Financial Times Guide to Investing for Income

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