INVESTMENT DEALERS. A Question & Answer Guide to Bond Investing Q&A BOND INVESTING

Transcription

1 INVESTMENT DEALERS A S S O C I AT I O N O F C A N A DA A Question & Answer Guide to Bond Investing Q&A BOND INVESTING 1

2 Table of Contents SECTION 1 BOND BASICS What is a Bond?... 1 How do bonds differ from stocks?... 2 Why do people invest in bonds?... 2 What terminology should bond investors be familiar with?... 3 Face Value... 3 Bond Price... 3 Coupon... 3 Yield... 3 Basis Point Accrued Interest... 4 Settlement Date... 4 How do I read a Bond Table published in the daily newspapers?... 5 SECTION 2 BOND TYPES AND FEATURES What are some types of Bonds?... 7 Government Bonds... 7 Corporate Bonds... 7 Strip bonds... 7 Real Return Bonds... 8 Canada Savings Bonds... 8 What are examples of bonds with features?... 9 Convertible bonds... 9 Callable bonds... 9 Step-Up bonds:... 9 Extendible/Retractable bonds:... 9 What are Money Market Instruments?...10 What are alternative ways to invest in bonds?...10 Mutual funds...10 Exchange Traded Funds (ETFs)...10

3 Table of Contents SECTION 3 GENERAL BOND PRICING PRINCIPLES What causes bond prices to fluctuate?...11 What is a Yield Curve?...12 SECTION 4 RISKS OF BOND INVESTING What risks are bond holders exposed to?...15 Purchasing Power Risk (Infl ationary Risk)...15 Maturity Risk (Reinvestment Risk)...15 Risk from embedded features...15 Liquidity Risk...15 Credit (Default) Risk...16 SECTION 5 TRADING IN CANADA S DEBT MARKETS Do bonds trade on an exchange? What is the difference between an agency and a principal transaction? How are bonds priced? Do retail investors and large institutional investors pay the same price for a bond?...19 Why are there two yields on my buy contract?...19 How do I know I am getting the best possible price in the marketplace? If there is no commission reported on my contract, how does my Advisor get paid?...20 How are commission and fees calculated?...20 Is commission on bond trades fixed?...20 What impact does commission have on my yield?...21 How can I know how much commission I m paying?...21 A FINAL WORD...22

4 bond basics 1 What is a Bond? A bond is a financial instrument representing a debt between a borrower (known as the issuer) and a lender (the investor or creditor). The issuer, usually a government or corporation, promises to pay the investor a specified rate of interest (the coupon rate) on the amount it has borrowed. The interest is paid on a regular basis (typically every six months) until a stated maturity date, and then the issuer repays the borrowed amount (the principal). Because the cash flow investors derive from bonds is usually fixed and the timing fairly predictable, they are classified as fixed-income securities. However, not all securities that pay income regularly or have a stated maturity date and value are bonds. 1 BOND INVESTING

5 HOW DO BONDS DIFFFER FROM STOCKS? Stocks are considered equity investments whereas bonds are debt investments. When purchasing stock (equity), an investor becomes a part owner of the corporation. The stock holder is entitled to a share in the profits of the corporation and may be given voting rights. When purchasing bonds (debt) an investor becomes a creditor to the issuer. As a creditor, a bond holder has a higher claim on assets than does a stock holder in the event of bankruptcy. Bondholders generally do not have an opportunity to share in the profits of the corporation, and are entitled only to the principal plus interest. Bonds also trade differently than stocks, as discussed in Section 5. WHY DO PEOPLE INVEST IN BONDS? Bonds appeal to certain investors for several reasons: Income Source: Investors requiring a certain level of income from their portfolios turn to fixed income securities such as bonds. High quality bonds can provide a series of predictable cash flows with minimal risk to their invested capital. Diversification: By adding an additional asset class such as fixed income to their portfolio, investors can achieve increased diversification which may allow them to reduce portfolio risk while potentially increasing returns over time. Safety: Investors in high quality bonds can have a high degree of confidence in the full repayment of principal plus interest if the bond is held to maturity. Bonds also rank ahead of equity securities in the event of company bankruptcy, and may pledge specific assets as collateral, providing investors with additional security. However, not all bonds offer the same level of security and this is reflected in the credit rating of the issuer which we discuss in Section 4. Choice: Investors can choose bonds from a wide range of issuers, with a variety of maturity dates and coupon rates. This allows investors to find the bond(s) whose cash flows match their income requirements while complementing their other portfolio holdings. BOND INVESTING 2

