Why Buying Government Bonds Isn’t Boring: Part 2

Evan Liberman Articles, Government 0 Comments

Israel issues a variety of government bonds. Bonds are a great way to safely earn income, putting your hard-earned capital to work. But, which ones should I buy? This is part 2 of the Solid Government Bond series, so if you missed the introduction, read [post=766]. In this article we will continue to examine several questions related to investing in Israel government bonds, and so that you can make an informed decision based on your personal needs.

What about inflation?

In past decades, Israel experienced hyperinflation, but in recent decades this has not been the case. For quite some time now, Israel has been in line, in this regard, with other Western developed nations. Some government bonds are linked to the government’s cost-of-living index, which attempts to keep bond prices in line with inflation in the country. In this way, the real shekel value of the bond principal and interest is preserved over time, irrespective of inflation. The Bank of Israel is predicting annual inflation of 3.7% through March, 2012.

How do I get paid?

Each bond type pays interest differently: some quarterly, some annually, and some at full maturity. See the table below for more details. Depending on when interest income may be needed, one can factor in the timing of the payments. One very liquid option for steady income is the Makam (Bank of Israel note): a short-term bond purchased for durations of one to twelve months. It is a zero-coupon government bond purchased below par value (full face value) – for example, bought at 98 Agorot – and redeemed at 100 agorot (i.e. 1 shekel). In this way, the “interest” paid is actually price appreciation. One could purchase Makam bonds with different maturities (bond laddering), each expiring in a different month, to create a steady income stream with high liquidity.

What type of returns can I expect?

With global interest rates at a historic low, Yield to Maturity (YTM) for Israel government bonds currently yield up to 5.5% annually (as of June, 2011). The yield depends on the bond duration, variable interest rate or fixed, and whether the bond is inflation-adjusted. Short-term (one year or less) Makam fixed-rate bonds yield up to 3.5% annually, and variable-rate 6-year bonds yield 3.6% (adjusted when the Bank of Israel changes Israel's basic interest rate). Fixed-rate, non-indexed Shahar bonds with a 15-year duration can yield 5.5% per year, for example. In today’s near-zero U.S. government interest rate, a 5.5% return on a government bond with very low risk is quite attractive. Keep in mind that the longer the duration of a fixed-rate bond, the more likelihood there is for downward price movement, if interest rates rise. A lower bond price would affect us only if we were to sell the bond before full maturity. So, in the current low interest rate environment, a shorter-term, variable-rate bond is usually preferable, keeping your bond yield automatically increasing with future interest rate hikes (and allowing you flexibility to move into higher yield bonds in the future).

Because Israel government bonds, as well as corporate bonds, are traded like stocks on a continual basis, there are uneven maturity durations. For example, if you wanted to buy a fixed-rate, non-linked Shahar bond, you may see nine different choices, ranging from 0.9 -15.4 years maturity (not round 5 or 10 years durations). First, you would determine the type of bond you wanted, see its various Yield to Maturity (YTM) interest rates offered for various durations, and then decide which bond is best suited to you. Here is a sampling of different types of bonds and their annual yields:

[TABLE=1]

What do I need to consider when it comes to taxes?

Israel does not tax capital gains, dividends or interest for non-Israelis. For Israeli residents, gains are taxed at 20%, except for non-linked bonds which are taxed at 15%, irrespective of the duration they are held (no high short-term tax rates). Therefore, this is a superb avenue for safely employing your capital, supporting the State of Israel, and receiving a good return on your money safely. A tax accountant can be consulted for more details regarding taxation in your home country. Consultation is not mandatory, though, as there is no end-of-year tax reporting requirement to Israel. When purchasing State of Israel bonds outside of Israel, you can consult your local accountant for tax implications.

What now?

Having understood the various factors that go into bond purchase decisions, you can see the current rates of the bonds you may wish to purchase [post=1526 text="online"]. You can then [post=1373 text="purchase"] the desired bond, and enjoy the interest payments, as well as the investment stability and peace of mind you’ve gained. A wise investor will continue to watch changes in interest rates, bond prices and yields to determine whether to switch to a potentially better yielding bond in the future, or allocate this capital to another asset class as economic conditions change.

In the next part of this series you will learn how to find out the current exact yield on government bonds and their securities numbers so that you can execute a transaction. Continue to [post=1526].

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