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