Conventional bonds

Introduction

Bonds have been defined by Hymas as instruments for which "there must be precise dates on which interest and principal repayment flow to the investor, in default of which an operating company is put into bankruptcy." Conventional bonds — that is, bonds not indexed to inflation - are issued by a variety of institutions. These include: the federal and provincial governments; municipalities (which unlike in the United States do not get preferential tax treatment for bond issues); Canadian companies; and non-Canadian companies that wish to obtain financing in Canadian dollars ("Maple bonds"). Inflation-indexed Real Return Bonds and High Yield Bonds are covered in separate sections.

Canadian bonds are rated by two different rating agencies: DBRS and Standard and Poor's.

When investing in bond funds, it is important to remember that costs matter. A study of bond fund returns concluded that "here is a strong, negative relation between funds' expense ratios and net return." In consequence, high-cost bond funds should generally be avoided.

Historical bond rates are available from the Bank of Canada.

Bond Indexes

Bond indexes were, until a few years ago, maintained by ScotiaMcleod. They were bought by the TMX Group, which controls the Toronto Stock Exchange, the Bourse de Montréal and has a stake in CanDeal, a bond-quote system for investment dealers. They are now known as the "DEX Bond Indexes." Investors not wishing to purchase individual funds can consider bond index mutual funds or bond ETFs.

Buying Individual Bonds

Until recently, all bond purchases had to be made by calling into the "bond desk" of individual brokerages. One major disadvantage of this approach was that bond commissions (which were hidden in the price difference between buying and selling — the "bid-ask spread") were not known by the purchaser. Most discount brokers have an online fixed income section where you can purchase individual bonds (federal government, provincial governments, municipalities and agencies, corporate, etc). If a cost conscious DIY investor in Canada has an account that is and always will be stuffed completely full of Canadian bonds (e.g. an RRSP), then a discount broker is not necessarily your best choice. You will get no break on spreads, i.e. the "discounter" saves you nothing, and you almost certainly have less inventory to choose from when you want to buy something. If that is the case, then you could consider opening an account at a full service broker.

The prices for Government of Canada (GoC) bonds offer the smallest spreads. You can quickly check the Bank of Canada Bond rates, and compare them to the price quoted online at the broker. It is also possible to estimate bond prices from external data suppliers such as CanadianFixedIncome.ca.

Generally you will find the ask prices to be quite close to the published prices of the GoC benchmark bonds, especially for anything at or above $20K. The price breaks at TD Waterhouse for example are at 10K, 20K, 30K, 50K, 75K, 100K, 250K. The biggest break is at $10K and the next biggest at $20K. The $5K rates aren't that great, so best to stick with $10K and above.

A typical spread for a $5K bond may be $1.25 per $100 face, but can drop to 0.50 per $100 at $50K. So for example, if you hold $20K, five year bonds and the spread is a dollar per $100 face, then you can roughly assume the cost to you at half the spread was 50 cents per 100. If you hold for 5 years until maturity, the cost to you (or your MER) was about 0.10% per year. Better than most bond funds and you get to control your capital gain liabilities and the duration of your holdings. Plus you get a defined rate of return and a know principle at maturity.

The spread on corporate bonds is considerable higher than on government bonds.

It's hard to find discount bonds when rates are falling, but if rates rise they'll be available and you could realize capital gains.

Because of the high bond commissions at modest investment levels, those purchasing less that $10000 in face value may wish to consider buying GICs, bond mutual funds or bond ETFs rather than individual bonds.

Stripped Bonds

Stripped bonds are a special category of bond that does not pay regular interest payments. They are sometimes called zero-coupon bonds. The bond is purchased at a discount to the face value (nominally $100); that face value will be paid only on maturity. The exact amount of the discount is determined mathematically. To take a simple example, at an interest rate of 5%, a bond coming due one year from now is worth only roughly $95, not $100. Several on-line bond calculators (see below) can be used to determine the exact return of a stripped bond. To use an on-line bond calculator for a stripped bond, enter a coupon rate of zero.

Stripped bonds should not be held in taxable accounts because tax is due on the imputed interest every year, even though no money is received.

Interest Rates and Bond Prices

Inverse relationship

Bond prices move in the opposite direction (sometimes called the "inverse") to interest rates: if interest rates go up, bond prices go down, and vice versa. The reasons can be seen in the following example:

Suppose a bond with a coupon rate of 5% is available with exactly one year until maturity. If the interest rate is 5%, the bond is worth $100. If the interest rate is higher than the coupon value, the value of the bond will be depressed such that the total amount received will be comparable. If interest rates are 7%, there would be a 2% difference between the coupon and the interest rate, and the price would drop by about 2% (to about $98) to compensate. But if the interest rate is only 3%, the bond is worth a bit more (roughly $102), so that the net amount received will be about $3.

Bonds purchased at a price above their par value are called premium bonds.

In a taxable account, the price difference between the purchase price of a bond and its sale price or value on redemption is deemed a capital gain or loss. This difference in tax treatment may lead to some differences in interest rates between discount and premium bonds.

Bond Duration

The sensitivity of a bond to interest rate movements is called its duration. Duration is measured in years. For example, if a bond has a duration of 8 years, an interest rate movement of 1% would cause the bond's price to change by approximately 8%. In general, bonds with a longer maturity will have a higher duration. The duration is decreased by a high coupon rate but increased by a low coupon rate. Zero-coupon bonds have the highest interest-rate sensitivity for a given bond maturity.

Several bond duration calculators are available on line. A few are listed below.

Maple Bonds

Maple bonds are Canadian-dollar denominated securities sold by foreign issuers.

