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A. OVERVIEW

Governments, corporations, and many other entities borrow funds to finance and expandtheir operations. In addition to bank lending and private loans, these entities also havethe option of issuing fixed-income securities into the financial markets.

From the perspective of investors, the purchase of a bond, T-Bill, or any other fixed-incomesecurity essentially represents the decision to lend money to the issuer. In doing so, investors donot gain any ownership rights, as in the case of an equity investment. Rather, they become credi-tors of the issuing organization.

This chapter explains the features of fixed-income securities, how they are priced in the second-ary market, and how prices are affected by interest rate changes. We begin with some defini-tions, describe the reasons why entities issue fixed-income securities , and provide a few meas-ures of its size. Next, we describe specific types of fixed-income securities as well as the featuresrelated to interest payments and the return of principal. We cover fundamental price and yieldcalculations, the theory of interest rate determination, basic pricing methods, and trading strate-gies. We also describe the settlement and delivery system for fixed-income securities. The chapterconcludes with a description of bond indexes.

1. Definitions

a) Fixed-income securities

Fixed-income securities represent debt of the issuing entity. The terms of a fixed-income securi-ty include a promise by the issuer to repay the maturity value or principal on the maturity date,and to pay interest either at stated intervals over the life of the security or at maturity. In mostcase, if the security is held to maturity, the rate of return is fairly certain.

Fixed-income securities trading in the market today come in a multitude of varieties, includingbonds, debentures, money market instruments, mortgages, and even preferred shares, reflectingwidely different borrowing needs as well as investor demands. Borrowers modify the terms of abasic fixed-income security to suit both their needs and costs, and to provide acceptable terms tovarious lenders.

b) Bonds and debentures

A bond is secured by physical assets in a trust deed written into the bond contract. If the bondgoes into default, the trust deed provisions allow the bondholders to seize specified physicalassets and sell them to recover their investment. These physical assets could be a building, a rail-way car, or any other physical property.

A debenture may be secured by something other than a physical asset that can be seized andsold in the event of default on the issue. The asset secured may be a general claim on residualassets or the issuer’s credit rating.

In this chapter, we follow the industry practice of referring to both types as bonds, unless thedifference is important. For example, government bonds are never secured by physical assets, andso technically are really debentures, but in practice they are always referred to as bonds.

Chapter 5

Fixed-Income Securities

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c) Interest

Many bonds pay regular interest at a rate known as the coupon rate. The coupon ratemay be fixed, such as 6% a year, or may be variable and will change in reference to abenchmark interest rate. Bonds with variable coupon rates are typically referred to asfloating-rate securities. Interest payment provisions may also take other forms:

• Coupon rates can change over time, according to a specific schedule (e.g., step-upbonds, most savings bonds).

• There may be no periodic coupon interest – interest can be compounded over time,and paid at maturity (e.g., zero-coupon bonds, strip coupons and residuals).

• A rate of interest does not have to be applied – the loan can be compensated in theform of a return based on future factors, such as the change in the level of an equityindex. These securities are known as index-linked notes.

In North America the majority of bonds pay interest twice a year at six-month intervals.Other bonds may pay interest monthly or annually. In all cases, the amount of interestat each payment date is equal to the coupon rate divided by the number of paymentsper year.

d) Face Value and Denomination

The amount the bond issuer contracts to pay at maturity (the maturity value) is knownas the face or par value. These terms are also used to describe the maturity value of eachbond holder’s position.

Bonds can be purchased only in specific denominations. The most commonly useddenominations are $1,000 or $10,000. Larger denominations may be issued to suit thepreference of investing institutions such as banks and life insurance companies.Normally, an issue designed for a broad retail market is issued in small denominations.An issue for institutional investors may be made available in denominations of millionsof dollars.

To accommodate smaller investors, Canada Savings Bonds are issued in denominationsas small as $100. The smallest corporate bond denomination is usually $1,000.

e) Price and Yield

Bonds that trade in the secondary market have a price and a quoted yield.

Bond prices are quoted using an index with a base value of 100. A bond trading at 100 issaid to be trading at face value, or par. A bond trading below par, say at a price of 98, issaid to be trading at a discount (the 98, based on the index of 100, indicates the bond istrading at 98% of par). A bond trading above par is said to be trading at a premium.

Example: If you buy a bond with a $10,000 face value at a price of 95, it will cost you$9,500. This is equal to the face value ($10,000) multiplied by the price divided by 100(95/100 = 0.95). If you paid 105 for the bond, it would cost you $10,500, or $10,000multiplied by (105/100).

Given the price of a bond, it is possible to calculate a yield for the bond. For mostbonds, the yield is an approximate measure of the annual return on the bond if it isheld to maturity. For example, if you bought a bond with yield of 5% and held it tomaturity, your annual return will be approximately 5%.

The yield of a bond should not be confused with the coupon rate; they are two differentthings. Given the yield and the coupon rate, the following relationships hold:

• If the yield is greater than the coupon rate, the bond is trading at a discount.

• If the yield is equal to the coupon rate, the bond is trading at par.

• If the yield is less than the coupon rate, the bond is trading at a premium.

f) Term to maturity

The maturity date is the date at which the bond matures and the principal is paid back.The remaining life of a bond is called its term to maturity.

Example: If a bond was issued three years ago with a term of ten years, it is no longerreferred to as a ten-year bond. Because three years have passed and only seven remain inthe life of the bond, it is referred to as a seven-year bond.

Bonds can be grouped into three categories according to their term to maturity. Short-term bonds have less than five years remaining in their term. Bonds with terms of fiveto ten years are called medium-term bonds, and long-term bonds have a term to matu-rity greater than ten years. Table 5.1 shows these categories.

Money market securities are a special type of short-term fixed-income security, generallywith terms of one year or less. Certain high-grade short-term bonds may trade as moneymarket securities when their term is reduced to a year or less, but for the most part,money market securities include Treasury bills, bankers’ acceptances, and commercialpaper.

TABLE 5.1

Categorization of Bonds by Term to Maturity

Money Market Short-Term Bonds Medium-Term Bonds Long-Term Bonds

Up to Up to 5 years From 5 to 10 years Greater thanone year term remaining remaining 10 years remainingto maturity to maturity to maturity

g) Liquid bonds, negotiable bonds, and marketable bonds

Liquid bonds are bonds that trade in significant volumes and for which it is possible tomake medium and large trades quickly without making a significant sacrifice on the price.

Negotiable bonds are bonds that can be transferred because they are in deliverable form(in “good delivery” means the certificates are not torn, a power of attorney has beensigned, and so on). That a bond be negotiable is not much of an issue anymore, as mostbonds are book-based now and certificates are not issued.

Marketable bonds are bonds for which there is a ready market. For example, a privateplacement or other new issue may be marketable (clients will buy it) because its priceand features are attractive. It would not necessarily be liquid, however, since most pri-vate placements do not have an active secondary market.

2. The Rationale for Issuing Fixed-Income Securities

Many Canadians are concerned about high government debt levels. We know that cor-porate debt can lead to bankruptcy and personal debt can keep individuals from gettingahead financially. It is useful to explore the rationale for borrowing money. There aretwo main reasons:

• To finance operations or growth; and

• To take advantage of operating leverage.

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a) Financing Operations or Growth

If a government spends more on programs and other payments than it receives in taxrevenue, it must make up the difference by borrowing money. Most governments bor-row by issuing fixed-income securities. Government borrowing is an example of issuingfixed-income securities to finance operations.

Unlike governments, companies have more options when they find themselves spendingmore on expenses than they receive in revenue; issuing fixed-income securities is onlyone option. They can also use cash on hand, raise cash by selling assets, borrow fromthe bank, or issue equity securities. The choice of financing method will depend on thecosts associated with each. Companies generally prefer to raise money from the lowestcost source possible.

In many cases, companies do not issue fixed-income securities to finance year-to-yearcash shortfalls. These will usually be financed with cash on hand or bank borrowing. Acompany that consistently finds itself using more cash than it takes in will not be inbusiness for too long.

Most companies issue fixed-income securities to finance growth. This usually meansusing the proceeds of a fixed-income issue to add or expand the companies’ currentoperations, or to buy other companies. When companies announce a new bond issue,they usually say why they are issuing the bond. If it is not being issued to buy anothercompany or other specific assets, they will usually state that the proceeds will be usedfor “general corporate purposes.” This usually means that the company will invest theproceeds in current operations.

b) Financial Leverage

If companies believe they can earn a greater return on cash invested in their businessthan it would cost to borrow money, they can increase the return on shareholders’ equi-ty by borrowing money. This is what is meant by financial leverage. The analysis thatdetermines whether to use leverage is made on an after-tax basis. This increases theleverage potential of bonds because, unlike dividends on equity securities, the interestpayments on bonds are a tax-deductible expense for the corporation.

Example: Suppose a company wants to open a new plant to increase production capaci-ty. It could borrow $1 million for the plant at 10% interest, at a cost of $50,000 a yearafter tax. If the expanded capacity is expected to increase after-tax profits by more than$50,000 a year, the company will probably proceed with the project. If the after-taxprofits are projected to be less than $50,000 a year, the company will either abandonthe project or find a cheaper source of funds.

3. Size of the Fixed-Income Market

Perhaps because it is not as highly publicized as the stock market, many people do notrealize just how large the fixed-income market really is. For example, Canadian second-ary market debt trading in 2004 totalled $10.3 trillion, or approximately 12 times thetotal equity trading of $834 billion, and approximately 8 times Canada’s GDP of nearly$1.3 trillion. The total debt outstanding at the end of 2004 was just over $1.7 trillion,compared with the total market capitalization of the Toronto Stock Exchange of $1.6trillion.


B. FEATURES AND PROVISIONS OF BONDSBonds are issued with a variety of features and provisions. Bonds may be callable,extendible, retractable, or convertible. Some will have sinking funds or purchase funds.The protective provisions discussed below refer to corporate bonds.

1. Call or Redemption Feature

Bond issuers often reserve the right, but not the obligation, to pay off the bond beforematurity, either to take advantage of lower interest rates, or to simply reduce their debtwhen they have the excess cash to do so. This privilege is known as a call or redemptionfeature. A bond bearing this clause is known as a callable bond or a redeemable bond.As a rule, the issuer agrees to give 10 to 30 days’ notice that the bond is being called orredeemed.

In Canada, most corporate, provincial, and municipal bond issues are callable.Government of Canada bonds are non-callable.

a) Standard Call Features

A standard call feature allows the issuer to call bonds for redemption at a specified priceon specific dates or during specific intervals over the life of the bond. The call price is usu-ally set higher than the par value of the bond. This provides a premium payment for theholder, as it is somewhat unfair to take away from the investor an investment from whichhe or she expected to receive a stated income for a certain number of years. The closer thebond is to its maturity date before it is redeemed, the less the hardship for the investor. Inrecognition of this principle, the redemption price is often set on a graduated scale and thepremium payment becomes lower as the bond approaches the maturity date.

