Conventional bonds

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Bonds have been defined by James Hymas[1] 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 (also referred to as "nominal 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 (RRBs), high yield bonds and foreign bonds are covered in separate articles.

The term bond and debenture tend to be used interchangeably but there is a significant difference. Technically a bond has assets pledged against it as security of the loan (government bonds are the exception) while a debenture has no specific assets pledged and is therefore backed only by general credit of the issuer.[2]

Canadian bonds are rated by three different rating agencies: DBRS, Moody's and Standard and Poor's. The credit rating agencies each have their own scale that is used to indicate creditworthiness and whether or not the bond is considered investment grade.

Historical bond rates are available from the Bank of Canada.[3]

The place of bonds in a portfolio

Bonds can serve three different functions in a portfolio:

  • A source of income;
  • A place of safety;
  • An emergency source of cash.

These functions are to some extent contradictory, and require the purchaser to select different bond characteristics depending upon the desired role. For example, high income requires the purchase of higher-risk bonds, either because they have a longer maturity or a lower rating, and may even mean the purchase of high yield bonds (sometimes called "junk bonds"). A requirement for safety, on the other hand, means accepting a lower yield and either a higher bond rating or a shorter maturity. Emergency cash can come from bond coupons, maturing bonds, or by selling shorter-term bonds before maturity.

Before buying bonds, it is important that the prospective investor decide on the role that bonds will play in their portfolio. This can be done by creating a financial plan and designing the appropriate portfolio.

Bond indices

See also: Index

Canadian bond indices were maintained by ScotiaMcleod until October 2007. They were bought by TSX Group Inc.'s wholly owned subsidiary, PC-Bond.[4] and rebranded as the "DEX Bond Indexes" on October 22, 2007. On April 5, 2013, FTSE Group, part of London Stock Exchange Group, and TMX Group completed the transaction to combine their fixed income businesses in a new joint venture, FTSE TMX Global Debt Capital Markets.[5] On October 1, 2013, FTSE TMX Global Debt Capital Markets Inc. announced that its Canadian index products would be re-branded to the FTSE TMX brand name,[6] which took effect in the first quarter of 2014.[7]

Bond index funds and ETFs

Investors not wishing to purchase individual funds can consider bond index funds or bond exchange-traded funds (ETFs). A notable Canadian bond index fund is the TD Canadian Bond Index Fund - e, fund code TDB909, MER of 0.5%.

TSX-listed ETFs that track the broadest possible Canadian bond indices include the BMO Aggregate Bond Index ETF (ZAG), the Vanguard Canadian Aggregate Bond Index ETF (VAB), the iShares Canadian Universe Bond Index ETF (XBB), and the iShares Core High Quality Canadian Bond Index ETF (XQB). As of January 2016, the management fee on XBB was still 0.30%, whereas the competitors, including XQB, had significantly lower fees.

Investors wanting TSX-listed broad-market Canadian bond ETFs with shorter durations may consider the Vanguard Canadian Short-Term Bond Index ETF (VSB), the iShares Canadian Short Term Bond Index ETF (XSB), or the iShares Core Short Term High Quality Canadian Bond Index ETF (XSQ). As of January 2016, XSB still charged a management fee of 0.25%, whereas the competitors, including XSQ, had significantly lower fees.

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. Those purchased below par are called discount 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.[8] 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.

The duration can be considered the 'balancing point' of the discounted cash flows of the bond principle and coupons - that is, the future time at which the near-term coupons (which are weighted most heavily) balance in value the far-term coupons and return of bond principle. Since zero-coupon bonds have no coupons, the entire cash flow comes at maturity, and their duration equals the time to maturity.

If the holding period of a bond (or bond fund or ETF) is longer than its duration, any price changes prior to the duration length will have been cancelled out by interest income changes. For example, if a bond ETF has a duration of 6.75 years, and has been held for 16.75 years, the first 10 years of price changes will have been cancelled out by interest income changes: lower prices will have been cancelled by higher interest income and vice-versa.

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

Special types of bonds

Stripped bonds

Main article: Strip 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.

Because they have no coupons and no cash flow is obtained until the strip matures, strip bonds have a duration equal to their term to maturity.

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.

Real Return Bonds

Main article: Real Return Bonds

A Real Return Bond (RRB) is a bond issued by the Government of Canada (GoC) and/or certain provincial governments that pay you a rate of return that is adjusted for inflation.

Maple bonds

Maple bonds are Canadian-dollar denominated securities sold by foreign issuers.[9][10]

Hybrid securities

Hybrid securities, such as convertible debenture, share some of the characteristics of both bonds and equities. They are beyond the scope of this article.

Buying bonds

Unlike equities, the bond market operates in an "over the counter" manner. The bond market is not visible publicly and operates mostly at the investment dealer level and is quote driven. The investment dealers maintain inventories and make markets based on their inventory. The inventory typically varies between investment dealers.