6 WHAT TERMINOLOGY SHOULD BOND INVESTORS BE FAMILIAR WITH? Understanding bonds requires some understanding of a few commonly used terms: Face Value: The face value of a bond, also referred to as the par value or principal, is the amount of money a bond holder receives back from the issuer on the bond s maturity date. A bond s price fluctuates throughout its life; therefore the face value and actual price of the bond often differ. When a bond s price is below its face value, the bond is said to be trading at a discount. When a bond s price is above its face value, the bond is said to be trading at a premium. When a bond s price is equal to its face value, the bond is said to be trading at par value. Most newly issued bonds are sold and mature at par to investors. If you purchase a bond at a discount (premium) you can expect to incur a gain (loss) on the price of the bond when it matures. Bond Price: Bond prices are quoted as a percentage of their face value, so that a bond quoted at 100 is trading at 100% of its face value, or at par. If for example the purchase price on a bond was quoted at 94.50, an investor could purchase the bond at 94.5% of its face value. If the face value of the bond is $1000, it would only cost $ to purchase ($1000 x.945). This bond is trading at a discount. If the quote was , then the cost is % of the face value, or $1, This bond would be trading at a premium. Coupon: The coupon represents the rate of interest the bondholder will receive and is stated as a percentage of the face value. Typically, bonds pay interest semiannually. For example, a $1,000 face value bond with a 6% coupon will pay its bondholders $30 dollars every six months, or $60 dollars a year until the maturity date. When the bond matures the investor receives back the full face amount of the bond - $1000. Most bonds pay fi xe d coupon rates which mean the rate of interest the bond pays stays constant throughout the life of the bond. Some bonds pay a variable or fl oating rate coupon which means the interest payments can change from period to period based on a predetermined schedule or formula. Some bonds also pay no interest at all until maturity. Yield: A bond s stated yield represents the return you get on the bond. There are two types of bond yields that you should be aware of: current yield, and yield to maturity. Current yield is the annual return on the dollar amount paid for the bond and is simply calculated by dividing the bond s 3 BOND INVESTING

7 annual interest payment by its purchase price. For example, a $1000 face value bond with a 6.50% coupon, purchased at par, has a current yield of 6.5% (Annual interest of $65 divided by $1000 purchase price). The same bond purchased at $950 (i.e. purchased at a discount) would have a current yield of 6.84% ($65 interest divided by $950 purchase price). And, if the price rises to $1,100, the current yield drops to 5.90% ($65 divided by $1,100). Yield to Maturity (YTM) is a more meaningful calculation which tells you the total return you will receive by holding the bond until it matures. YTM equals all the interest payments you will receive, (and assumes you reinvest these interest payments at the same rate as the current yield on the bond), plus any gain (if you purchased the bond at a discount) or loss (if you purchased the bond at a premium) on the price of the bond. YTM is useful because it enables you to compare bonds with different maturities and coupons. Basis Point: A basis point is a unit for measuring a bond s yield. 1 basis point is equal to 1/100th of 1% of yield, or alternatively, 100 basis points are equal to 1% of yield. If for example a bond s yield increased from 5.10% to 5.35%, its yield is said to have increased 25 one hundredths of 1% or simply 25 basis points. Accrued Interest: Accrued interest is the interest that has accumulated on a bond since its last interest payment. Accrued interest is added to the total cost of a bond transaction and shown separately. For example, if you sell a bond before receiving the next scheduled interest payment; you add to your proceeds the accrued interest to account for the interest you have earned since the previous payment. The purchaser of this bond will pay the bond s market price plus any accrued interest; however they will receive the full amount of the next scheduled coupon payment, which repays them for the accrued interest paid to the seller. Settlement Date: The settlement date is the date on which the purchaser of a bond must pay for the cost of the bond. It is also the date by which the seller of that bond must provide delivery in order to be entitled to the proceeds. In Canada, money market instruments such as T-bills settle the same day as the transaction. Short-term Government of Canada bonds (maturing in three years or less) settle in two business days. Most other bonds settle three business days after the transaction date. (Note: with the exception of Canada Savings Bonds, physical delivery of bond certifi cates rarely takes place. Most bonds are held on your behalf by your dealer and trading, clearing and settlement are done electronically) BOND INVESTING 4