Provincial bonds are usually callable at 100 plus accrued interest. Accrued interest refersto the interest that has accumulated since the last interest payment date. Accrued inter-est belongs to the holder of the bond.

Example: CHC Helicopter’s call feature (for other than sinking fund purposes) is shownin Table 5.2. In this example, if you owned a $1,000 debenture of this issue and yourdebenture was called:

• After September 1, 2003, and before or on September 1, 2004, you would receive$1,012 plus accrued interest;

• After September 1, 2004 and before or on September 1, 2005, you would receive$1,008 plus accrued interest; and

• So on, with the premium gradually reducing according to Table 5.2.

TABLE 5.2

Example of a Corporate Debt Call Feature

CHC Helicopter 8% debentures due August 31, 2007.Not redeemable before September 1, 1999.Thereafter, redeemable

on 30 days’ notice up to the 12 months ending September 1, 2006, as follows:

1999 102.80 2003 101.20

2000 102.40 2004 100.80

2001 102.00 2005 100.40

2002 101.60 2006 100.00Thereafter redeemable at par to maturity.

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For callable bonds, the period before the first possible call date (during which the bondscannot be called) is known as the call protection period.

b) Canada Yield Calls

Most corporate bonds are issued with a call feature known as a Canada yield call. Theseallow the issuer to call the bond at a price based on the greater of (a) par, or (b) theprice based on the yield of an equivalent-term Government of Canada bond plus a yieldspread. A yield spread is simply an additional amount of yield. Generally, this spread isless than what the spread was when the bond was issued, and remains constant through-out the term of the issue.

Example: A 10-year corporate bond is issued at par with a coupon and yield of 7%,which represents a yield spread of 200 basis points above the current 5% yield on 10-year Canada bonds. (A basis point equals one one-hundredth of a percentage point.)The corporate bond contains a Canada yield call of +50, meaning that the bond can becalled at a price based on a yield of 50 basis points over Canada bonds, with a mini-mum call price of par.

The following year, with 9-year Canada bonds yielding 4.75%, the company decides tocall the bonds. Given the Canada yield call of +50, the company must call the bonds ata price based on a yield of 5.25% (which is 4.75% + 0.50%), regardless of where thebonds have been trading in the market before the call.

2. Sinking Funds and Purchase Funds

Some issuers must repay portions of their bonds for redemption before maturity, eitherby calling them on a fixed schedule of dates (via a sinking fund obligation) or by buyingthem in the secondary market when the trading price is at or below a specified price(through a purchase fund).

a) Sinking Fund Debt

Some corporate bonds have a mandatory call feature for sinking fund purposes. Sinkingfunds are sums of money that are set aside out of earnings each year to provide for therepayment of all or part of a debt issue by maturity. Sinking fund provisions are as bind-ing on the issuer as any mortgage provision.

Example: Westcoast Energy 10.625% senior debentures, due July 15, 2006, have amandatory sinking fund. The company must retire $800,000 of the principal amounton July 15 every year, from 1988 to 2005 inclusive. Any debentures purchased orredeemed by the company other than through the sinking fund can be paid to thetrustee as part of the sinking fund obligation. The debentures are redeemable for sinkingfund purposes at the principal amount plus accrued interest to the date specified.

b) Purchase Fund Debt

Some companies have a purchase fund instead of a sinking fund. Under such anarrangement, a fund is set up to retire a specified amount of the outstanding bonds ordebentures through purchases in the market, if these purchases can be made at or belowa stipulated price. Occasionally, a bond will have both a sinking fund and a purchasefund.

Example: Domtar Inc. 10% pay debentures, due April 15, 2011, have a purchase fund.Beginning on July 1, 1992, the company must make all reasonable efforts to purchase ator below par 1.125% of the aggregate principal amount during each quarter, cumulativefor eight quarters. The purchase fund normally retires less of an issue than a sinkingfund.


3. Extendible and Retractable Bonds

Some corporate bonds are issued with extendible or retractable features.

a) Extendible Debt

Extendible bonds and debentures are usually issued with a short maturity term (usuallyfive years), but with an option for the investor to exchange the debt for an identicalamount of longer-term debt (usually ten years) at the same or a slightly higher rate ofinterest by the extension date. In effect, the maturity date of the bond can be extendedso that the bond changes from a short-term bond to a long-term bond.

Example: 407 International Inc. 7% Extendible Junior Bonds, Series 00-B1, due July26, 2010 are extendible to July 26, 2040 from July 26, 2010 at a rate of 7.125%.

b) Retractable Debt

Retractable bonds are the opposite of extendible bonds. These bonds are issued with along maturity term (usually at least ten years), but give investors the right to turn in thebond for redemption at par several years sooner (usually five years) by the retractiondate.

Example: Nova Scotia Power Inc. 5.2% Medium Term Notes, Series P, due April 9,2029 are retractable at par on April 9, 2006.

c) Election Period

With both extendible and retractable bonds, the decision to exercise the maturity optionmust be made during a time period called the election period. In the case of anextendible bond, the election period may last from a few days to six months or more,before the short maturity date. During the election period, the holder must notify theappropriate trustee or agent of the debt issuer either to extend the term of the bond orallow it to mature on the earlier date. If the holder takes no action, the bond auto-matically matures on the earlier date and interest payments cease.

In the case of a retractable bond, if the holder does not notify the trustee or agentbefore the retraction date of his or her decision to shorten the term of the bond, thedebt remains a longer-term issue.

4. Convertible Bonds and Debentures

Convertible bonds and debentures combine certain advantages of a bond with theoption of exchanging the bond for common shares. In effect, a convertible securityallows an investor to lock in a specific price (the conversion price) for the commonshares of the company. The right to exchange a bond for common shares on specificallydetermined terms is called the conversion privilege.

Convertibles have the characteristics of regular bonds and debentures, in that they havea fixed interest rate and there is a definite date upon which the principal must be repaid.They offer the possibility of capital appreciation through the right to convert the deben-tures or bonds into common shares at the holder’s option at stated prices over statedperiods.

a) Why Convertible Debentures are Issued

The addition of a conversion privilege makes a debenture more saleable or attractive toinvestors. It tends to lower the cost of the money borrowed and may enable a companyto raise equity capital indirectly on terms more favourable than those possible throughthe sale of common shares.

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Convertible debentures can also be used to interest investors in providing capital forcompanies if investors would not otherwise be interested in buying relatively low yield-ing or non-dividend-paying common shares.

The convertible debenture permits the holding of a two-way security. In other words, itcombines much of the safety and certainty of the income earned on a bond with theoption to convert into common shares and benefit from any increase in their value. Theconvertible has a special appeal for the investor who:

• Wants to share in the company’s growth while avoiding any substantial risk; and

• Is willing to accept the lower yield of the convertible in order to have a call on thecommon shares.

b) Characteristics of Convertible Debentures

In most convertible debentures, the conversion price is gradually raised over time toencourage early conversion. In view of the ability of most Canadian companies toincrease net worth and earning capacity, this arrangement seems to be reasonable.

A properly drawn trust deed provides that, if the common shares of the company aresplit, the conversion privilege will be adjusted accordingly. This is known as protectionagainst dilution.

Convertible debentures may normally be converted into stock at any time before theconversion privilege expires. However, some convertible debenture issues have a clausein their trust deeds that stipulates “no adjustment for interest or dividends.” This clauseexcuses the issuing company from having to pay any accrued interest on the convertibledebentures that has built up since the last designated interest payment date. Similarly,any common stock received by the debenture holder from the conversion will normallybe entitled only to dividends declared and paid after the conversion takes place.

Convertibles are normally callable, usually at a small premium and after reasonablenotice.

The term of convertible debentures usually ranges from 5 to 10 years, but declininginterest rates may encourage issuers to revert to terms of 10 to 20 years, as was the casesome years ago. Most convertibles have a sinking fund.

c) Forced Conversion

Forced conversion is an innovation built into certain convertible debt issues to give theissuing company more scope in calling in the debt for redemption. This redemptionprovision usually states that once the market price of the common stock involved in theconversion rises above a specified level and trades at or above this level for a specificnumber of consecutive trading days, the company can call the bonds for redemption ata stipulated price. The price is much lower than the level at which the convertible debtwould otherwise be trading, because of the rise in the price of the common stock.

This provision is an advantage to the issuing company rather than to the debt holder,because forced conversion can improve the company’s debt-equity ratio and make newdebt financing possible. However, it is not so disadvantageous to the debt holder that itdetracts from an issue when it is first sold. Once the price of the convertible debt risesabove par, subsequent prospective buyers should check the spread between the prevail-ing purchase price and the possible forced conversion level.

Example: The 7.875% convertible subordinated debentures of First Capital Realty, dueJanuary 31, 2007, have a forced conversion clause. Until January 31, 2007, the deben-tures are convertible into 58.824 common shares for each $1,000 of face value. Thisgives them a conversion price of $17 a common share. The debentures may not be



redeemed before January 31, 2003. The company has the option to pay the principalamount on redemption or maturity, or to pay the investor in common shares. The priceof the common shares will be obtained by dividing $1,000 by 95% of the weightedaverage trading price for 20 consecutive trading days on the TSX, ending five daysbefore maturity or the date fixed for redemption.

This is considered to be a forced conversion clause, because the client must choosewhether to convert the debentures into common shares at $17 a share or accept thecompany’s redemption offer, which could force them to pay a considerably higher priceper share. For example, if the weighted average price was $23.40, the company woulddivide $1,000 by $22.23 (95% of $23.40) to arrive at 45 shares. The investor wouldreceive fewer shares (45 shares) than if they had chosen to convert before the forcedconversion was imposed by the issuer.

d) Market Performance of Convertibles

Market prices of convertible debentures are influenced by their investment value and bythe price of the common shares into which they can be converted. In general, theirprices rise in reaction to increases in the price of the common shares (depending uponthe proximity of the conversion date) and decline in value when the common stockprice falls, but only to the levels at which they represent competitive values as straightdebenture investments.

Over the past few years, observers have noted the following market action of convertibledebentures:

• When the stock of the issuing company is well below the conversion price, the con-vertible debenture acts like a straight debenture, responding to the general level ofinterest rates, the activity of the sinking fund, and the quality of the security;

• When the stock approaches the conversion price, a premium appears. For example,a $1,000 debenture convertible into 40 shares of stock ($25 a share) will sell formore than $1,000, perhaps at $1,100. This premium reflects the value to investorsof holding a two-way security. Although what constitutes a reasonable premiumvaries, 15% to 20% or even higher may be considered attractive; and

• When the common stock rises above the conversion price, the debenture will rise inprice accordingly and is then said to be selling off the stock. If, in our example, thecommon stock rises to $30 a share, the convertible debenture will rise to 40 × $30= $1,200, plus some premium.

