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Chapter 1: What’s a bond? Some key concepts

Everybody knows what shares are – buy a share and you own a small stake in a company. If the company does well and makes a profit, this may be distributed to shareholders as dividends. If the company continues to do well, these dividends will rise. Meanwhile, the capital value of your share, driven by other investors in the market, will likely rise.

That’s the plan.

But as most investors will tell you, it doesn’t always work out like that. Dividends may be conspicuous by their absence. Even reliable blue chips such as BP (or indeed most of the world’s banks) can be knocked for six by disaster, and dividends withheld for many years.

Bonds are different. A bond holder does not own the company – he or she is lending it money, and that loan comes with the usual package of conditions: a fixed annual or semi-annual coupon and agreed date of repayment. In a nutshell, a bond is this; a tradable security with a fixed interest payment and (usually) a pre-determined repayment date. The key point is this: the forward cash flows of the investment are known.

What is more, in the majority of situations the company does not have the option to withhold such payment and the bondholder has a prior claim on the issuer’s assets in liquidation.

Bonds can be issued by a government, company or many other types of organisations. Effectively they are marketable loans, or IOUs, issued by these entities and bought by investors such as banks, insurance companies and fund managers.

Tip

It is worth mentioning at this point that there are numerous retail-targeted investment products marketed as “bonds”. These include fixed term (typically 2, 3 or 5 year fixed term deposits from banks and building societies) and packaged equity-linked products from life insurers etc, again often with a fixed life. This is sloppy nomenclature on the part of the financial service industry and I, for one, would like to see the term “bond” reserved exclusively for fixed income securities.

Investors are often heard to say “I don’t understand bonds”, but the truth is that these instruments are much simpler than equities.

Key features

The key features can be broken down as follows:

At launch, bonds are sold to investors (typically institutional) via an investment bank or broker. This is known as the primary market. Gilt issues are also offered directly to the general public. After this primary phase, bonds are then free to trade between investors and/or market counterparties. However, unlike equities that trade through a centralised stock exchange, bonds generally trade on a peer-to-peer basis from one institution (such as an investment bank) to another (such as broker).

This global market in bonds is enormous. Figures released by the International Monetary Authority in 2002 estimated the total amount of debt securities as around 43 trillion US Dollars. At the time this was nearly twice the total of the world’s stock market capitalisation. The number of bonds in circulation is considerable, and a large and regular issuer such as the European Investment Bank or General Electric may have several hundred issues trading at any one time. These bonds will be issued in a variety of currencies and may differ greatly from each other in terms of coupon or coupon type, date of maturity and other features such as imbedded puts and calls.

This book is primarily concerned with the sterling bond market, and even in this relatively small subset of the international bond markets, a quick check on my Bloomberg Terminal reveals over 6,000 issues outstanding. Bear in mind that this number is constantly changing (bonds are issued and redeemed all the time).

Although the bond market is considerable in size, one point to bear in mind is that the secondary market is less consistent than that seen in equities. Many bonds are bought on a buy and hold basis as new issues, and this investor behaviour has a tendency to reduce secondary market turnover. Government bonds remain highly tradable with very tight bid-offer spreads for large size deals. However, the liquidity situation in corporate bonds is variable with only a proportion of the huge number of new issues that are readily tradable in the secondary market or accessible at any given time. The skills required to deal with this variable liquidity picture make bond dealing a slightly more complex art compared to the highly transparent equity market, and I address this issue over the course of the book.