8 HOW DO I READ A BOND TABLE PUBLISHED IN THE DAILY NEWSPAPERS? The following table helps make sense of the bond tables that appear in your daily newspaper. COUPON MAT. DATE BID $ YLD % HydOne Jun 03/ IPL Feb 15/ Loblaw Nov 08/ Column 1 Column 2 Column 3 Column 4 Column 5 Column 1 Issuer This is the company, province, or country issuing the bond. Column 2 Coupon This is the coupon (interest) rate the the issuer is paying bond holders. Column 3 Maturity date The date on which the issuer will repay the principal to the bond holder. Normally the year is truncated so that only the last two digits show. Nov 08/27 for example would imply a maturity date of November 8th Column 4 Bid Price This is the highest price someone is willing to pay for the bond. As you can see, all three bonds above are trading at a premium. Sometimes the Ask Price may also be quoted; this is the lowest price at which someone is willing to sell the bond. Column 5 Yield This indicates the bond s annual return until maturity. It usually represents the Yield to Maturity as opposed to the Current Yield Notice that because all three of the bonds above are trading at a premium, their yield % is less than their coupon rate. 5 BOND INVESTING

9 bond types and features 2 A benefit to bond investing is the variety of bonds to choose from. However investors need to understand the different types and features of bonds in order to choose an investment that is best suited for their objectives and tolerance for risk. BOND INVESTING 6

10 WHAT ARE SOME TYPES OF BONDS? Government Bonds: Federal, provincial and municipal governments issue bonds as a way of raising capital to fund deficits or program spending. These bonds are backed by the credit and taxing power of the issuing government and generally represent secure bond investments. This added safety implies investors should expect a lower return (yield) from these bonds. The federal government is the largest single issuer in the Canadian bond market. The Government of Canada issues bonds in its own name and also guarantees bonds issued by federal crown corporations and agencies such as Farm Credit Canada or Business Development Bank of Canada. Corporate Bonds: Corporations also raise capital by issuing debt, commonly in the form of bonds, debentures, or notes. All three differ in their terms, and degree of security. A debenture for example, is a debt obligation that is secured solely by the general creditworthiness of the issuer. Unlike bonds, debentures do not pledge specific assets of the issuer as collateral, but may offer a general claim on any residual assets. Since investors are offered less protection, debentures carry a higher risk, and therefore a higher expected return when compared to bonds. Corporate debt holders have a prior legal claim, to both the income and assets of the corporation, over stockholders. However each debt issuance by the corporation has its own ranking with respect to priority. A bond classified as senior debt, for example, will rank ahead of subordinated debt. Corporate notes generally will have the least claim among the group of prior claimants. Investors should be aware that the term corporate bond is often used generically to refer to bonds, debentures, or notes, issued by a corporation. Check with your advisor or read the securities prospectus or other disclosure documents to learn the details of the debt instrument you are interested in. Strip bonds: also known as zero-coupon bonds, are bonds whose coupon is stripped or detached from the principal of the bond and the two components are sold separately at a discount. The holder of a strip bond would not be entitled any interest payments but instead earns a return from the appreciation of the discounted price of the bond to its face value at maturity. For example, a strip bond with a face value of $10,000 maturing in 10 years might be purchased for $6440. No interest will be paid during the life of the bond, but at the end of the 10 years, the investor will receive the full face value of 7 BOND INVESTING