The payback period on a convertible debenture is an important evaluation tool forthese securities. The payback period is the time it takes the convertible to recoup its pre-mium through its higher yield, compared with the dividend that is paid on the stock.The payback period for a convertible preferred is calculated in Chapter 6.

4. Protective Provisions

In addition to principal repayment features, corporate bonds may also have generalcovenants that secure the bond and make it more likely that the investor will receive allthat he or she is due. These clauses are called protective provisions, and are essentiallysafeguards in the bond contract to guard against any weakening in the security holder’sposition. The object is to create a strong instrument that does not force the companyinto a financial straitjacket.

Following are some of the more common protective and other provisions found inCanadian corporate bonds:

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a) Prohibition of Prior Lien

If a company has first mortgage bonds outstanding, no securities may be issued thatrank senior to these bonds as a claim on the mortgage properties.

b) Negative Pledge Provision

When debentures are issued, a common provision states that no subsequent mortgagebond issue may be secured by all or part of the company’s properties, unless at the sametime the debentures are similarly secured by the mortgage.

Example: The following provision appears in the prospectus of the unsecured mediumterm notes issued by Bombardier Capital Ltd.:

“The Indenture contains a negative pledge covenant substantially to the following effect:Unless the benefit of the relevant Charge or Guarantee Obligation is at the same timeextended equally and rateably to the holders of Notes regarding the obligations of theCompany in respect of the Notes, the Company will not, and will ensure that none ofits subsidiaries will, create or have outstanding any Charge of Guarantee Obligation onor over their respective assets (present or future) in respect of any Indebtedness forBorrowed Money of any person, except for…” (The Pledge goes on to list several exceptions in detail.)

c) Restricting Additional Borrowing

It is usual to add some restriction on the creation of additional amounts of the sameissue to the trust deed of a mortgage bond. This is usually done through:

• A closed-end mortgage; or

• An open-end mortgage, carrying restrictive provisions.

The Closed-End Mortgage

When a mortgage is closed, no additional bonds may be issued against the propertypledged under the mortgage. This provision protects the bondholders from having theirposition weakened by additional bonds with an equal claim against the property.

The After-Acquired Clause

An even stronger protection is given to bondholders by an after-acquired clause. Thisclause provides that, in addition to all property owned at the time of issue, all otherproperty that the company may acquire during the life of the bond issue shall automati-cally come under the mortgage to provide additional security to the bondholder.

Example: Aliant Telecom Inc.11.45% first mortgage bonds, Series S, due July 20, 2008,are secured by the following provision: “Secured by a fixed first and specific mortgage,pledge and charge upon all real and immovable property and equipment of the compa-ny and a floating charge on all other property of the company, both present and future.”

Purchase Money Mortgage

It is customary to permit the assumption of purchase money mortgages. These are alegal hold or claim attached to a new property subsequently acquired by the issuer. Theydo not affect the position of the holders of mortgage bonds already outstanding.

The Open-End Mortgage

In the open-end mortgage, there is no limit to the number of bonds the corporationmay issue under the mortgage. To protect the security of the bondholder, it is usual toinsert certain provisions that limit the number of bonds the corporation may issue to atotal within its financial capacity. The provisions may limit additions to the bond issue


to less than a certain percentage of the value of new assets; or require that interestcharges, including those of the proposed new issue, be adequately covered.

Example: Brookfield Commercial Properties Ltd. 6.4% first mortgage bonds, Series A,due April 8, 2013, are secured by a first mortgage on the leasehold title of the projectand a fixed and floating charge on all the undertakings, property, and assets of theissuer.

These are general provisions. The trust deed contains certain clauses limiting the num-ber of bonds that may be issued under these provisions, in order to maintain a propermargin of safety. The purpose of these conditions is to safeguard the position and quali-ty of the bonds outstanding without unduly compromising the financial position of thecorporation.

Open mortgages are well suited to the needs of growing corporations, since financing iseasier if all fixed assets are covered by one mortgage. The existence of several mortgagesmay create legal difficulties. For example, it may be difficult to move the equipment andmachinery from a plant covered by one mortgage to a plant covered by another. If theprotective provisions are adequate, the open-end feature is not objectionable to thebondholders.

d) Working Capital Requirements

Some Canadian issues, especially debentures, contain a restriction designed to maintainworking capital at a satisfactory level. This clause usually states that dividends may notbe paid on common shares if payment would result in the reduction of the workingcapital below a stated sum.

e) Sinking Fund Clause

The purpose of a sinking fund is to set aside cash for the repayment of all or part of thefunded debt by the maturity date. The typical sinking fund requires the annual depositwith a trustee of a stated sum of money, or its equivalent in a principal amount ofbonds. The percentage of a sinking fund in relation to the outstanding principal variesfrom issue to issue, but it is usually substantial.

f) Sale and Leaseback Prohibition

A clause may be added that prohibits the sale and leaseback of certain assets that arepart of the security of a debt issue. This practice would be permitted only if such atransaction took place at the fair market value of the assets and if the net proceeds wereapplied to the redemption of the debt issue involved.

g) Sale of Assets and Mergers

A clause may be added that prohibits the sale of assets (either by direct sale or by anamalgamation or merger) that are part of the security for the debt issue. However, thedisposal of assets is permitted if the purchasing or surviving company assumes all theobligations of the issuing company and meets all requirements as defined in the TrustIndenture.

h) Disposal of Designated Subsidiaries

A clause may be introduced prohibiting:

• The disposal of the shares of a subsidiary by the company issuing the debt;

• The issuance of debt or shares by a subsidiary of the company issuing the debt;

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• The disposal of the debt or the shares of another subsidiary by the parent company;or

• The amalgamation or merger of a subsidiary, unless the surviving company is theparent company or a subsidiary.

However, the issue or disposal of debt or shares by a designated subsidiary may be per-mitted under certain conditions.

Example: A typical provision in the trust deed may state:

“The Company covenants

(a) that it will not, nor will it permit any Subsidiary to, create, assume or otherwiseincur any Funded Obligations unless, after giving effect thereto, the amount ofAvailable Earnings for any 12 consecutive calendar months of the 23 calendarmonths immediately preceding the date of the creation, assumption or incurringshall be at least 2 times the amount of Consolidated Annual Interest Requirements;and

(b) that it will not, nor will it permit any Subsidiary to, create, assume or otherwiseincur any indebtedness for money borrowed if immediately thereafter allIndebtedness for money borrowed of the Company and its Subsidiaries would be inexcess of 75% of the Total Capitalization of the Company and its Subsidiariesexcluding retractable preferred shares.”

C. TYPES OF FIXED-INCOME SECURITIES1. Government of Canada Securities

a) Marketable Bonds

The Government of Canada issues marketable bonds in its own name. It also allowsCrown Corporations to issue debt that has a direct call on the Government of Canada.

Example: The Farm Credit Corporation, a Crown Agency, issues medium and long-termnotes that are “direct obligations of Farm Credit and as such will constitute direct obli-gations of Her Majesty in right of Canada. Payment of principal and interest on theNotes will be a charge on and payable out of the Consolidated Revenue Fund.”

These issues are called marketable bonds because, as well as having a specific maturitydate and a specified interest rate, they are transferable, which means that they may betraded in the market. This is in contrast to instruments such as Canada Savings Bonds(CSBs), which are not transferable and not marketable.

The federal government is the largest single issuer in the Canadian bond market, havingdirect marketable debt of about $262.1 billion outstanding as of April 30, 2005(excluding Treasury bills). All Government of Canada bonds are non-callable, that is, thegovernment cannot call them for redemption before maturity.

The Government of Canada also issues real return bonds. In 1991, an issue of $700million Government of Canada Real Return Bonds were sold. The nominal return onthese bonds is linked to the Consumer Price Index (CPI). The bonds carry a 4.25%coupon, were priced at 100 at issue date, and provide a real yield of about 4.25% tomaturity on December 1, 2021. Both the semi-annual interest payments and the finalredemption value of each bond are calculated by including an inflation compensationcomponent.



POST-TEST

PRE-TEST

Example: If inflation (as measured by the CPI) had been 1.5% over the first six-monthperiod after issue, the value of a $1,000 Real Return Bond at the end of the six monthswould have been $1,015. The interest payment for the half-year would be based on thisamount rather than the original bond value of $1,000. At maturity, the maturityamount would be calculated by multiplying the original face value of the bond by thetotal amount of inflation since the issue date.

When comparing the bonds issued by Canadian issuers (corporations, federal, provincialand municipal governments), investors assign the highest quality rating to federal gov-ernment bonds. However, foreign investors compare the quality of Canadian issues tothe issues of other governments. The relative risk of investing in each country is reflect-ed in the yields of their bonds and the yields fluctuate in response to political and eco-nomic events. In the past, Canadian bonds have had higher yields than those of theU.S. Between 1995 and 2000, Canada had lower yields with respect to the U.S. At allmaturities, Canadian yields are currently higher than U.S. yields.

b) Treasury Bills

Treasury bills are short-term government obligations. They are offered in denomina-tions from $1,000 up to $1 million and have traditionally appealed to large institutionalinvestors such as banks, insurance, and trust and loan companies, and to some wealthyindividual investors. When the government started offering them in denominations aslow as $1,000, their appeal broadened to retail investors with smaller amounts of moneyto invest. Treasury bills are particularly popular when their yields exceed the yield onCSBs and other retail instruments, such as commercial paper.

Treasury bills do not pay interest. Instead, they are sold at a discount (below par) andmature at 100. The difference between the issue price and par at maturity represents thereturn on the investment, instead of interest. Under the Income Tax Act this return istaxable as income, not as a capital gain.

Every two weeks, Treasury bills are sold at auction by the Minister of Finance throughthe Bank of Canada. These bills have original terms to maturity of approximately 3-months, 6-months and 1-year.

c) Canada Savings Bonds

Basic Characteristics

Unlike other bonds, Canada Savings Bonds (CSBs) can be purchased only betweenOctober and April of each year, but can be cashed by the owner at any bank in Canadaat any time. Since they are not transferable and hence have no secondary market, CSBsdo not rise and fall in price and may always be cashed at their full par value plus anyaccrued interest. Thus, although they are not marketable, they are liquid.

CSBs are not sold in bearer form but must be registered in the name of:

• An individual (adult or minor);

• The estate of a deceased person; or

• A trust for an individual.

Registration provides proof of purchase but it also ensures that an individual does nothold more than the maximum amount that he or she is allowed to purchase. (For eachseries, individual purchases are limited to a certain maximum; the amount varies fromseries to series.) Purchasers must be bona fide Canadian residents with a Canadianaddress for registration purposes.

