(Article for the Jakarta Globe – issue date 14 January 2013)
MONEY WISE
WHY WOULD ANYONE INVEST IN BONDS?
The word ‘bond’ has a number of meanings in the financial world. The bonds I
would like to discuss today however are fundamentally securities issued bygovernments to raise funds to support investment, spending, or even to repay
existing debts. Raising money this way avoids the pain of raising taxes. The
bonds are generally for a fixed term and pay a guaranteed rate of interest,
usually half-yearly. At the end of the term the capital is repaid in full.
US Treasuries considered the safest
Perhaps I should start by reiterating that there is risk in every investment. Evenfailing to invest is risky, since inflation will erode the purchasing value of cash
over time or even wipe it out overnight!
However, US Government Bonds, or Treasuries, are considered one of thesafest investments in the world. So much so that both the Chinese andJapanese governments have each bought over $1 trillion of them. What kind ofreturns are they getting? 30-year bonds are currently paying 3.1% per annum;10-year bonds are yielding only 1.9%%.
Why is there such faith in Treasuries? Basically because they are extremely
unlikely to default. It is not impossible however, and they could come to brinkof default in a few months’ time unless politicians agree to raise the debt
ceiling yet again. But raise it they will as a US default on its debt would destroy
US Treasuries’ reputation as a safe haven and would cause havoc in global
financial markets. At the end of the day, any government can meet its debt
obligations by simply printing money. The exception is the Eurozone, whereindividual countries cannot print money as this is the prerogative of theEuropean Central Bank. This is why they have to offer rates of return thatreflect the risk of their perceived ability to honour the debt and why rates arerock bottom in Germany and have been sky high in weaker countries.
What about Indonesian bonds?

Currently the return on Indonesian bonds is just over 5%. In 2008 it reached an
all-time high of 20.8% at the height of the global financial crisis. Had youbought bonds at the time you would still be enjoying that high rate of interest.
Or you could have lost heavily if the crisis turned out badly for Indonesia.
So at over 5% wouldn’t it be better to buy Indonesian bonds as opposed to US
Treasury bonds offering only 1.8%? Well it could be, except that in 2012 theRupiah fell by 6% against the US Dollar so you would have been worse off at
the end of the year in USD terms despite the higher interest rate, as you would
also have been with a bank deposit. On the other hand, had you bought USTreasury bonds the previous year you would have been worse off in Rupiahterms as not only was the Rupiah offering a higher return it also strengthened
against the US Dollar. What will happen in 2013 is anybody’s guess and thisleads us to the other factors that must be considered when investing in bonds.
What are the risks?
There are four main risks with government bonds: Currency risk, political risk,
inflation risk and interest rate risk.
We have already seen above how currency risk can affect the real return. Asfor political risk, any government can interfere in or manipulate the financial
markets to its own benefit and the detriment of investors. Such interference
usually backfires as it will discredit the reputation of the country concernedand make it difficult to raise credit in the future.
Inflation is a big risk. Right now, the interest rates being offered by the US andseveral other ‘strong’ economies are lower than their respective rates ofinflation so the real return investors are getting from bonds is negative. Inother words, when you cash in your bond even with the interest you havereceived, the cash you now have will buy less that it would have bought when
you invested it.
The final risk is that of interest rates. Should prevailing interest rates rise, thecapital value of your bond will fall, meaning it is worth less on the market thanyou paid for it should you want to sell it on the open market prior to its
maturity.
So why on earth buy government bonds?

The reason is very simple. By and large they are very safe and guaranteed by
the country of issue. They may not offer the same returns as stocks (the S&P500 rose 13% last year), but neither will they tumble like stocks as the S&P did
by 37% in 2008. Pension funds cannot afford to risk everything in stocks toproduce growth. Such strategies caused havoc to many funds in 2008. To
ensure liquidity and guarantee their ability to pay pensions when due they
have to hold a major portion of their funds in government bonds. It is not theirconcern if the purchasing value falls. Their concern is that they have the cash
to meet their obligations.
For the same reason, the private investor should consider bonds as an integral
part of a balanced portfolio, particularly the closer one is to retirement.
But we have considered only government bonds so far. There is a much wider
universe of bonds that space does not permit us to explore at this time.
Colin Bloodworth, director of PPI Indonesia, has spent over 20 years inIndonesia. If you have any questions on this or a related subject you cancontact the writer at indonesia@ppi-advisory.com