Because of the high bond commissions at modest investment levels, those purchasing less that $10000 in face value may wish to consider buying Guaranteed Investment Certificates, or well diversified (broad-based) bond mutual funds or bond ETFs rather than individual bonds. This point is further considered below in the section on Risk Granularity.

When investing in bond funds, it is important to remember that costs matter. A study of bond fund returns[11] 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.

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. a Registered Retirement Savings Plan), 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.[12]

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.[13]

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 management expense ratio (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 known 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.

Bond credit ratings

The bond credit rating represents the creditworthiness of corporate or government bonds. The ratings are published by credit rating agencies and used by investment professionals to assess the likelihood the debt will be repaid. They are not a buy/sell/hold recommendation. A rating is not a comment on the market price of a security nor is it an assessment of the appropriateness of ownership given various investment objectives.[14]

Credit ratings are assigned when the bond is issued. The credit rating agencies monitor the issuers and may change their rating over time. The reasons are broadly related to overall shifts in the economy or business environment or more narrowly focused on circumstances affecting a specific industry, entity, or individual debt issue.[15]

A bond is considered investment grade if its credit rating is:

  • BBB (low) or higher on the scale used by DBRS or
  • BBB- or higher on the scale used by Standard & Poor's or
  • Baa3 or higher on the scale used by Moody's.

Generally they are bonds that are judged by the rating agency as likely enough to meet payment obligations that banks are allowed to invest in them.

Ratings play a critical role in determining how much companies and other entities that issue debt, including sovereign governments, have to pay to access credit markets, i.e., the amount of interest they pay on their issued debt. The threshold between investment-grade and speculative-grade ratings has important market implications for issuers' borrowing costs.

Bonds that are not rated as investment-grade bonds are known as high yield bonds or more derisively as junk bonds.

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.[16]

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 different types of risk[17]:

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.

Interest rate risk can be mitigated by setting up a bond ladder - that is, a series of bonds with stepped maturities (say, 1, 2, 3, 4, and 5 years). Also, the interest rate risk for an individual bond (or bond fund, bond ETF, or bond ladder) is mitigated if it is held for a period longer than its duration.

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 they are 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.

In a liquidity crisis, funds in certain instruments may become frozen and unavailable. This happened during the Canadian Asset Based Commercial Paper (ABCP) crisis which started in August, 2007, and was not resolved until 2009.[18] Therefore, a liquidity crisis may impose more hardship on the creditor because of extended unavailability of funds than an outright default.

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.

Inflation risk can be mitigated by investing in RRBs.

Risk granularity

Since a default or credit event could result in an extended period of fund unavailability, purchasers of individual bonds must consider the amount of their portfolio that could be adversely affected in those circumstances. Such events present mathematically discrete, rather than continuous, risk events and are sometimes referred to as the granularity of the risk, and depend 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 2% ($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

Bond duration

See also

Further reading

References

  1. James Hymas, Bond Characteristics, Canadian Moneysaver, February, 2009.
  2. WebBroker Fixed Income Glossary, viewed December 20, 2013.
  3. Bank of Canada, Rates and Statistics, viewed Feb. 16, 2009
  4. TSX Group Inc. | Scotia Capital Universe Bond Index* rebranded as DEX Universe Bond Index(TM), viewed December 18, 2013.
  5. TMX Group Inc. | FTSE and TMX Datalinx complete transaction to create new global fixed income index business: FTSE TMX Global Debt Capital Markets, viewed January 15, 2015.
  6. Sun Life Financial - New names for DEX Bond Indices, viewed January 15, 2015.
  7. iShares Canadian Universe Bond Index ETF | XBB, viewed January 15, 2015.
  8. Wikipedia, Bond Duration, viewed February 19, 2009.
  9. Bank of Canada, The “Maple Bond” Market, viewed December 18, 2013.
  10. Investopedia, Maple Bonds, viewed Feb. 19 2009.
  11. Reichenstein, William. Bond Fund Returns and Expenses: A Study of Bond Market Efficiency, The Journal of Investing, Winter 1999
  12. Norbert Schlenker, Financial Wisdom Forum • View topic - Bonds and Inflation, viewed Jan. 21, 2012.
  13. like_to_retire, Financial Wisdom Forum • View topic - Bonds and Inflation, viewed Jan. 21, 2012.
  14. DBRS, Limitations to Uses of a Rating, viewed December 20, 2013.
  15. S&P | Ratings Credit Ratings Definitions & FAQs | Americas, viewed December 20, 2013.
  16. Landon, Stuart and Smith, Constance. Taxation and bond market investment strategies: Evidence from the market for Government of Canada bonds. (pdf), viewed May 30, 2010.
  17. ghariton, Financial Wisdom Forum • View topic - Bonds and Inflation, viewed on Jan. 22, 2012.
  18. CBC News Business, Asset-backed commercial paper's long road back, January 13, 2009.

External links