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Although the ownership of a CSB cannot be transferred or assigned, chartered banksmay accept assignments of CSBs as collateral for loans. Individuals, estates of deceasedpersons and trusts governed by certain types of deferred savings and income plans areallowed to acquire CSBs.

The first series of CSBs went on sale in the fall of 1946 and raised slightly under $500million. Between 1946 and December 31, 2004, 91 series have been issued. Theamount of CSBs outstanding has climbed steadily in almost every year since 1946.

CSBs were originally designed to provide the best return if held for their full term, butthis is no longer the case, because the rate of interest could be lower in later years. Someinvestors buy them as a temporary haven for funds in uncertain markets, because theyhave attractive interest rates and are cashable on demand.

Retail distribution is an important component of the government’s overall debt strategy.The federal Department of Finance created the Canada Retail Debt Agency (CRDA) in1995 to make it easier for small Canadian investors to buy federal government securi-ties. Given the scale of debt operations, the government needs to ensure as broad aninvestor base as possible for the cost-effective management of the debt.

Types of CSBs

Since 1977, CSBs have been available in two forms: a regular interest bond and a com-pound interest bond.

(i) Regular Interest Bond

The regular interest bond pays annual interest, either by cheque or by direct depositinto the holder’s bank account on November 1 each year. It is issued in denominationsof $300, $500, $1,000, $5,000, and $10,000. Registered owners may hold only fiveeach of the $300 and $500 bonds. Regular interest bonds may be exchanged for com-pound interest bonds of the same series only during a specified period after the originalpurchase.

If the holder of a new CSB issue cashes the bonds in the first three months after theissue date, he or she normally receives their face value without interest.

Example: A buyer of the Series 83 bonds, issued April 1, 2003, would receive no interestif he or she cashed the bonds before June 30, 2003. If the holder cashed Series 83 afterthat date, he or she would receive interest earned for each full month the bond was heldafter April 1, 2003.

The interest payments for regular interest bonds are prepared and issued during the11th and 12th months following the issue date and annual anniversary dates. If thebonds are redeemed during these months, an amount equal to any unearned interest forthose months is deducted from the proceeds of redemption and that amount will beincluded in the investor’s annual interest payment.

(ii) Compound Interest Bond

Compound interest has been a standard feature since the 1977 series. It allows the hold-er to forgo receiving interest each year so that the unpaid interest can compound. Theholder earns interest on the accumulated interest. The minimum denomination of thistype of bond is $100. The compound interest is calculated each November 1, and isaccrued in equal monthly amounts over the next twelve months. At redemption, theholder receives the face value plus the total of the earned interest. CSBs should beredeemed early in the month to ensure that the holder receives the maximum amountof interest accrued. For example, an investor redeeming a bond on October 2 will


receive the interest owed as of September 30. Another investor waiting until October 29will also receive the interest owed as of September 30, effectively missing out on amonth’s interest.

For income tax purposes, holders must report compound interest as taxable income inthe year in which it is earned rather than the year in which they receive it. This is a dis-advantage for the holder, as the holder must pay tax on the income without actuallyreceiving the cash.

(iii) Canada Premium Bond (CPBs)

Canada Premium Bonds (CPBs) are very similar to CSBs, but offer a higher interestrate when they are issued. They can be redeemed only once a year without penalty, onthe anniversary of the date of issue and for 30 days thereafter.

(iv) The Canada RSP and RIF Option

The government offers a “Canada RSP Option” and a “Canada RIF Option” whichallows Canadians can hold CSBs and CPBs directly in a government account as RRSPor RIF investments without having a self-directed plan. An investor who already ownsCSBs and CPBs can transfer them into this account or buy new CSBs and CPBs fordeposit in this account. There are no fees. Certificates for new purchases are not issued.A Canada RSP account can be converted into a Canada RIF when needed.

v) Payroll Savings Plan

The Bank of Canada sells Canada Savings Bonds on a payroll savings plan throughmore than 12,000 organizations in all parts of Canada. These organizations include alllevels of government, universities, school boards, hospitals, crown corporations, and pri-vate companies. Close to a million Canadians purchase CSBs through payroll deductioneach year.

The company merely has to submit the money to the government each pay period. Thegovernment is responsible for depositing it in the investors’ accounts. The individualcompanies are no longer responsible for distributing certificates. Employees can changeor cancel the plan at any time. They can also have the deductions continue if theychange jobs. Investors receive a semi-annual statement rather than an actual certificate.

2. Provincial Government Securities and Guarantees

a) Why Provinces Borrow

A typical provincial bond or debenture issue is used to provide funds for programspending and to fund deficits. These expenditures may be charged over a period of yearsagainst the tax revenues of those years, since the province has undertaken the project toprovide a continuing benefit over those years. Provinces also issue bonds to finance cur-rent social welfare expenditures. All provinces have statutes governing the use of fundsobtained through the issue of bonds.

b) Quality of Provincial Bonds

Provincial “bonds”, like Government of Canada “bonds”, are actually debentures. Theyare simply promises to pay and their value depends upon the province’s ability to payinterest and repay principal. No provincial assets are pledged as security.

Provincial bonds are second in quality only to Government of Canada direct and guar-anteed bonds because most provinces have taxation powers second only to the federalgovernment. Different provinces’ direct and guaranteed bonds trade at differing pricesand yields, however.

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Bond quality is determined by two factors, credit and market conditions. The credit of aprovince – the degree of certainty that interest will be paid and the principal repaidwhen due – depends on such factors as:

• The amount of debt the province owes on a per capita basis compared with that ofother provinces. Obviously, Province A with half the debt per capita of Province Bcommands a higher credit rating than that of B;

• The level of federal transfer payments;

• The philosophy and stability of the government; and

• The wealth of the province in terms of natural resources, industrial developmentand agricultural production. A province rich in natural resources and with welldiversified industries, balanced by good farming communities, should be better ableto meet its obligations, particularly during recessions, than a province whichdepends on limited natural resources, small industrial production or almost totallyon agricultural production.

c) Guaranteed Bonds

Many provinces also guarantee the bond issues of provincially appointed authorities andcommissions.

Example: The Ontario Electricity Financial Corporation’s 5.6% notes, due July 18,2008, are “Irrevocably and Unconditionally Guaranteed by the Province of Ontario.”

Provincial guarantees may also be extended to cover municipal loans and school boardissues. In some instances, provinces extend a guarantee to industrial concerns, usually asan inducement to a corporation to locate (or remain) in that province. Most provinces(and some of their enterprises) also issue Treasury bills. Investment dealers and bankspurchase them, both at tender and by negotiation, usually for resale.

The bonds of nearly all the provinces are available in a wide range of denominations,from $500 to hundreds of thousands of dollars. The most popular denominations are$500, $1,000, $5,000, $10,000, and $25,000.

The term of a provincial bond issue will vary, depending on the use to which the pro-ceeds will be put and the availability of investment funds at various terms.

In addition to issuing bonds in Canada, the provinces (and their enterprises) also bor-row extensively in international markets. Unlike the federal government, whose policy isto borrow abroad largely to maintain exchange reserves, the provinces resort to foreignmarkets to take advantage of lower borrowing costs, based on the foreign exchange rateand financial market conditions. Provinces may also decide to borrow through issuesdenominated in, for example, U.S. funds, if the proceeds from the loan will be spent inthe U.S. The interest cost (in U.S. funds) is offset by the revenues.

Issues sold abroad are underwritten by syndicates of dealers and banks similar to thosethat handle foreign financing for federal government Crown Corporations. In recentyears, issues have been sold, for example, payable in Canadian dollars, U.S. dollars,Euros, Swiss francs, and Japanese yen.

As early as 1990, provincial guaranteed issues were offered in a global bond offering.Global bond offerings are distributed simultaneously in domestic and foreign markets,and settle in different clearing agencies (such as EuroClear or Cedel). These offerings areexpected to become an increasingly popular financing mechanism for Canadian govern-ments and corporations.


d) Provincial Savings Bonds

Most provinces offer their own savings bonds. As with CSBs, there are certain character-istics that distinguish these instruments from other provincial bonds and make themsuitable as savings vehicles:

• They can be purchased only by residents of the province.

• They can be purchased only at a certain time of the year.

• They are redeemable every six months (in Quebec, they can be redeemed at anytime).

Some provinces issue different types of savings bonds. For instance, there are three typesof Ontario Savings Bonds (OSBs): a step-up bond (interest paid increases over time), avariable-rate bond, and a fixed-rate bond. In British Columbia, investors can buy BCSavings Bonds in redeemable or non-redeemable (fixed-rate) forms.

As with CSBs, these bonds are RRSP-eligible and they can be purchased in very smallamounts, starting as low as $100 ($250 in Quebec).

3. Municipal Debentures/Installment Debentures

Today, the instrument that most municipalities use to raise capital from market sourcesis the installment debenture or serial bond. Part of the bond matures in each year dur-ing the term of the bond.

Example: A debenture of $1 million may be issued so that $100,000 becomes due eachyear over a 10-year period. The municipality is actually issuing 10 separate debentures,each with a different maturity. At the end of 10 years, the entire issue will have beenpaid off.

Some municipalities issue term debentures with only one maturity date, but these aregenerally confined to very large cities such as Montreal, Toronto, and Vancouver. Atpresent, the usual practice is to pattern issues according to market preference as to termand repayment scheduling.

Installment debentures are usually non-callable: the investor who purchases them knowsbeforehand how long he or she may expect to keep funds invested. Also, if the money isneeded at future specific dates, it can be invested in an installment debenture so that itwill be available when it is needed.

Municipalities are in the third rank of public borrowers, following the federal andprovincial authorities. However, not all municipal credit ratings rank below those ofeach province. It is not unusual for debenture issues of some large metropolitan areas tobe favoured by investors over the securities issued by one or more of the provinces.

The high standing of most municipal securities is reflected in the provincial laws regu-lating the investment of funds by trustees. Managers investing funds held in trust, havecertain restrictions as to what types of investments they are allowed to choose. Theymust be very conservative with the funds entrusted to them. Almost without exception,municipal debentures in the province in which they are issued are classified as trusteeinvestments. Some provinces also include in this class the municipal securities issuedunder the authority of other provinces.

Broadly speaking, a municipality’s credit rating depends upon its taxation resources. All else being equal, the municipality with many different types of industries is a betterinvestment risk than a municipality built around one major industry. Similarly, themunicipality with good transportation facilities is preferable to one that lacks them.

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Older municipalities with good repayment records are able to borrow money on morefavourable terms than less mature municipalities in newly opened areas. Population andindustrial growth, the condition of the town’s services, the experience of officials inmunicipal office, the level of tax collections and debt per capita are also key factors indetermining a municipality’s credit rating.