11 $10,000. The difference between the $10,000 received and $6440 paid is equivalent to a 4.5% compounded annual yield. There are some important tax and risk considerations to be familiar with before you invest in strip bonds. View the IDA Strip Bond Information Statement on our website, or speak to your financial advisor. Real Return Bonds (RRBs): securities that pay the holder a rate of return that is adjusted for infl ation. This feature assures bondholders that their purchasing power is maintained regardless of the future rate of infl ation. RRBs pay interest semi-annually and both the interest and principal are adjusted in step with the general level of prices as measured by the Consumer Price Index (CPI). Most RRBs are issued by the federal government, though some provinces and corporations also have issued them. RRBs also contain tax implications which need to be considered. Please speak to your financial advisor or visit the Bank of Canada website: for a more detailed discussion on RRBs. Canada Savings Bonds (CSBs): issued and backed by the Government of Canada, CSBs pay only a modest return compared to other bonds but are immediately redeemable (cashable) by the holder at their full face value, plus any interest that has collected since the last interest payment (no interest is paid if redeemed within 3 months of issuance). Their high liquidity makes them popular investments in the cash or emergency funds portion of investor portfolios. CSBs are available with either regular or compound interest options. Issued by the Government concurrently with the CSBs are the Canada Premium Bonds (CPBs). CPBs offer investors a higher rate of interest than do CSBs but unlike CSBs are cashable only once a year, on the anniversary of the issue date or within 30 days thereafter. Some provincial governments also issue savings bonds, check with your advisor or the province s ministry of finance for applicable terms and conditions. BOND INVESTING 8

12 WHAT ARE EXAMPLES OF BONDS WITH FEATURES? Convertible bonds: A bond (or debenture) that gives the holder the option to exchange their bond at a future date for a predetermined amount of some other class of security issued by the borrower (typically common or preferred shares). Through this conversion option, these bonds offer some of the upside potential of stocks but also some of the protection of bonds. Convertible bonds tend to carry a lower coupon than comparable straight bonds (conventional bonds without special features embedded) because of the additional conversion benefit. Callable bonds: A bond (or debenture) that gives the issuer the option to retire the bond (payback bondholders) before the maturity date. An issuer may choose to exercise this option if interest rates have fallen, so that they can issue new bonds at the prevailing lower rates. The payback price is prespecified and is normally set at or above par value. Callable bonds typically carry a higher yield than comparable straight bonds because of the added risk the call feature presents to investors. If a bond is called early, investors wanting to reinvest their principal will have to do so at the new prevailing lower interest rates. Step-Up bonds: A bond (or debenture) that pays the investor a coupon that increases over the life of the bond. Generally, the coupon is initially set above the prevailing rates but on the date of each coupon payment, the issuer decides whether to call the bond at par or whether to extend it until the next payment date at the new coupon rate. Extendible/Retractable bonds: Short-term bonds whose maturity date can be extended are known as Extendible bonds. Long-term bonds that can be redeemed at par several years sooner are known as Retractable bonds. Generally, the option to extend or retract the maturity lies with the issuer. These embedded options alter the risk profile of the bonds so need to be considered when making an investment decision. 9 BOND INVESTING

13 WHAT ARE MONEY MARKET INSTRUMENTS? Money Market Instruments are another class of fixed income products. They commonly include Treasury Bills (T-Bills), which are issued by the federal government to meet near term borrowing needs, Bankers Acceptances (BA s) which are promissory notes issued by corporations with the unconditional guarantee of a major Canadian bank, and Commercial Paper which is shortterm debt issued by a corporation. Money Market instruments are short term in nature and typically available in maturity terms of 30 days, 60 days, 90 days, 6 months and a year. Generally, money market instruments are sold at a discount and mature at par. The difference between the cost of purchase and the maturity amount represents the investor s return which is typically considered interest income. The short-term nature of these instruments and their high liquidity generally makes them a conservative investment and a popular substitute for cash holdings in a portfolio. Liquidity and risk does vary among the instruments and the issuers so consult with your advisor. WHAT ARE ALTERNATIVE WAYS TO INVEST IN BONDS? Mutual funds: such as bond or balanced funds, are an indirect method of investing in bonds. These products combine professional management with exposure to to a basket of bonds of various maturity dates and quality. Like most mutual funds, a bond or balanced mutual fund also offers systematic purchase/withdrawal plans, reinvestment of distributions, and low initial investment requirements. However, unlike with individual bond holdings, funds do not have a stated maturity date or coupon rate, making the timing and size of your cash flows uncertain. Additionally, it may be diffiucult to determine the quality of the bonds held in the fund or the general level of risk they may expose you to. The fees charged on these products should also be considered becuase they have an impact on your overall return. Exchange Traded Funds (ETFs): are mutual fund trusts whose units trade on a stock exchange such as the TSX. Some ETFs can give you exposure to an entire bond market index while others try to track the performance of a government benchmark bond. Because ETFs are not actively managed, they tend to be characterized by lower management fees than conventional mutual funds. To find out more visit: BOND INVESTING 10

