Bonds in a Day

Everything you need to master the mathematics that drives bonds

Stewart Cowley

• Publisher: Harriman House
• Year: 2018
• eBook ISBN: 9780857196361
• Edition: 1
• Topic: Business
• Subtopic: Financial Accounting
• Index: Business

The bond markets can be a bewildering place - the words, the concepts and the mathematics can be mind-bogglingly confusing even to seasoned professionals. In this step-by-step guide, Stewart Cowley - one of the UK's best-known bond managers - takes investors through the basics they need to know to begin understanding bonds.From compound interest, through yield calculations, how the bond markets work and how to make the most out of the bond markets, this practical, easy-to-read handbook uses spreadsheet examples combined with a wealth of experience to help you work through real-world examples of bond management.

1. Introduction

Bonds are both ubiquitous and the least visible things in the world. Everybody owns bonds, or has some exposure to them, but very few people know how or what they are – or for that matter how they work. Those rare individuals who have the slightest inkling of their internal workings are rightfully called ‘bondmeisters’. Literature has, from time to time, tried to confer some kind of celebrity on bondmeisters; F. Scott Fitzgerald’s Jay Gatsby of The Great Gatsby was a bond salesman, whilst the hapless subject of Tom Wolfe’s The Bonfire of the Vanities, Sherman McCoy, traded in the bond markets. The less said about Mickey Rourke’s John Gray in 9½ Weeks the better; besides, he seemed to have something to do with US government debt and had a penchant for sitting in front of open refrigerators.

Any sliver of glamour enjoyed by people working in the bond markets came to an abrupt end on 15 September 2008 when an American investment bank called Lehman Brothers collapsed – filing for bankruptcy owing $619 billion. In the following month, $10 trillion was wiped off global stock markets as the fallout spread through the global financial system. Its effects were felt from Boston to Beijing. All but a handful of Lehman’s 25,000 employees lost their jobs; those that remained were mainly employed to say “Sorry” quite a lot. Millions of American, European, Asian and emerging market workers lost their jobs too. People began to ask how this could happen. With the question came the end of the Age of Bond Innocence and the 2008 Financial Crisis began. Its consequences ricochet around our financial system even as I write a decade later.

The fact is bonds are all around us, like the nitrogen in the air we breathe. All borrowed money is debt – and bonds are only one form of it.

Our relationship with debt is complex; it offers limitless possibility for both good and evil. Reading The Communist Manifesto by Karl Marx and Frederick Engels reveals even the two most hardened redistributors of other people’s wealth understood that for capitalism to work you had to have a fully functioning lending and borrowing system. Ideas could be turned into products, which could then be sold to the public, only if you borrowed money to kick the process off. The hope was your sales proceeds would be greater than your production costs (including debt interest), in which case you made a profit and got to live in a big house and stride down Pall Mall, 5th Avenue, the Kaiserstrasse or through Ginza with a top hat, a silver-handled cane and a monocle. In the process of this thoroughly reprehensible act of personal enrichment, people were employed, families sustained, governments received taxes, social welfare programmes were funded and the general good was enriched. Debt-driven capitalism possessed the potential to lift mankind to a higher place, ending 98,000 years of grubbing around in the soil looking for root vegetables. On the face of it – how could it possibly go wrong?

How it goes wrong is very simple: human beings have little or no self-restraint. Faced with a good idea, they really can’t help themselves. Taking a good thing too far has been their main source of amusement since a caveman called ‘Ug’ lent his mate ‘Oog’ two blue pebbles and told him he wanted three back before the next full moon. Throughout history we have repeatedly borrowed too much, leading to financial crises, revolutions and periodic misery. It’s as though we have a unique ability to repeat the same mistake over and over again and represent it to ourselves as entirely original. But, leaving aside this recurring lemming-like dash towards disaster, our ability to repeat the same mistake can, in no small part, be traced back to our inability to comprehend the first thing about the mathematics of debt or bonds. This has to stop. That is what this book is for.

