The Bond Brief. Overview. BMO Nesbitt Burns

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1 BMO Nesbitt Burns The Bond Brief Today, Canadian investors have a wide range of fixed income investments to choose from. Whether you need an income stream today or are planning for future financial considerations, the bond market holds many opportunities to help you achieve your goals. Fixed income investments include securities that pay interest annually, semi-annually, quarterly or monthly, or where interest payments compound until the investment matures. Types of investments include treasury bills, government and corporate bonds, savings bonds, strip bonds, foreign currency bonds, GICs and structured notes; with terms to maturity ranging from one month to more than 30 years. The Bond Brief was prepared by BMO Nesbitt Burns to help introduce investors to fixed income investments. Having a general knowledge of the types of investments available will help you choose the ones that are most appropriate for you in order to reach your personal financial goals. Overview What is a fixed income investment? A fixed income investment is a debt obligation. The borrower issues a bond, debenture, note or other evidence of the debt, and in exchange is required to make periodic interest payments and repay the amount of the loan (face value) at maturity. Typically, interest is paid at regular intervals at a predetermined fixed rate. What is the difference between a bond and a debenture? Both bonds and debentures are evidence of a debt. Technically speaking a bond is backed by specific collateral, such as fixed assets or property, and a debenture is backed by the general credit worthiness of the borrower. Because investments that are backed by specific collateral are the exception rather than the norm, the term bond is used generically to describe many types of debt obligations. How secure are fixed income investments? The security behind any given fixed income investment is the general credit of the borrower. Consequently, the level of financial protection to the investor will vary depending on the investment selected. For example, governments (federal, provincial and municipal securities) are considered to be among the most credit worthy borrowers due to their ability to collect and raise taxes or print money to honour their obligation. Other important factors that determine a government s ability to repay debt include the size of its tax base and the stability and growth potential of its economy. For a corporate borrower, such as Bell Canada or Bank of Montreal, the level of protection provided to investors is based on financial factors such as liquidity, cash flow, earnings, guarantees (if they exist), debt-to-equity ratios and interest coverage ratios, as well as the ability of the corporation to withstand adverse economic cycles. In Canada, Dominion Bond Rating Service (DBRS), Standard and Poor s (S&P) and Moody s assess the credit worthiness of bond issuers and assign ratings from AAA, for the highest quality, to C for lowest. These ratings are used by investors as a guide to the issuer s capability and willingness to make prompt interest and principal payments based on the terms of their debt obligation. When is interest paid? Typically, interest is paid every six months (semi-annually). For example, a Government of Canada 2.25 per cent bond due June 1, 2025 pays interest on the first day of June and December until 2025 when the bond matures. Exceptions include: Eurobonds,

2 BMO Nesbitt Burns The Bond Brief PAGE 2 which pay interest annually; floating rate bonds, which pay interest monthly or quarterly; and strip bonds, which compound on a semi-annual basis from the date of purchase and pay interest only at maturity. How much interest is paid? Interest is paid on the par value (face value) of the bond s stated coupon rate. For example, a $10,000 par value Government of Canada 2.25 per cent bond due June 1, 2025 pays $ every six months ($10,000 x /2 = $112.50). What is meant by accrued interest? When an investor disposes of a bond prior to its maturity, they are entitled to receive the interest they earned since the last interest payment date up to, and including, the day the transaction settles (settlement date). This amount is called the accrued interest. For example, if the owner of a $10,000 Government of Canada 2.25 per cent bond due June 1, 2025 were to sell their bond on October 1, they would be entitled to accrued interest from June 2 to October 1, inclusive. What happens on the maturity date? The maturity date refers to the date on which the final interest payment is made and the principal amount is repaid in full. What denominations are available? Bond denominations will vary depending on the issue. In general, the smallest denomination in which bonds trade are in $1,000 multiples and are subject to specific minimum purchase amounts, such as $5,000 par value. How is ownership recorded? Ownership of a bond is recorded with the Canadian Depository for Securities (CDS) through a computerized book-based system. When interest payments are made or the principal amount is repaid, funds are deposited into the owner s account at their respective investment firm, or another account as per the bond owner s instruction. Investing in bonds What is the bond market? The bond market is made up of investment firms, banks and other financial institutions where individuals, called bond traders, buy and sell fixed income instruments. Bond salespeople and brokers (e.g. your BMO Nesbitt Burns Investment Advisor) act as a liaison between these traders and their clients. Who invests in the bond market? Investors include individuals, banks, government agencies, corporations, mutual fund companies, pension funds, exchange traded funds, etc. They buy bonds for safety of capital, a regular cash flow and the pre-established maturity value. They serve to fulfill many investor goals, including: generating income; saving for future goals, such as retirement or a child s education; and diversifying an investment portfolio. How do you purchase a bond? Individual investors can purchase bonds through their financial advisor. They may be purchased in both the primary (i.e., a new bond issue) and the secondary markets; with the latter being by far the most active. In the secondary market, a bond s price will deviate from its par value as interest rates change. Why do bond prices fluctuate? A bond s coupon rate reflects prevailing market yields at the time the bond was issued. With the exception of floating rate notes, the coupon rate is fixed for the term of the investment. Since market interest rates are constantly changing, a bond s coupon rate is considered to be current, high or low relative to prevailing interest rates. This has a direct impact on the bond s market value at any time prior to its maturity. For example, if market rates fall below the bond s coupon rate, the bond s price (or value) will increase. The reverse is true if market rates rise above the coupon rate the bond s price will decrease. When a bond s price is above its par value, it is said to be trading at a premium, while a price below par value is called a discount. What are the tax implications of bond ownership? Coupon interest is taxable at the bond holder s marginal tax rate. If a bond is sold prior to maturity, the accrued interest received is taxed as interest income and the difference between the sale proceeds (excluding accrued interest) and the adjusted cost base of the bond will result in either a capital gain or loss. On interest-bearing bonds, the difference between a premium purchase price and par value at maturity is considered a capital loss. Conversely, the difference between a discounted purchase price and par value at maturity is considered a capital gain.