14 general bond pricing principles 3 WHAT CAUSES BOND PRICES TO FLUCTUATE? Interest rate fluctuation is a key factor that influences bond prices. Because a bond bears an annual interest (coupon) rate that remains constant through to maturity, a bond becomes more valuable to its holder as market interest rates fall, and less valuable as market rates rise. Bond prices therefore move inversely with interest rates. 11 BOND INVESTING

15 To illustrate, let s assume you purchase a 1,000 par value 5-year Government of Canada bond with a 5% coupon rate (therefore yields 5%). A year passes, and the term remaining on the bond is now 4 years. Over the past year, interest rates have gone up. Today, an investor can buy a par value 4-year Government of Canada bond that pays a 6% coupon (therefore yields 6%). Since your bond pays only 5%, its value in the market must fall to reflect the new rate environment. Your bond would likely fall below $1,000 (trade at a discount). Conversely, if interest rates had dropped to 4% from 5%, your bond would likely be worth more than $1,000 today (trade at a premium) as it pays more than current market rates. Generally, the lower the bond s coupon rate and the longer its term to maturity, the greater the impact interest rate changes will have on price. Bond prices are also more volatile when interest rates are low, since the relative change of a 1% change in rates is more significant. Despite fluctuations in price prior to maturity, a bond will mature at par value as long as the issuer is able to repay the debt. To an investor who holds their bond through to maturity, these day-to-day price fluctuations may seem irrelevant. However, in practice, bonds may be traded daily in secondary markets. A trading-oriented investor may use a short-term price increase for example, as an opportunity to sell their bond at a profit to enhance their total return. Many bonds also have special features, such as call or conversion provisions, which may have significant impacts on the risk and price of a bond. In sum, the price of a bond is a function of current interest rates, its coupon, its term to maturity and its individual risk factors. WHAT IS A YIELD CURVE? Investors purchasing longer- term bonds are exposed to additional risks because of the increased probability of encountering adverse market conditions (or a deterioration of the financial health of the issuer) at some point during the life of the bond. These investors will want to receive extra compensation (i.e. extra yield) for taking on this additional risk. This direct link between maturity and yield can be seen by looking BOND INVESTING 12

16 at a yield curve. A yield curve is a line on a graph that shows the yield to maturity on bonds (usually Government of Canada bonds), maturing at various dates. For example, the graph below shows the Government of Canada yield curve at the close of business on January 21, Generally, the further a bond s maturity date, the higher the yield will be in order to compensate investors for bearing additional risk. This results in an upward sloping yield curve. GOVERNMENT OF CANADA YIELD CURVE (AS AT THE CLOSE OF BUSINESS, JANUARY 21, 2005) JA JA JA JA JA JA JA JA JA JA JA JA JA JA JA Sometimes the difference between short and long-term rates is relatively small, and the yield curve is said to be fl at. When yields on short-term issues are higher than those on longer-term issues the yield curve is said to be inverted. By monitoring the yield curve, bond investors can get a sense of where the market expects interest rates to be headed. An inverted yield curve for example indicates that investors expect longer-term interest rates to decline. The Bank of Canada publishes the Government of Canada yield curve on its website under Rates & Statistics. Bond prices and yields are also quoted daily in the newspaper. 13 BOND INVESTING

