gone up to around 15%. Why should investors buy a bond with an interest rate of 10%, when
they can buy a new bond at an interest rate of 15%? You will have to drop the price of the bond
below the price you paid for it – to around R7 000 (R1 000/R7 000 means the buyer gets an
effective interest rate of 14.3%).
Suppose, on the other hand, you needed to sell when the prevailing interest rate had gone
down to 5%. You could charge a premium price – around R20 000 – for your bond, which is paying
R1 000 (R1 000 / R20 000 means the buyer gets an effective interest rate of 5%). Either way, the
buyer will receive R10 000 when the bond matures, because that is the face value of the bond.

Issuing Company/Organisation
The South African government sells bonds through the Treasury to finance the national debt.
Semi-government institutions (such as Eskom and Transnet) issue bonds to finance long-term
equipment development. Corporations sell bonds (often called debentures) to finance their
long-term capital projects, such as building new factories or investing in information technology.
Maturity
Maturity refers to the duration of the loan – the length of time until the principal is repaid.
Short-term bonds mature in less than three years, long-term bonds mature in more than ten years.
A medium-term bond typically matures in about seven years. In general, the longer the maturity,
the greater the interest rate risk.
Quality
Bond quality refers to the creditworthiness of the issuing organisation and the likelihood that it
will repay its debt. Independent overseas rating services, such as Moody’s Investors Service and
Standard & Poor’s in the USA, conduct in-depth research across a wide range of political, economic
and business criteria, based on which, they publish a “rating” of the dependability of the issuer. A
lower rating means that there is a greater credit risk with that particular bond issuer.

Costs and Minimums for Bond Funds
The Bond Funds sector became the Variable Term sector in 2013. Many of the funds in the
sector, however, still use “Bond Fund” in their names.
The initial fees of domestic bond funds are usually zero (broker commission excepted) and
annual fees range from 0.21% to 1.15%. Bond funds in the global and regional categories have
initial fees of zero and annual fees ranging from 0.2% to 0.9%. Only two funds (across all
categories) charge performance fees.
Minimum lump sum investments range from R2 000 to R50 000 (with R5 000 and R10 000 the
most common). Debit order minimums range from R200 to R1 000 a month.

Equity Funds
Equity-based schemes dominate the CIS industry in South Africa, with some three-quarters of
funds on offer being pure equity schemes or having a significant equity component (like multi
asset funds).
Equity investments give investors part ownership in listed companies on the JSE (and
sometimes, to a very limited extent, to unlisted companies). Equity-based investments are the
most volatile asset class: the value of investments rises and falls according to the prevailing market
conditions. Historical analysis, however, indicates that returns on equity investments have been
superior to any other class of investment over the long-term.

129
Profile’s Unit Trusts & Collective Investments — Understanding Unit Trusts