3 BMO Nesbitt Burns The Bond Brief PAGE 3 For discounted fixed income securities, such as treasury bills and strip bonds, the difference between the discounted purchase price and par value at maturity is considered interest income. What type of bond should you buy? As a rule of thumb, the type of bond you purchase should meet your personal investment objectives, income requirements, risk tolerance and tax situation. For example, an individual who does not require income should buy a bond with a relatively low coupon rate. An investor who wants to defer all income until some future date, such as retirement, should purchase a zero-coupon or strip bond. An individual who relies on the income from their portfolio will find higher coupon bonds most appealing. A table outlining the types of fixed income investments, their features and suitability can be found on page 4 of this report. What currencies are available? Bonds are issued all over the world and in many different currencies. Periodically, Canadian borrowers issue bonds in a foreign currency. The most common example is a U.S. dollar denominated bond issued by a Canadian borrower. Similarly, when foreign governments or corporations issue bonds that are denominated in Canadian dollars, the bonds are commonly known as Maple Bonds. Bond prices and yields What determines a bond s price? A bond s price and yield are determined by a number of variables, including prevailing interest rates, liquidity, term to maturity, credit rating and any unique features, as described below. 1. Interest Rates When a bond is issued, its price and yield reflect the return demanded by investors based on its term to maturity and credit quality. Under normal conditions, investors demand a higher yield on a longer-term bond than they do on a short-term bond because of the uncertainty with respect to where interest rates will be headed in the future. As previously discussed (see Bond Price Fluctuations), bond prices move inversely to market interest rates. When interest rates move up, bond prices move down and vice versa. The reason for this inverse relationship is that a bond s coupon rate is fixed until maturity. Consequently, a bond s cash flow will become more valuable if market rates fall and less valuable if market rates rise. For example, let s assume that you pay $1,000 for a five-year Canada bond with a five per cent coupon and a five per cent yield to maturity. If rates suddenly rise to six per cent, your bond will be worth less than $1,000, because now it is possible to buy five-year Canada bonds with a six per cent yield to maturity. In fact, if you tried to sell your bond, it would be worth approximately $957. While these fluctuations can prove unfavourable, investors who intend to hold their bonds until maturity are unaffected by these interim fluctuations in market value. Interest rates fluctuate for many reasons, but the two main factors are: economic growth and inflation. During periods of strong economic growth, short-term interest rates tend to rise as central bankers tighten monetary policy in order to reduce the risk of excess supply and to curb inflation. Long-term bond yields also rise because the higher the expected rate of inflation, the higher bond yields have to be in order to protect an investor s purchasing power. 2. Liquidity Very small bond issues do not trade as actively as larger issues. Therefore they may command a higher yield (and lower price) to entice investors to buy them. This is an advantage for investors who want a higher yield and intend to hold the bond to maturity. 3. Term to Maturity As previously mentioned, investors generally demand a higher interest rate on long-term bonds than on short-term bonds. As the time remaining to maturity decreases, the price of the bond will approach its maturity or par value. 4. Credit Rating The better the credit rating of the issuer, the more favourable the terms under which they can borrow money. Rating agencies provide independent credit ratings for most major bond issuers. Bonds that are rated BBB (low) or higher are considered to be investment grade. This is the minimum credit rating required by most pension fund managers.