Hybrid Securities

Hybrid securities share some of the characteristics of both bonds and equities. They are considered separately.

Taxation in Non-Registered Accounts

Premium and Discount Bonds

Although the interest received from a bond is fully taxable, capital gains or losses are only taxed at 50% when the bond is held in a non-registered account. This leads to inequitable tax treatment, as can be shown by the following example. Suppose one year interest rates are exactly 5%. Consider three separate bonds, each with one year term, with coupons of 5%, 3%, and 7%. These three bonds will trade at prices (rounded to the nearest dollar) of $100, $98, and $102, respectively. Holding these three bonds in a non-registered account gives the following results, assuming a 50% inclusion rate for capital gains:

Coupon	Price	Interest	Capital Gain (Loss)	Total Taxable
5%	$100	$5	$0	$5
3%	$98	$3	$2	$4
7%	$102	$7	($2)	$6

Therefore, because of the disadvantageous taxation, bonds that trade at a premium ($102 in the example) should not be held in non-registered accounts.

Stripped Bonds

As noted above in the section on stripped bonds, taxes will be due on the imputed interest each year, despite the fact that no cash flow is received until the bond matures. Consequently, stripped bonds should not be purchased in non-registered accounts.

Risk

Generally speaking, when looking at a bond, you need to consider four types of risk:

Credit risk

Will the issuer be able to honour his promises? Corporate bonds vary in this credit risk, with a rating assigned by the credit rating agencies. The lower the rating, the higher the interest rate (or yield) that investors will require. Sovereign countries used to be considered free of credit risk, at least in the developed world, but we have seen in recent years that this is not a safe assumption.

Interest rate risk (sometimes called market risk)

As noted above, bond prices vary inversely with interest rates. Interest rates can change for all sorts of reasons. The main one is changes in inflation, but in addition a central bank can lower interest rates to stimulate the economy or lower foreign exchange rates (causing bond prices to rise), or raise interest rates to stimulate the economy or increase foreign exchange rates (causing bond prices to fall).

A rough approximation to the change in bond price caused by a change in interest rates is given by the bond's duration. Duration is published for various bonds on various sites, e.g. Globe Investor. The higher the duration, the more a bond's price changes in response to interest rate changes. One way to look at duration is as a weighted average of the times of a bond's future cash flows. Thus long term bonds have higher durations than short term bonds and so are more sensitive to interest rate changes. This is one reason (but not the only one) why investors generally require higher yields for longer term bonds -- they are riskier.

Inflation is a major factor in a bond's interest rate. A formula due to Irving Fisher says that the nominal interest rate (the one you see) is approximately equal to the real interest rate on the bond plus the expected rate of inflation. This formula has been found to hold in the long term, but may not hold for short periods. But it's usually a pretty handy tool.

Liquidity risk

If the market for a given bond is "thin", i.e. if the daily volume is low -- sometimes a bond may not trade at all for days on end -- it is illiquid. If you have to sell it on short notice, you may not be able to do so at a reasonable price. Even if you do sell it, the broker may maintain a wide spread between the bid and ask prices (the prices at which he is willing to sell it to you or buy it from you).

Investors like liquidity. If a bond is illiquid, they charge a higher interest rate, in the form of a liquidity premium (better called an illiquidity premium).

Very short term bonds, e.g. 30 days to maturity, are liquid by their nature. If you can't find a buyer, just wait the 30 days to maturity. The longer out the maturity, the less this form of liquidity will act to save you. So generally (but not always) short term bonds will carry lower interest rates than long term bonds from the same issuer. This has nothing to do with the issuer's credit-worthiness.

Inflation risk

This is not usually listed as a separate risk. It has already been covered its main impact above, under interest rate risk, i.e. increased inflation generally leads to higher interest rates, which lead to lower bond prices. But there is an additional risk, that the future dollars you will receive may be worth less than you expect now. This happens when there is unanticipated inflation, whose impact has not been built into the interest rate investors have demanded. Thus, suppose you expect inflation to be 2% for the next ten years and real interest rates of 1%. You price a bond to yield 3%. If inflation does indeed come in at 2%, everything is fine. You get your principal back at the end of ten years in devalued dollars, but you got annual payments of 3% for ten years. Effectively, you got part of your capital back every year. Over all, you make 1% per year.

But now suppose inflation comes in at 4% per year. Then you obtain a nominal rate of 3% less inflation of 4%, for a real return of - 1%. Here your principal is eroded by more than is made up by the annual payments, and on net you do lose money.

Risk Granularity

Purchasers of individual bonds must consider the amount of their portfolio that could be adversely affected by a single default. This effect is sometimes referred to as the granularity of the risk and depends upon the size of each bond holding compared to the portfolio size. For example, if the total portfolio is $1M, a $20K bond gives a granularity of 5%. ($20000/$1000000). Controlling risk granularity in the event of default requires a large portfolio. If, for example, the $1M portfolio above had 20% in corporate bonds, then 10 bonds at $20K face value each could be accommodated. As indicated earlier, small bond holdings have high commissions, so lower granularity results in higher costs because of the smaller bond purchases needed.

Because of the high potential effects of a single default, holders of small portfolios may wish to consider low-cost bond funds or bond ETFs in order to reduce risk granularity.

On-Line Bond Calculators

Bond Yield

Smartmoney bond calculator
Moneychimp bond calculator

Bond Duration

Investopedia bond duration calculator
Bond Price, Duration and Convexity Calculator

Further Reading

Cunningham, W.H.("Hank"). In Your Best Interest: The Ultimate Guide to the Canadian Bond Market