4. Corporate Bonds

a) Mortgage Bonds

A mortgage is a legal document containing an agreement to pledge land, buildings, orequipment as security for a loan and entitling the lender to take over ownership of theseproperties if the borrower fails to pay interest or repay the principal when it is due. Thelender holds the mortgage until the loan is repaid, at which point the agreement is can-celled or destroyed. The lender cannot take ownership of the properties unless the bor-rower fails to satisfy the terms of the loan.

There is no fundamental difference between a mortgage and a mortgage bond except inform. Both are issued to allow the lender to secure property if the borrower fails torepay the loan.

The mortgage bond was created when the capital requirements of corporations becametoo large to be financed by the resources of any one individual lender. However, since itis impractical for a corporation to issue separate mortgages securing different portions ofits properties to different lenders, a corporation can achieve the same result by issuingone mortgage on its properties to many lenders.

The mortgage is then deposited with a trustee, usually a trust company, which acts forall investors in safeguarding their interests under the terms of the loan contractdescribed in the mortgage. The amount of the loan is divided into convenient portions,usually $1,000 or multiples of $1,000. Each investor receives a bond that represents theproportion of his or her participation in the full loan to the company and his or herclaim under the terms of the mortgage. This instrument is a mortgage bond.

First mortgage bonds are the senior securities of a company, because they constitute afirst charge on the company’s assets, earnings, and undertakings before unsecured cur-rent liabilities are paid. It is necessary to study each first mortgage issue to determineexactly what properties are covered by the mortgage.

Most Canadian first mortgage bonds carry a first and specific charge against the compa-ny’s fixed assets and a floating charge on all other assets. They are generally regarded asthe best security a company can issue, particularly if the mortgage applies to “all fixedassets of the company now and hereafter acquired.” This last phrase, known as the “afteracquired clause”, means that all assets can be used to secure the loan, even thoseacquired after the bonds were issued.

b) Collateral Trust Bonds

A collateral trust bond is one that is secured, not by a pledge of real property, as in amortgage bond, but by a pledge of securities, or collateral. Collateral trust bonds areissued by companies such as holding companies, which do not own much in the way offixed assets on which they can offer a mortgage, but do own securities of subsidiaries.This method of securing bonds with other securities is similar to the common practiceof pledging securities with a bank to secure a personal loan.


c) Equipment Trust Certificates

A variation on mortgage and collateral trust bonds is the equipment trust certificate.These certificates pledge equipment as security instead of real property. CPLocomotives, for example, issues these kinds of bonds, using its locomotives and traincars as security. The investor owns the rolling stock under a lease agreement with therailway, until all of the stock has been paid off. These certificates are usually issued inserial form, with a set amount that matures each year.

d) Subordinated Debentures

Subordinated debentures are junior to other securities issued by the company or otherdebts assumed by the company. The exact status of an issue of subordinated debenturesis described in the prospectus.

e) Floating Rate Securities

Since 1979, floating rate securities (also known as variable rate securities) have been apopular underwriting device because of the volatility of interest rates. Since these bondsautomatically adjust to changing interest rates, they can be issued with longer termsthan more conventional issues.

Floating rate securities have proved popular because they offer protection to investorsduring periods of very volatile interest rates. For example, when interest rates are rising,the interest paid on floating rate debentures is adjusted upwards at regular intervals,which improves the price and yield of the debentures. The disadvantage of these bondsis that when interest rates fall, the interest payable on them is adjusted downwards atsix-month intervals, so their yield tends to fall faster than that of most bonds. A mini-mum rate on the bonds can provide some protection to this process, although the mini-mum rate is normally relatively low.

In a portfolio, floating rate securities behave like money market securities because, if therate changes every three months, it is similar to holding a three-month instrument androlling it over.

f) Corporate Notes

A corporate note is an unsecured promise made by a borrower to pay interest and repaythe funds borrowed at a specific date or dates. Corporate notes rank behind all otherfixed-interest securities of the borrower.

Finance companies frequently use a type of note called a secured note or a collateraltrust note. When an automobile is sold on credit, the buyer makes a cash down pay-ment and signs a series of notes by which he or she agrees to make additional paymentson specified dates. The automobile dealer takes these notes to a finance company, whichdiscounts them and pays the dealer in cash. Finance companies pledge notes like theseas security for collateral trust notes. These notes mature at different times and are soldto financial institutions or to individual investors who have substantial portfolios.

Another kind of secured note is the secured term note, which is backed by a writtenpromise to pay. These notes are signed by people who buy automobiles or appliances onan instalment plan. These notes trade on the money market.

g) Bonds or Debentures Carrying Warrants

A warrant is a certificate that gives the holder the right to purchase securities at a stipu-lated price within a specified time limit.

Warrants are attached to debentures or preferred or common shares to make them moresaleable and to reward investors who provide the business with long-term capital. Theyare discussed in the material on derivatives.

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h) Units

A unit is a package of two or more corporate securities offered for sale to the public byan investment dealer at an overall price. Until a few years ago, most units consisted of abond or debenture and a stated number of common shares. Many dealers nowadaysoffer units of preferred shares with warrants and common shares with warrants.

i) Real Estate Bonds

The impact of high inflation and high interest rates on real estate financing in the early1980s virtually ended the practice of issuing traditional long-term fixed-rate mortgagesor mortgage bonds for industrial and commercial real estate. A variety of differentfinancing structures were created to replace the traditional vehicles in this high-inflation,high-interest-rate period. Most were variations on the following five arrangements:

• Projects in which the lender owns the development outright, or shares ownershipwith other partners, and so participates in the risks and rewards of the whole project.

• Income participation deals in which a lender still puts up most of the money in along-term mortgage-backed loan, but also gets a share of the net income after oper-ating expenses are covered.

• Deals in which the developer takes the risk of financing a long-term project by bor-rowing money for short periods at a fixed rate and “rolling over” the loan at thegoing interest rate later on.

• Deals in which the lender makes a long-term loan backed by a mortgage, with aprovision to revise the interest rate regular intervals, such as five years. The rate isusually increased, but in some cases there is a possibility of a cut in the rate.

• Deals combining mortgage bonds with share purchase warrants.

Financing arrangements for real estate projects usually involve one or more of thesearrangements, depending on the relative negotiating strength of the developer and thelenders.

5. Other Types of Fixed Income Securities

a) Strip Bonds

The strip or zero coupon bond first appeared in Canada in 1982. A strip bond is creat-ed when a dealer acquires a block of high-quality bonds and separates the individualfuture-dated interest coupons from the rest of the bond (known as the underlying bondresidue). The dealer then sells each coupon as well as the residue separately at significantdiscounts to their face value. Holders of strip bonds receive no interest payments.Instead, the strips are purchased at a discount at a price that provides a certain com-pounded rate of return, when they mature at par. Similar to Treasury bills, the income isconsidered interest rather than a capital gain. This can cause a problem for the investortax must be paid annually on the income, even though the interest income on the bondis not received until the instrument matures. For this reason, it is often recommendedthat strip bonds be held in a tax-deferred plan such as an RRSP.

b) Domestic, Foreign, and Eurobonds

Domestic bonds are issued in the currency and country of the issuer. If a Canadian cor-poration or government issued bonds in Canadian dollars in the Canadian market, thesewould be domestic bonds. This is the most common type of bond.

Foreign bonds are issued in a currency and country other than the issuer’s. This allowsissuers access to sources of capital in many other countries. For example, Rogers CableInc., a Canadian company, has issued U.S.-dollar-denominated bonds in the U.S. mar-



ket; these bonds are considered foreign bonds in the U.S. market. (Bonds denominatedin yen are known as Samurais, just as foreign issues in U.S. dollars and placed in theU.S. market are called Yankee bonds.)

Some bonds offer the investor a choice of interest payments in either of two currencies;others pay interest in one currency and the principal in another. These foreign-paybonds offer investors increased opportunity for portfolio diversification while providingthe issuer with cost-effective access to capital in other countries.

Eurobonds are issued and sold outside a domestic market and are typically denominatedin a currency other than that of the domestic market. They are issued in the Eurobondmarket or the international bond market and can be issued in any number of differentcurrencies. The Eurobond market is a large international market with issues in many cur-rencies, including Canadian dollars, and attracts both international and domesticinvestors looking for alternative investments. For example, the Province of Ontario hasissued Australian-dollar-denominated bonds in the Eurobond market, attracting investorsaround the globe, including Canadian investors seeking foreign-currency exposure.

If a Canadian corporation or government issued Eurobonds denominated in Canadiandollars, they would be called EuroCanadian bonds. If they were denominated in U.S.dollars, they would be Eurodollar bonds.

Table 5.3 shows examples of types of bonds by currency and location.

TABLE 5.3

Types of Bonds by Currency and Location

Issuer Issued in: Currency of issue: Called:

Canadian Canada Cdn$ Domestic bond

Canadian Mexico Pesos Foreign bond

Canadian France U.S.$ Eurobond (Eurodollar)

Canadian Euromarket Cdn$ Eurobond (EuroCdn bond)

Canadian U.S. U.S.$ Foreign (Yankee) bond

c) Preferred Securities

Preferred securities are very long-term subordinated debentures, and are sometimescalled preferred debentures. The characteristics of these securities fall between standarddebentures and preferred shares:

• They are very long-term instruments with terms in the range of 25–99 years;

• They are subordinated to all other debentures, but rank ahead of preferred shares;

• Interest can often be deferred at management’s discretion for up to five years; and

• They often trade on an exchange.

Preferred securities pay interest, have better yields than standard debentures, and offerbetter protection of principal than preferred shares. However, there is some riskinvolved, since if the issuer defaults, preferred securities have a lower priority than otherdebentures. Issuers may also defer interest payments for a number of years, while thesecurity holder will be taxed on this accrued unpaid interest yearly.

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d) Term Deposits and Guaranteed Investment Certificates (GICs)

Other fixed-income products offered by banks, trust companies, caisses populaires,insurance companies, and credit unions tend to have safety as their prime objective. Asthe financial services industry becomes more integrated and investors more sophisticat-ed, new products are being developed or traditional ones customized to suit the needs ofthe investor.

Term deposits offer a guaranteed rate for a short-term deposit (usually up to one year).Usually there are penalties for withdrawing funds before a certain period (for example,the first 30 days after purchase).

Guaranteed Investment Certificates (GICs) offer fixed rates of interest for a specificterm (longer than with a term deposit). Both principal and interest payments are guar-anteed. They can be redeemable or non-redeemable. Non-redeemable GICs cannot becashed before maturity, except in the event of the depositor’s death or extreme financialhardship. Interest rates on redeemable GICs are lower than standard GICs of the sameterm, since they can be cashed before maturity.