17 RISKS OF BOND INVESTING 4 Though high quality bonds are considered lower risk investments, bonds also expose investors to some level of risk. As previously discussed, a common and significant risk factor is from adverse changes in interest rates (interest rate risk). However, other sources of risks do exist, a few of which are discussed next. BOND INVESTING 14

18 WHAT RISKS ARE BOND HOLDERS EXPOSED TO? Purchasing Power Risk (Infl ationary Risk): Rising infl ation adversely impacts investors because it reduces their real (infl ation-adjusted) return on investments. A bond promises to repay principal at maturity, but if the general prices of goods over the life of the bond increase, the principal received at maturity will purchase fewer goods. Since coupon payments on bonds are usually fixed, rising levels of infl ation will also mean that coupon payments received will not be able to provide the same level of benefit as they could have previously. Investors highly dependent on a bond s cash flows for their day-to-day living expenses are the ones most exposed to purchasing power risk because it may lead to deterioration in their standard of living. Maturity Risk (Reinvestment Risk): On the maturity date, the bondholder will receive a lump sum amount representing the issuer s repayment of principal and final interest payment. Investors who want to reinvest this amount back into the debt market must now do so under prevailing market conditions. If market interest rates have fallen since the initial bond was purchased, the bonds on the market now may offer lower yields or coupon payments. For bondholders wanting to reinvest a coupon payment received a similar risk may be faced. A common strategy used by some advisors that may reduce this risk involves staggering the maturity dates of your bonds so that not all your money matures around the same time. This is referred to as a bond ladder. Risk from embedded features: Some bonds contain features which may adversely alter the amount or timing of a bond s cash flow, adding risk for the bondholder. Investors of callable bonds for example are exposed to the risk that their bonds might get called or redeemed prior to the stated maturity date (call risk). The holder of a bond which has been called may be forced to reinvest the principal sooner than expected, usually at a lower interest rate (reinvestment risk). It is important you determine whether any embedded features exist by asking your advisor or reading the bonds disclosure documents. Liquidity Risk: Investors sometimes need to sell their holdings quickly, but an insufficient secondary market may prevent the sale or limit the funds that can be generated from the sale. Federal and Provincial bonds are generally very 15 BOND INVESTING

19 liquid while others such as certain corporate bonds are much less liquid. The size of the bond issue and the spread between the bid and ask yield are indicators investors can look at to get some sense of a bonds expected liquidity. Credit (Default) Risk: A bond issuer is in default by failing to repay principal and interest in a timely manner. Federal and provincial government bonds are virtually free of default risk. Debt issued by corporations has greater exposure to default risk since corporations may more easily go bankrupt. This greater risk is a major reason why corporate bonds offer higher yields than comparable government bonds. Investors can assess the probability of default or the credit risk inherent in a bond by looking at the bond s credit rating, an evaluation from a rating agency indicating the likelihood that a debt issuer will be able to meet scheduled interest and principal payments. Rating agencies often make their ratings available to the public through the internet, their information desks, or published reports commonly available in many local libraries. The chart below summarizes the rating scale used by Dominion Bond Rating Service (DBRS), though credit ratings are also issued by other agencies such as Standard and Poor s ( and Moody s Investors Service ( using a fairly comparable rating system. Typically, debt assigned a rating of AAA represent the lowest level of default risk. Debt rated in the BBB category or above are normally considered investment grade, whereas debt with a rating of BB or below are considered speculative or non-investment grade. Non-investment grade bonds are also commonly referred to as Junk or High-yield bonds due to the higher yields typically associated with these bonds reflecting their increased level of risk. BOND INVESTING 16

