3
Bonds government and
corporate
The basics
The wide and wonderful world of bonds represents a kind of terra incognita
for most private investors. In popular lore bond investing is the preserve
of the rich and wealthy investment banker, sitting in his gilt-edged tower
lording it over the rest of the planet. When bond investors start asking
awkward questions of governments and their credit worthiness, the term
‘bond vigilante’ is usually invoked and it’s instructive that nearly every
‘bond vigilante’ this author has ever interviewed is a professional, institu-
tional fund manager or banker.
By contrast over in the world of shares otherwise known as equities,
and explored in the next chapter it’s automatically assumed that pri-
vate investors have a big role to play. Yet this perception of equities as
being easy for the layperson to understand in contrast to bonds is almost
certainly false. In many respects bonds are a simpler idea to grasp than
equities or other complex financial instruments and can provide a steady,
long-term secure income.
In fact building a portfolio of diversified bonds – be they issued by govern-
ments or corporations as well as equities is an eminently sensible and
practical idea for both cautious and adventurous investors. In this chapter
we’ll look at how a bond is structured and also analyse the various types
of bonds issued, with issuers as diverse as global superpowers and small
companies. Later on in this chapter we’ll also look at how to trade bonds,
before concluding with some simple trading strategies.
72 The Financial Times Guide to Investing for Income
Let’s start this adventure into the world of bonds with a simple definition of
what constitutes a bond. In essence a bond is a very simple creation. A bond
is nothing more than a loan structured as an IOU and issued by a borrower.
Imagine if you lent say £10,000 to the government or a company and
they make a payment comprised of interest which works out at 5% per
annum. That means as the investor who makes the loan you receive a
yield (or coupon) that’s equivalent to £500 per annum. The crucial twist
is the structure of the loan that IOU. That IOU is structured as a note
or bond, with various terms written on the piece of paper or via the elec-
tronic record, i.e. the name of the borrower, the interest rate expressed as a
coupon, the face value of the note or bond and, crucially, the duration of
the loan (this represents the bond’s maturity).
Later on in this chapter we’ll explore these simple concepts in much
greater depth but in summary a bond is just a piece of paper that consti-
tutes an IOU issued to the investor who made the loan to the borrower.
Crucially that piece of paper, electronic record or note the bond itself
can be held until the end of its life’ (called redemption) or traded to
another party on a market of some form, at a given price well before the
bond is due to redeem or mature.
This simplicity of construction easily tradeable paper with clear features,
understood by all as part of a contract between a lender and borrower
has allowed a massive global market to emerge incorporating a diverse
range of buyers ranging from pension fund managers through to a much
smaller number of private investors. This market has also enabled inves-
tors to construct diversified portfolios of different types of bonds, issued
by different borrowers, over different time frames and with different inter-
est rates or yields.
Before we go any further, it’s worth noting a couple of key features from
our simplistic IOU-based description. The most immediately obvious one
is the price attached to that piece of paper which constitutes the bond.
The principal – let us say you lent out £10,000 – might be split up into lots
of smaller units each with their own initial, par value: for example, if you
lent £10,000 and that’s been broken down into 10,000 £1 notes or bonds,
each bond will be issued at par or valued at £1 per bond.
Crucially you should receive back the principal per unit that par of £1
when the bond matures at the end of the period agreed between the lender
and the borrower. There is of course an obvious risk that your borrower

Get Financial Times Guide to Investing for Income now with O’Reilly online learning.

O’Reilly members experience live online training, plus books, videos, and digital content from 200+ publishers.