Recently, banks have been customizing their GICs to provide investors with morechoice. For instance, investors can choose a term of up to 10 years, depending upon theamount invested (for less than a month, it must be a large amount). Investors can alsochoose the frequency of interest payments (monthly, semi-annual, annual, or at maturi-ty) and other features. Many GICs offer compound interest.

Note that the Canada Deposit Insurance Corporation (CDIC) does not cover GICs ofmore than five years. Also, not all GICs are eligible for RRSPs.

GICs can be used as collateral for loans, can be automatically renewed at maturity, orcan be sold to another buyer privately or through an intermediary.

GICs with special features include:

• Escalating-rate GICs: the interest rate increases over the GIC’s term.

• Laddered GICs: the investment is evenly divided into multiple term lengths (forexample, a five-year $5,000 GIC can be divided into one-, two-, three-, four- andfive-year terms of $1,000 each). As each portion matures, it can be reinvested orredeemed. This diversification of terms reduces interest rate risk.

• Instalment GICs: an initial lump sum contribution is made, with further minimumcontributions made weekly, bi-weekly, or monthly.

• Index-linked GICs: these guarantee a return of the initial investment upon expiryand some exposure to equity markets. They are insured by CDIC. They may beindexed to particular domestic or global indexes or to a combination of bench-marks.

• Interest-rate-linked GICs: these offer interest rates linked to the changes in otherrates such as the prime rate, the bank’s non-redeemable GIC interest rate, or moneymarket rates.

Some banks have also developed GICs with specialized features, such as the ability toredeem them in case of medical emergency, or homebuyers’ plans, where regular contri-butions accumulate for a down payment.



6. Reading Bond Quotes

A typical bond quote in a newspaper might look like this:

Issue Coupon Maturity Date Bid Ask YieldABC Company 11.5% 1 July/06 99.25 99.75 11.78%

This quote shows that, at the time reported, an 11.5% coupon bond of ABC Companythat matures on July 1, 2006, could be sold for $99.25 and bought for $99.75 for each$100 of par or principal amount. (Remember, prices are quoted as a percentage of par,rather than an aggregate dollar amount.) To buy $5,000 face value of this bond wouldcost $5,000 × 0.9975 = $4,987.50, plus accrued interest.

Some financial newspapers publish a single price for the bond. This may be the bidprice, the midpoint between the final bid and ask quote for the day, or an estimatebased on current interest rate levels. Convertible issues are usually grouped together in aseparate listing.

7. The Bond Rating Services

In Canada, the Dominion Bond Rating Service, Moody’s Canada Inc. and theStandard & Poor’s Bond Rating Service provide independent rating services for manydebt securities. These ratings can help investors assess the quality of their debt holdingsand confirm or challenge conclusions based on their own research and experience. Table5.4 provides a brief overview of the rating scale of Standard and Poor’s. The definitionsindicate the general attributes of debt bearing any of these ratings. They do not consti-tute a comprehensive description of all the characteristics of each category.

Similar services in the U.S., such as Moody’s and Standard & Poor’s, have provided rat-ings on a ranked scale for many years. Investors closely watch these ratings. Any changein rating, particularly a downgrading, can have a direct impact on the price of the secu-rities involved. From a company’s point of view, a high rating provides benefits, such asthe ability to set lower coupon rates on issues of new securities.

The Canadian rating services carry out credit analysis and provide an independent andobjective assessment of the investment grade of securities. The ratings indicate whetheran investment is a high- or low-risk, that is, the likelihood that interest payments willcontinue without interruption and that the principal will be repaid on time and in full.

Ratings classify securities from investment grade through to speculative and can be usedto compare one company’s ability to meet its debt obligations with those of other com-panies. The rating services do not manage funds for investors, buy and sell securities, orrecommend securities for purchase or sale.

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TABLE 5.4

Standard and Poor’s Bond Rating Service

Rating Description

AAA This category is used to denote bonds of outstanding quality with the Highest Credit Quality highest degree of protection of principal and interest. Companies with

debt rated AAA are generally large national or multinational corporationsthat offer products or services essential to the Canadian economy.Thesecompanies usually have had a long and creditable history of superior debtprotection, in which the quality of their assets and earnings has beenconstantly maintained or improved, with strong evidence that this per-formance will continue.

AA Bonds rated AA are very similar to those rated AAA and can also be(Very Good Quality) considered superior in quality.These bonds are generally rated lower in

quality than AAA because the margin of asset or earnings protection maynot be as large or as stable as it is for those rated AAA.

A Bonds rated A are considered to be good-quality securities with(Good Quality) favourable long-term investment characteristics.The main feature that

distinguishes them from the higher-rated securities is that these compa-nies are more susceptible to adverse trade or economic conditions.Theprotection is consequently lower than for AAA and AA.

BBB Issues rated BBB are classified as medium- or average-grade investments.(Medium Quality) These companies are generally more susceptible than any of the A-rated

companies to swings in economic or trade conditions.

Some internal or external factors may adversely affect the long-termprotection of BBB debt.These companies bear close scrutiny, but in allcases both interest and principal are adequately protected at present.

BB Bonds rated BB are considered to be lower-medium-grade securities(Lower Medium Quality) and have limited long-term protective investment characteristics.Asset

and earnings coverage may be modest or unstable.

Interest and principal protection may deteriorate significantly duringadverse economic or trade conditions.

B Securities rated B lack most qualities necessary for long-term fixed-(Poor Quality) income investment. Companies in this category generally have a history

of volatile operating conditions that have left in doubt the company’s abil-ity to adequately protect the principal and interest. Current coveragesmay be below industry standards and there is little assurance that thelevel of debt protection will improve significantly.

CCC Securities in this category are currently vulnerable to nonpayment, and(Speculative Quality) are dependent upon favourable business, financial, and economic condi-

tions for the company to meet its financial commitment on the obliga-tion. In the event of adverse business, financial, or economic conditions,the company is not likely to have the capacity to meet its financial com-mitment on the debt.

CC The company is highly vulnerable to nonpayment of debt.(Very Speculative Quality)

C A subordinated debt is highly vulnerable to nonpayment.This rating is(Highly Speculative used to cover a situation where a bankruptcy petition has been filed orQuality) similar action taken, but payments on this obligation are being continued.

D Bonds in this category are in default of some provisions in their trust(Default) deed.The company may be in the process of liquidation.

Suspended A company that has its rating suspended is experiencing severe financial(Rating Suspended) or operating problems of which the outcome is uncertain.The company

may or may not be in default, but there is uncertainty as to the compa-ny’s ability to pay off its debt.



POST-TEST

D. BOND PRICING PRINCIPLES1. The Use of Present Value

The most accurate method of determining the value of a bond is by calculating its pres-ent value. This is a technique for determining the value today of an amount of moneyto be received in the future. The cash flow from a typical bond is made up of regularcoupon payments and the return of the principal at maturity. Since a bond represents aseries of cash flows to be received in the future, the sum of the present values of thesefuture cash flows is what it is worth today.

There are four steps in calculating a bond’s present value:

1. Choose the appropriate discount rate.

2. Calculate the present value of the bond’s income stream (the coupons).

3. Calculate the present value of the bond’s principal to be received at maturity.

4. Add these two present values together to determine its worth today.

a) The Discount Rate

The appropriate discount rate or yield to maturity depends on the risk of the particularbond. It can be estimated by the yields currently applicable to bonds with similarcoupon, term, and credit quality. These yields are determined by the marketplace andchange as market conditions change.

Yields are often quoted as being equal to a Government of Canada bond with a similarterm, plus a spread in basis points. The spread reflects credit risk, liquidity, and otherfactors.

The discount rate or yield to maturity should not be confused with the coupon rate onthe bond. The coupon rate determines the interest to be paid to the holder of the bondand is set when the bond is issued and does not change.

If the bond pays interest more than once a year, divide the discount rate by the numberof times interest is paid each year. If a bond pays interest twice a year (semi-annually), asalmost all bonds do, divide the discount rate by 2. (If a bond pays interest monthly,divide the interest rate by 12.)

In our examples, we will use a discount rate of 5%, (a discount rate of 10% divided by2) to reflect semi-annual interest payments.

b) Present Value of the Income Stream

The present value of a bond’s income stream is the sum of the present values of eachcoupon payment. For example, for a 9% four-year bond with a par value of $100, therewould be eight remaining semi-annual coupon payments of $4.50 each. The presentvalue of each of these coupons, added together, is the present value of the bond’sincome stream.

The formula to calculate the present value of a coupon payment is:

where: PV = present value

FV = future value (the coupon payment amount)

r = the discount rate

n = the number of compounding periods from the present to the date on which the coupon is calculated

PVFV

(1 r)n=

+

CSC CHAPTER 5

VOLUME 1


PRE-TEST

In the example of a 9% four-year bond of $100 par, the present value of the firstcoupon is:

The present value of the coupon to be received six months from now is approximately$4.29. In the same example, the present value of the second coupon is:

The present value of the coupon to be received two six-month periods from now isapproximately $4.08.

Repeat this process for each of the coupon payments to be received, and add the presentvalues together to obtain the present value of the income stream. In this example, itwould be $29.08. (If this were a strip bond and you were planning to buy only thestripped coupons, this is the maximum amount you would be willing to pay for thestripped coupons to achieve a 10% yield.)

There is a faster way to calculate the present value of a series of time payments, using acalculation called the present value of an annuity. With this formula, the sum of thepresent value of all coupons is found all at once, relieving the tedium of calculating eachseparately. The formula is as follows:

where: APV= present value of the series of coupon payments

C = payment (the value of one coupon payment)

r = the discount rate: that is, the level of interest rates that an investor would expect to receive from comparable investments in each payment period

n = the number of coupon payments

Applying the formula to our previous bond calculation problem we get:

APV

APV

=−

+⎡

⎣

⎢⎢⎢⎢

⎤

⎦

⎥⎥⎥⎥

=−

$ .( . )

.

$ ...

4 50

11

1 0 050 05

4 501 0 676839

0

8

005

4 500 323161

0 05

4 50 6 4632

2

⎡⎣⎢

⎤⎦⎥

= ⎡⎣⎢

⎤⎦⎥

= ×

=

APV

APV

APV

$ ..

.

$ . .

$ 99 08.

APV C r

r

n

=−

+⎡

⎣

⎢⎢⎢⎢

⎤

⎦

⎥⎥⎥⎥

11

1( )

PV =+

=

=

$ .

( . )

$ ..

$ .

4 50

1 0 05

4 501 1025

4 0816

2

PV =+

=

=

$ .

( . )

$ ..

$ .