20 TRADING IN CANADA S DEBT MARKETS 5 17 BOND INVESTING

21 DO BONDS TRADE ON AN EXCHANGE? There is no central exchange for trading fixed income securities, with the exception of convertible debentures, which trade on the TSX. Most bonds and debentures are traded on an over-the-counter (i.e., over the phone) market. However, fixed income trading systems are currently being used in the United States, and there has also been some developments in Canada. WHAT IS THE DIFFERENCE BETWEEN AN AGENCY AND A PRINCIPAL TRANSACTION? Most equities trade in a centralized electronic stock exchange such as the Toronto Stock Exchange. Your investment firm acts as an agent by placing your order on the exchange where it is matched with a counter-party s order. An agency transaction is completed when a buyer is matched with a seller directly on the exchange. The counter-party to your trade may be a client of your investment dealer or that of another investment dealer. An agency trade will not be completed if a counter-party cannot be found. Most bonds trade over-the-counter (i.e., over the phone) rather than on a listed exchange. In a principal transaction, your dealer facilitates bond orders typically using its bond inventory as the counter-party. Principal trading presents some risk to your dealer as it must use its own capital to maintain an inventory and then must offset its inventory positions at a later time, hopefully at a profit. Principal trading enhances market liquidity as it is not necessary to locate a counter-party for every order. HOW ARE BONDS PRICED? Newly issued bonds are normally priced at par (100). If you purchase a new bond issue, your advisor will provide you with the bond s prospectus or other disclosure documents detailing the bond s terms, features, and risks. You can also buy or sell bonds which have previously been issued. These trades occur in the secondary market, normally on a principal basis with your dealer. Bonds trading in the secondary market are priced, or valued, against a benchmark (usually a Government of Canada bond). A particular bond s coupon rate, term to maturity and credit rating are compared to a similarterm Government of Canada bond, and priced accordingly. These prices can change more frequently than daily and as we discuss later, can vary slightly from dealer to dealer. BOND INVESTING 18

22 DO RETAIL INVESTORS AND LARGE INSTITUTIONAL INVESTORS PAY THE SAME PRICE FOR A BOND? Not usually. Because of the costs involved in trading bonds, a bond trader is likely to quote a better price for a large bond order. For example, if a bond trader had a 1 million block in their inventory, they would rather trade the entire block than break it up. Consequently, they would likely charge you a higher price if you only wanted to buy 10,000. Your Investment Advisor is also likely to charge a higher commission percentage on a 10,000 par value transaction than on a 1 million transaction. A higher commission will impact your price and yield, as discussed below. WHY ARE THERE TWO YIELDS ON MY BUY CONTRACT? One is a semi-annual yield to maturity and the other is an annual yield to maturity. It is important when you are comparing yields on different securities that you compare semi-annual yields to semi-annual yields and annual yields to annual yields. HOW DO I KNOW I AM GETTING THE BEST POSSIBLE PRICE IN THE MARKETPLACE? Because bonds are traded principally, it s possible for two investment firms to quote slightly different prices for the same bond transaction. An investment firm that is short a particular bond is likely to bid more aggressively (i.e., quote a higher price) than a firm who already owns a large position in that security. That being said, prices generally do not vary widely among firms due to the competitive nature of the marketplace. However, it is advisable to have some knowledge of bond prices and yields before placing an order. For instance, you may use a recent closing quote from the newspaper to get an approximation. Keep in mind however that because bond prices are partly a function of the liquidity of the dealer market and the size of the issue being traded, prices quoted in the financial press may or may not be completely indicative of what you will be able to buy or sell the bond for. As discussed, there is no single location, or exchange, where you can view live bond quotes from every investment firm. The Collective Bid website displays live institutional offering prices and yields on a limited range of liquid issues ( Alternatively, subscribers to an information vendor carrying the TSX Datalinx products can view the institutional bond prices of CanDeal. Once again retail investors should be aware of the limitations in these quotes. 19 BOND INVESTING