4 BMO Nesbitt Burns The Bond Brief PAGE 4 5. Unique Features Many corporate and some provincial bonds have a provision that allows the issuer to redeem (i.e,. buy back) a portion, or all of the bond s par value prior to maturity. This is known as a call feature. The ability to retire or refund their outstanding debt when interest rates are low is a benefit from the issuer s point of view, but may inconvenience the bondholder. Today, call features are structured to be favourable to the investor; however, they should be cautiously considered prior to purchase. The price movement of a callable bond can be quite different from that of a non-callable bond of similar quality and term to maturity. Your investment What are the choices? The table below lists the types of bonds and other fixed income investments available to Canadian investors and highlights their features and suitability. Investors who are not necessarily looking for exposure to individual securities but would like to gain access to the asset class in their portfolios can also consider fixed income mutual funds and exchange traded funds (ETFs). All of the securities listed below are RRSP/RRIF eligible. Fixed Income Investments Security Quality Liquidity Income Frequency Suitability T-bills Highest Highest interest payments Short-term / Liquidity Savings Bonds Highest Moderate Varies Quality / Liquidity Canada Bonds Highest Highest Semi-annual Quality / Liquidity Real Return Bonds Highest Moderate to Low Semi-annual protection Inflation Protection Strip Bonds Government Highest/High High to Moderate Bank/Trust GICs Highest for amounts under $100,000 Low to None interest payment Annual, Semi-annual, Monthly or Compounding Wide Range of Terms / Compound Interest Buy and Hold Provincial Bonds High High Semi-annual Higher Yield than Canada Bonds Municipal Bonds Varies Moderate to Low Semi-annual Buy and Hold Corporate Bonds Varies High to Low Semi-annual Strip Bonds Corporate Varies High to Low interest payments Structured Notes Varies Moderate (Proprietary to Annual, Semi-annual, Monthly issuing Dealer) or Compounding (accruals) Higher Yield than Government Bonds Wide Range of Terms / Corporate Compound Interest Buy and Hold Maple Bonds Varies Moderate to Low Annual or Semi-annual Portfolio Diversification Foreign Currency Bonds Varies Moderate Annual/semi-annual Portfolio Diversification

5 BMO Nesbitt Burns The Bond Brief PAGE 5 Conclusion BMO Nesbitt Burns is one of North America s leading full-service investment firms. We ve been committed to helping clients meet their investment goals and objectives since Today, BMO Nesbitt Burns is focused on meeting the needs of individual investors through a customized approach to wealth management. As part of BMO Financial Group, BMO Nesbitt Burns also provides clients with access to one of the broadest selections of wealth management solutions and services available today. Whether you need income or longer-term capital growth; whether you are planning for your retirement or are just starting to enjoy it; whatever your objectives, your BMO Nesbitt Burns Investment Advisor will work with you to determine the right investment portfolio to help you to achieve your goals. For more information on our products and services visit us online at BMO (M-bar roundel symbol) is a registered trade-mark of Bank of Montreal, used under licence. Nesbitt Burns is a registered trade-mark of BMO Nesbitt Burns Inc. BMO Nesbitt Burns Inc. is a wholly-owned subsidiary of Bank of Montreal. BMO Wealth Management is the brand name for a business group consisting of Bank of Montreal and certain of its affiliates in providing wealth management products and services. The opinions, estimates and projections contained herein are those of BMO Nesbitt Burns (BMO NBI) as of the date hereof and are subject to change without notice. BMO NBI makes every effort to ensure that the contents have been compiled or derived from sources believed to be reliable and contain information and opinions which are accurate and complete. However, BMO NBI makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors, omissions which may be contained herein and accepts no liability whatsoever for any loss arising from any use of or reliance on this report or its contents. Information may be available to BMO NBI which is not reflected herein. This report is not to be construed as an offer to sell or solicitation for or an offer to buy, any securities. BMO NBI, its affiliates and/or respective officers, directors or employees may from time to time acquire, hold or sell securities mentioned herein as principal or agent. BMO NBI may act as financial advisor and/or underwriter for certain of the corporations mentioned herein and may receive remuneration for same. Members of the Canadian Investor Protection Fund. Members of the Investment Industry Regulatory Organization of Canada BMO Nesbitt Burns PART (02/15) bmonesbittburns.com