4 50

1 0 05

4 501 05

4 2857

1



c) Present Value of the Principal

The present value of the bond’s principal amount is found using the same formula. Theprincipal amount simply represents one final, large cash flow at the end of the othercash flows (coupons).

The formula used is:

where: PV = present value

FV = future value of the principal

r = the discount rate

n = the number of compounding periods from the present to maturity

In the example of the 9% four-year bond of $100 par, the present value of the principal is:

The present value of the principal is approximately $67.68. (If this were a strip bondand you were planning to buy only the bond residue, this is the maximum amount youwould be willing to pay to achieve a 10% yield.)

d) Adding the Present Values

The fair price for a bond is the sum of its two sources of value: the present value of itscoupons and the present value of its principal.

In the example above, the coupons are worth about $29.08 and the principal is worthabout $67.68. Therefore, to achieve a 10% yield on this bond, an investor should notpay more than $29.0845 + $67.6839 = $96.77 for it.

Thus, the value of a bond is the sum of what its coupons are worth today, plus what itsprincipal is worth today, based on an appropriate discount rate that reflects the risks ofthat particular bond. The appropriate discount rate changes with changing economicconditions and reflects the yield investors expect.

2. Bond Yield Calculations

a) Current Yield

The current yield of any investment, whether it is a bond or a stock, can be calculatedusing the following formula:

Current yield looks only at cash flows and the current market price of the investment,not at the amount that was originally invested.

For example, a $1,000 10% bond, trading at 92, would have a current yield of:$100920

100 10 8696× = . %

Current YieldAnnual Cash FlowAmount Invested

= ×100

PV =+

=

=

$

( . )

$.

$ .

100

1 0 05

1001 47746

67 6839

8

PVFV

(1 r)n=

+

CSC CHAPTER 5

VOLUME 1



5-28

b) Treasury Bill Yield

Treasury bills are very short-term securities that trade at a discount and mature at par.No interest is paid in the interim, so the return is generated from the difference betweenthe purchase price and the sale (or maturity) price. A special yield calculation applies toT-bills. Theoretically, this yield is the percent discount divided by the percent term. Asimple formula for calculating this yield is:

For example, if you bought an 89-day T-bill for a price of 98, the yield would be:

c) Approximate Yield to Maturity

This yield calculation is essentially the opposite of the price calculation using presentvalue. In a price calculation, the purchaser establishes a satisfactory level of yield, anduses that yield to calculate the maximum price he or she should pay for a bond. In ayield calculation, the price is known and is used to calculate the yield.

Although all yields are calculated as income divided by price, the approximate yield tomaturity includes different assumptions about income and price. For example, unlike acurrent yield, where the yield is calculated as interest payment divided by price, thisbond yield is complicated by the assumption that the investor will be repaid the parvalue of the investment at maturity.

Therefore, unlike a stock yield, this bond yield not only reflects the investor’s return inthe form of interest income, but includes any capital gain from purchasing the bond ata discount and receiving par at maturity (or any capital loss from purchasing the bondat a premium and receiving par at maturity). Consequently, the yield to maturity usingthe approximate yield to maturity method is made up partly of interest income andpartly of price gains (or losses).

A second difference from current yield is the price used. In the current yield calculation,the purchase (or current market) price is used. However, a more precise yield can befound on bonds by averaging the purchase price with the redemption price, which is paror 100.

The formula for approximate yield to maturity is:

All bond yields are calculated based on $100 par, no matter how large a bond aninvestor holds. Interest income, change in price, and purchase price are always based on$100 par.

For example, let us calculate the yield on a 10% $5,000 bond due to mature in eightyears and purchased at 92.

Interest income annual price changePurchase price 100) 2

++ ÷

×(

1100

Yield =−

× ×

= × ×

=

100 9898

36589

100

298

36589

100

8 3696. %

Yieldprice

price term=

−× ×

100 365100


• What is the annual interest income on this bond (based on $100 par)? The contrac-tual interest obligation on this bond is 10% of par, and so $10.00 of interestincome will be paid each year for each $100 par.

Interest income = $10.00

• What is the annual price change on this bond (based on $100 par)? The bond waspurchased at 92, and will mature at 100. Therefore, it will increase over the remain-ing life of the bond by $8.00. Since there are eight years remaining in this bond’sterm, the bond will increase in price by $8.00 over eight years, for an annual gainof $1.00.

Annual price change = + $1.00

• What is the average price on this bond (based on $100 par)? The purchase pricewas $92. The redemption or maturity value is $100. The average of 92 and 100:(92 + 100) ÷ 2 = 96.

Average price is 96

Therefore, the yield on a 10% $5,000 bond due to mature in eight years and purchasedat 92 is:

Bond yields are usually rounded off to two decimal places. This is accurate enough formost purposes. The exception is Treasury bills and other money market instruments,where yields may be rounded off to three or more places.

Remember, this is a rough method of calculating yields. A financial calculator or spread-sheet using the present value method is required to achieve a precise yield.

Although current rates (and features) are important in determining a bond’s price today,what is far more important is where that price is going in the future. Such a forecastrequires a study of the determination of future interest rates.

3. Theories of Interest Rate Determination

Interest rates affect bond prices. To have a successful trading strategy, the investor needssome expertise in determining the future direction of interest rates. The following sec-tion discusses the factors that determine:

• the general level of interest rates at any particular time, and

• the level of interest rates at different terms to maturity.

a) Inflation and the Real Rate of Interest

In a general sense, interest rates are simply the result of the interaction between thosewho want to borrow funds and those who want to lend funds. There is at least one majortheory behind the determination of interest rates: the inflation rate/real rate theory.

The rate of return that a bond (or any investment) offers is made up of two compo-nents:

• The real rate of return; and

• The inflation rate.

Because inflation reduces the value of a dollar, the return that is received, known as thenominal rate, must be reduced by the inflation rate to arrive at the actual or real rate ofreturn.

$ . $ .(

$ .. %

10 00 1 0092

100

11 0096

100 11 4583

+÷

× =

× =

+100) 2

or 11.46%

CSC CHAPTER 5

VOLUME 1



5-30

The real rate is determined by the supply of funds (supplied by investors) and thedemand for loans (created by business). Businesses are more inclined to borrow to investin, for example, new plant and equipment, when they believe that this investment willearn returns that are higher than the costs of borrowing.

Thus, when real interest rates are low, the demand for funds will rise. The supply offunds tends to rise when real rates are high, as investors are more likely to lend funds.The nominal rate for loans will be made up of the real rate, as established by supply anddemand, plus the expected inflation rate.

Nominal Rate = Real Rate + Inflation Rate

Two factors affect forecasts for the real rate:

• The real rate rises and falls throughout the business cycle, becoming lower duringrecessions as demand for funds falls, and rising during the expansion phase asdemand for funds increases.

• An unexpected change in the inflation rate also affects the real rate. An investorlending money will demand an interest rate that includes his or her expectations forinflation, thereby assuring a satisfactory real rate. If the inflation rate is higher thanexpected, the investor’s real rate of return will be lower than expected.

b) Factors Affecting Specific Rates:The Term Structure of Interest Rates

There is not just one interest rate in the economy, but many rates. These rates vary,depending on the term to maturity of various debt instruments. This is referred to asthe term structure of interest rates. A graph depicting this term structure is known as ayield curve (see Figure 5.1 for an example of a Government of Canada yield curve).

Interest rates can rise or fall faster than each other, or even move in opposite directions.The following section offers several explanations that have been proposed to explain whyinterest rates for various terms vary, creating different term structures or yield curves.

Expectations Theory

An investor who wants to invest money in the fixed-income market for a certain timeperiod has a number of choices of terms. For example, if the investment is for two years,the investor could purchase a two-year bond, or invest in a one-year bond and then buyanother one-year bond when the first one matures, or even buy a six-month bond androll it over three more times during the two years.

Since an efficient market (and arbitrage) ensures that each route will be equally attrac-tive, the two-year interest rate must be an average of two successive and consecutiveone-year rates, and the one-year rate must be an average of two consecutive six-monthrates, and so forth. Therefore, an upward sloping yield curve indicates an expectation ofhigher rates in the future, while a downward sloping curve indicates an expectation thatrates will fall in the future. A humped curve indicates that rates are expected to rise andthen fall in the future. Therefore, the yield curve is said to reflect a market consensus ofexpected future interest rates.

Liquidity Preference Theory

According to this theory, investors prefer short-term bonds because they are more liquidand less volatile in price. An investor who prefers liquidity will venture into longer-termbonds only if there is sufficient additional compensation for assuming the additionalrisks of lower liquidity and increased price volatility.

According to this theory, an upward sloping yield curve (see Figure 5.1) reflects addi-tional return for assuming additional (term) risk. Although the simplicity of this theorymakes it appealing, it does not explain a downward sloping yield curve.


Market Segmentation Theory

The various institutions that are major players in the fixed-income arena each concen-trate their efforts in a specific term sector. For example, the major chartered banks tendto invest in the short-term market, while life insurance companies, because of their longinvestment horizon, mainly operate in the long-term bond sector.

This theory postulates that the yield curve represents the supply of and demand forbonds of various terms, primarily influenced by the bigger players in each sector. Thistheory can explain all types of yield curves, from normal to inverted to humped.

Summary

These are the most popular theories that try to explain the structure of interest rates.Each has its strengths, but perhaps the best explanation of how interest rates are deter-mined is a combination of these theories, because each complements the others.

4. Fixed-Income Pricing Properties

In the section on calculating present value, we saw how to determine the appropriateprice to pay for a fixed-income security. However, it is also important to know wherethat price is headed. The previous section on general interest rate levels and term struc-ture may help you forecast generally where bond prices may be headed, but you shouldunderstand the specific features of an individual bond that determine how that particu-lar bond will react to rate changes.

There are some conventional rules regarding the price changes of fixed-income securi-ties. Each rule is explained below. Then we will look at the specific features that may beattached to a bond, with a focus on the way they affect price changes. These rules andfeatures will help you assess the price volatility, and therefore risk, of any fixed-incomesecurity.

The stronger the borrower’s financial position and the higher its credit rating, the morefavourable are the terms upon which it can borrow. That is, it can borrow at a lowerinterest rate. For example, the Government of Canada can borrow at lower cost than aprovincial government and a provincial government can borrow at lower cost than mostmunicipalities. Similarly, a well-known established company can borrow on morefavourable terms than a small business.

The yields in the following tables are calculated using precise present value techniques,including semi-annual compounding and full reinvestment of all coupons at the prevail-ing yield. These results cannot be obtained using the basic approximate yield to maturi-ty technique. If you try to “prove” these numbers, you will not arrive at the same valuesusing simple yield calculations.

a) As Interest Rates Rise, Bond Prices Fall;As Interest Rates Fall,Bond Prices Rise

There is very little difference between interest rates and yields. Each represents a rate ofreturn on an investment. Therefore, as interest rates rise, the yields on competing invest-ments must also rise, and vice versa. As we saw in the section on yield calculations,bond prices fall when bond yields rise.