Whether you are a lay person, a student of finance or a seasoned professional who skipped the bond module in their training programme 20 years ago, there is now a burning need to have a rudimentary understanding of how bonds work; how you can make money with bonds; how you can lose money with bonds; and how bonds can help you protect what you already have. The aim of this book is to lift the veil from the bond markets in the simplest possible way. It will give you the rudiments of how they work, how the mathematics that drives them works and, possibly most importantly, explain the words used to describe this important area of finance – words which seem to have been specifically designed to confuse people and keep the tourists away.

I am going to start right at the beginning, assuming no knowledge on the part of anyone, and take you through, step-by-step, using worked examples and spreadsheets so you can play with the numbers just to get a feel for how the whole thing operates. I do not deny that there are systems that will do this for you, but this book is designed to show you how things work behind the scenes – and to do that you have to go back to basics.

I have to admit I am somewhat hampered right from the start. The process of quantitative easing (the buying of mainly bonds by global central banks in order to drive interest rates down), combined with near-zero interest rate policies that have been in place for the best part of a decade now, makes some calculations too nuanced for them to be good examples. To rectify this, I will be using numbers for interest rates and bond yields which, frankly, look unfeasibly large if you were born after about 1995 but were commonplace once and, who knows, may come back again one day.

This book is also written with as much humour as can be mustered from a musty subject and uses, by and large, the kind of mathematics your average 16-year-old possesses these days. But you shouldn’t mistake a light touch for a lack of serious intent. As someone who worked in the bond markets for 30 years (please feel free to jump in at this point and exclaim “NO! Really, Stewart! You don’t look old enough!”) this is also a heartfelt and practical manifesto on the more obvious opportunities and mistakes for bond investors. I dare say there are more learned and detailed texts you could buy and frankly this book won’t be able to satisfy all of the pedants in the financial markets; my aim is to push you in the right direction rather than drop you onto a pinhead from 30,000 feet. Still, this book may feel a little didactic at times – like when I use words such as ‘didactic’ – but I also want to give you the benefit of my hard-won lessons and experience. We also aren’t going to cover everything about bonds – the clue is in the title of this book: ‘in a day’. Treat this as your diving board for the leap into a much bigger subject. But if you follow the stepwise process outlined here, this time tomorrow you could be bragging about being able to perform multi-variable total return analysis to your co-workers at the water cooler.

Stewart Cowley
March 2018

2. ‘Piero the Gouty’ and Other Interesting People

If there is a nation that represents everything we are as a species, it is the Italians. Italy is synonymous with cooking which, some people say, kicked off our technological progress because the cooking and preserving of meats gave us more leisure time, leading to the development of language, art, painting and science (all of which the Italians have in abundance).

Arguably of equal importance, Italy was the place a Florentine mercantile agent called Francesco Balducci Pegolotti wrote The Practice of Commerce in about 1340, showing, for the first time, tables of interest on a loan stretching over many years. This allowed lenders and borrowers a hitherto unprecedented level of accuracy and precision in their dealings with each other. It paved the way for the wholesale use of debt, which the Medici family of 14th-century Florence was more than happy to facilitate – for a fee.

Starting off as textile traders, within a few generations the Medicis became the bankers of Europe and pretty much ran the place for several hundred years – with one or two notable mishaps along the way. The five-year rule of Piero de Medici between 1464 and 1469, for instance, was cut short when ‘Piero the Gouty’ retired to his bed and never got up again. There was also the small incident of rival banking families – the Pazzis and Salviatis – conspiring with the local priesthood in a botched 1478 assassination attempt intended to wipe out the Medicis once and for all. Having miscalculated the strength of their enemy, this merely concluded with Francesco de’ Pazzi and other conspirators being hanged from the windows of the Palazzo della Signoria. Besides these minor...

Table of contents

• Contents
• About the Author
• 1. Introduction
• 2. ‘Piero the Gouty’ and Other Interesting People
• 3. Stop Being an Adolescent – Yield to Maturity!
• 4. Never Mind the Yield – Feel the Total Return
• 5. Be a Freud – be Very a Freud
• 6. Is the Yield Curve Just a Capitalist Plot?
• 7. When Nothing is the Best Thing You Can Do…
• 8. Individual Bonds Versus Portfolios
• 9. Man is Born Free, and Everywhere he is in Bonds
• 10. Bringing it All Together
• 11. Outro…
• Publishing details