23 IF THERE IS NO COMMISSION REPORTED ON MY CONTRACT, HOW DOES MY ADVISOR GET PAID? Investment Advisors are compensated either by charging a commission on every transaction (transaction-based), or by charging a fee based on the value of the assets in the account ( fee-based). If your account is transaction-based, then commission on a bond trade will be embedded in the price that you pay and won t appear separately on your contract. Fees on fee-based accounts are either billed periodically, or charged directly to the account. HOW ARE COMMISSION AND FEES CALCULATED? For transaction based accounts, commission is charged once based on the bond s par value., For example, if you were charged one point on a 50,000 par value bond, you would pay a $500 commission (i.e., 50,000/100 x 1.00pt). No further commission is charged unless you sell the bond prior to maturity. There is no commission involved when a bond is called for redemption or when it matures. Fees on fee-based (managed) accounts are usually charged annually on the current value of the account. For example, if your annual fee is 1.5% and your account has a value of $100,000, you would pay a fee of $1,500. This fee represents the advice being given and level of work involved in managing your portfolio, as well as the execution of trades. IS COMMISSION ON BOND TRADES FIXED? The commission charged on new bond issues is usually fixed. However, there is no set commission rate for secondary market bond transactions. Fees charged for secondary bond trades may vary by dealer and by bond, based on the liquidity of the bond, size of the issue, size of the order, and the amount of the issue a dealer may have in inventory. That being said firms have systems in place to monitor the amount of commission that is being charged. BOND INVESTING 20

24 WHAT IMPACT DOES COMMISSION HAVE ON MY YIELD? The impact of commission on yield depends on the bond s term to maturity. The shorter the term, the greater the impact will be. For example, if you were charged one point commission on a 5-year bond that is trading at par and has an annual interest rate of 4%, your yield would be reduced by approximately 22 basis points (0.22%). If you were charged 1 point commission on a 30-year bond, your yield would be reduced by only 6 basis points (0.06%). HOW CAN I KNOW HOW MUCH COMMISSION I M PAYING? When you open an account, no matter what the investment strategy or type of securities you invest in, you should discuss compensation with your Advisor. You need to determine together whether transaction-based or fee-based is more suitable for you. You should ask how much commission the advisor generally charges. This is no different than dealing with any professional you should discuss compensation. This also applies when opening an account with an online trading firm or a discount brokerage firm. 21 BOND INVESTING

25 A Final Word Virtually all investments, including bonds, have some degree of risk. There exist a number of key variables which investors need to consider when investing in bonds. The bond s price, coupon rate, yield, maturity date, redemption features, credit quality and tax status all impact the value of bond investments. Market conditions and other risk factors also need to be considered. As with all investments, a bond s expected return is linked to its level of risk. The higher the expected return, the greater the risk. SOME BOND CONSIDERATIONS ISSSUER TYPE MATURITY QUALITY YIELD INTEREST RATES SIZE TAXES FEATURES Corporate bonds riskier than Government bonds Bonds, debentures, notes, strips, step-ups, etc. Longer maturity means more risk Higher quality means less risk Higher yield may indicate greater risk If rates go up, bond prices usually go down Small issues tend to be less liquid Impact cash flows and returns Convertables, Callables, Extendable, Retractable, etc There are a variety of types of bonds to choose from and some may serve a useful purpose in your portfolio. Discuss with your financial advisor which bond is best suited for your investment objective and tolerance for risk. The information contained herein is for general information purposes only. The Investment Dealers Association of Canada makes neither a recommendation as to the appropriateness of investing in fi xed-income securities nor is it providing any specifi c investment advice. Supplemental information and sources may be required to make informed investment decisions. Speak to your Investment Advisor/Firm for further information. BOND INVESTING 22

26 CALGARY Suite Fourth Ave. S.W. Calgary, Alberta T2P 0J1 Tel.: (403) Fax: (403) HALIFAX TD Centre, Suite Barrington St. Halifax, Nova Scotia B3J 3K9 Tel.: (902) Fax: (902) MONTRÉAL Bureau Place Ville Marie Montréal, Québec H3B 4R4 Tel.: (514) Fax: (514) TORONTO Suite King St. W. Toronto, Ontario M5H 3T9 Tel.: (416) Fax: (416) VANCOUVER Suite 1325 P.O. Box West Georgia St. Vancouver, BC V6B 4N9 Tel.: (604) Fax: (604) Ce rapport est aussi disponible en français sur demande. The Investment Dealers Association of Canada is the national self-regulatory organization and representative of the securities industry. The Association s mission is to protect investors and enhance the efficiency and competitiveness of the Canadian capital markets.