Table 5.5 shows a 7% five-year bond. When yields on this type of bond are 7%, thisbond will be priced at par, or 100 (line 3). Suppose that yields on bonds of this typeincrease to 8%. This bond will drop in price to 96.01 (line 2). If yields instead drop to6%, the price of this bond will rise above par to 104.21 (line 4). Bond prices and bondyields, then, are inversely related.

CSC CHAPTER 5

VOLUME 1




TABLE 5.5

Interest Rate Changes and Bond Prices7% Five-Year Bond

Line Yield % Change Yield Price Price Change % Price Change

1 9% +28.57 92.22 – 7.78 – 7.78%

2 8% +14.29 96.01 – 3.99 – 3.99%

3 7% 0 100.00 0.00 0

4 6% –14.29 104.21 + 4.21 + 4.21%

5 5% –28.57 108.66 + 8.66 + 8.66%

b) Longer-term Bonds are More Volatile in Price than Shorter-term Bonds

Table 5.6 compares a 7% five-year bond with a 7% ten-year bond. Note that if interestrates are 7%, both bonds will be priced at par to yield 7%.

TABLE 5.6

Interest Rate Changes and Term7% Five-Year Bond

Yield % Change Yield Price Price Change % Price Change

9% +28.57 92.22 – 7.78 – 7.78%

8% +14.29 96.01 – 3.99 – 3.99%

7% 0 100.00 0.00 0

6% –14.29 104.21 + 4.21 + 4.21%

5% –28.57 108.66 + 8.66 + 8.66%

7% Ten-Year Bond


9% +28.57 87.16 – 12.84 – 12.84%

8% +14.29 93.29 – 6.71 – 6.71%

7% 0 100.00 0.00 0

6% –14.29 107.36 + 7.36 + 7.36%

5% –28.57 115.44 + 15.44 + 15.44%

If interest rates rise to the point at which each bond yields 8%, both the five-year andthe ten-year bond will drop in price. However, the five-year bond drops 3.99%, and theten-year bond drops 6.71%. A similar pattern occurs when interest rates, and thereforeyields, drop. The longer the bond, the more volatile its price. The longer bond will risemore sharply (7.36% if yields drop to 6%) than the shorter term (which rises only4.21%).

As a bond approaches its maturity over the years, it will become less volatile. For exam-ple, a bond originally issued with a ten-year maturity will, seven years later, have athree-year term, and will be priced as and trade as a three-year bond at that time.

c) Lower Coupon Bonds are More Volatile in Price than High Coupon Bonds

Table 5.7 compares a 7% five-year bond is compared with a 6% five-year bond. Allother factors are assumed to be constant, such as credit quality and liquidity, thereforethe only difference between the two bonds is the coupon rate. Market rates start at 7%.

TABLE 5.7

Interest Rate Changes and Coupon7% Five-Year Bond


9% +28.57 92.22 – 7.78 – 7.78%

8% +14.29 96.01 – 3.99 – 3.99%

7% 0 100.00 0.00 0

6% –14.29 104.21 + 4.21 + 4.21%

5% –28.57 108.66 + 8.66 + 8.66%

6% Five-Year Bond


9% +28.57 88.33 – 7.57 – 7.89%

8% +14.29 92.01 – 3.89 – 4.06%

7% 0 95.90 0.00 0.00

6% –14.29 100.00 + 4.10 + 4.28%

5% –28.57 104.33 + 8.43 + 8.79%

When yields rise, for example, from 7% to 8%, both bonds drop in price, but the lowercoupon bond drops more (4.06%) than the higher-coupon bond (which drops 3.99%).This difference is significant when there is a considerable difference between coupons,or when large sums of money are invested. Even in this case of relatively similarcoupons and a small change in yields, the difference in price change is $0.10 ($3.89 ver-sus $3.99).

d) Special Features Lead to Special Price Considerations

Many bonds have special features, such as call provisions, conversion privileges, orretractable or extendible maturities. Each feature influences the bond’s price.

For example, consider a callable bond that is trading at a significant premium to par. Itis very likely that this bond will be redeemed on the first call date. This bond will there-fore be priced as a shorter-term bond, with an effective maturity of the call date. On theother hand, if the same bond was trading at a discount, it is unlikely to be called andtherefore would be priced as a longer-term bond with a term equal to its true maturity.If the bond fluctuates between a premium and a discount, it can exhibit substantialprice volatility due to the perceived change in term. Similar perceived changes in termalso apply to extendible and retractable bonds.

The prices of convertible and exchangeable bonds are influenced by the value of theunderlying security rather than the perceived term. These pricing impacts wereexplained in the section on convertibles.

There are many special features possible in a bond, and the specific issue should beexamined carefully for a full appreciation of its potential contribution to price volatility.

CSC CHAPTER 5

VOLUME 1


e) Bond Prices are More Volatile when Interest Rates are Low

The relative yield change is more important than the absolute yield change. For exam-ple, a drop in yield from 12% to 10% will have a smaller impact on a bond’s price thana drop in yield from 4% to 2%. Although both represent a drop of 200 basis points, theformer is a 17% change in yield, and the latter is a 50% change in yield. Thus, bondprices are more volatile when interest rates are low.

This principle applies even when the change in yield is small. Returning to the sample7% five-year bond and a yield of 7% (the bond is priced at par), Table 5.8 demonstratesthat a 1% drop in yield leads to a different (and greater) change in price than a 1% risein yield. The price rises by $4.21 in the first scenario, and falls by $3.99 in the second.This non-uniform change in price is called convexity, and is described in detail inadvanced investment courses on fixed-income securities.

TABLE 5.8

Relative Interest Rate Changes7% Five-Year Bond


9% +28.57 92.22 – 7.78 – 7.78%

8% +14.29 96.01 – 3.99 – 3.99%

7% 0 100.00 0.00 0

6% –14.29 104.21 + 4.21 + 4.21%

5% –28.57 108.66 + 8.66 + 8.66%

f) Reinvestment Risk

The yield to maturity (YTM) of a bond is calculated on the assumption that all interestreceived from coupon bonds is reinvested (or compounded) at the discount rate prevail-ing at the time the bond was purchased.

Since interest rates fluctuate, the interest rate prevailing at the time of purchase isunlikely to be the same as the interest rate prevailing at the time the investor reinvestscash flows from each coupon payment. The longer the term to maturity, the less likely itis that interest rates will remain constant over the term. The risk that the coupons can-not be reinvested at the same interest rate that prevailed at the time the bond was pur-chased is called reinvestment risk.

If all coupon payments are reinvested, on average, at a rate higher than the bond’s fixedcoupon rate, the overall return on the bond will increase. The yield to maturity quotedat the time the bond was purchased will be understated.

If, on the other hand, coupon payments are reinvested, on average, at a rate lower thanthe bond’s fixed coupon rate, the overall return on the bond will decrease. The yield tomaturity quoted at the time the bond was purchased will be overstated.

Only a zero coupon bond has no reinvestment risk, since there are no coupon cashflows to reinvest before maturity. Instead, these bonds are purchased at a discount fromtheir face value. The price paid takes into account the compounded rate of return thatwould have been received had there been coupons.



g) Duration

Changes in interest rates represent one of the main risks faced by investors when hold-ing fixed-income securities. The following relationships have already been discussed:

• The value of a bond changes in the opposite direction to interest rates – i.e., asinterest rates rise, bond prices fall and as interest rates fall, bond prices rise. Thus,depending on the investment strategy pursued by the bondholder, changes in inter-est rates can create a loss or a gain for the holder;

• Bonds with high coupons are usually not very volatile in price; and

• Bonds with long terms to maturity are usually volatile in price.

But what about a bond with a high coupon and a long term? Will its price be volatile ornot?

A given change in interest rates will impact the prices of bonds with different features,coupons, maturities, protective covenants, etc., differently. For bondholders, being ableto determine the impact of interest rate changes on bond prices will lead to betterinvestment decisions.

Duration is a measure of the sensitivity of a bond’s price to changes in interest rates. Itis defined as the approximate percentage change in the price or value of a bond for a1% point change in interest rates. The higher the duration of the bond, the more it willreact to a change in interest rates. Duration is simply an investment tool that helpsinvestors determine the volatility or riskiness of a bond or a bond fund – i.e., how muchthe price of the bond will move up or down with changes in interest rate. In this way, asingle duration figure for each bond can be compared directly with the duration ofevery other bond.

If the duration of a bond is 10, then its price will change by approximately 10% ifinterest rates change by 1%. For example, assume you hold a bond with a 6% couponthat is currently priced at 102.15. If interest rates rise by 1% then the price of the bondwill fall by approximately 10% to 91.935.

We are not constrained to 1% interest rate changes. As long as the duration of the bondis known, the effect of any range of interest rate changes can be determined. For exam-ple, for a 0.5% change in interest rates the approximate price change on our bond witha duration of 10 is 5% (10 × 0.5%); for a 0.25% change in interest rates the approxi-mate price change on the bond is 2.5% (10 × 0.25%).

Calculation of a bond’s duration is complicated. Moreover, a bond’s duration canchange over longer holding periods and larger interest rate swings. Therefore, we havenot shown its calculation here. The duration of any bond should be available frominvestment dealers’ bond desks.

Table 5.9 shows the impact interest rate changes have on bonds with different dura-tions. As the table shows, the same interest change of 1% has a greater impact on theprice of Bond A compared with the price change on Bond B.

CSC CHAPTER 5

VOLUME 1


TABLE 5.9

Impact of an Interest Rate Change on Bonds with Different Durations

Bond A Bond BDuration = 10 Duration = 5

Both Bond A and Bond B are priced at $1,000 $1,000 $1,000

Interest rates rise by 1%.The price of Bond A $900 $950falls by 10%; the price of Bond B falls by 5%.

Interest rates fall by 1%.The price of Bond A $1,100 $1,050rises by 10%; the price of Bond B rises by 5%

Duration is explained more fully in CSI’s Investment Management Techniques (IMT),Portfolio Management Techniques (PMT), and Professional Financial Planning (PFPC)courses.

5. The Yield Curve and Bond Switching

Not only do bond prices and yields fluctuate, but the relationship between short-termand long-term bond yields also tends to fluctuate. This relationship is easily plotted on agraph for similar long-term and short-term bonds and results in a line called a yieldcurve, which continually changes.

Because of changing prices and yields as well as changing yield curves, there are oftenmany bond-switching opportunities in bond portfolios. The differences between short-term and long-term Government of Canada bond yields that have existed in recentyears are shown in Figure 5.1.

FIGURE 5.1

Short and Long Term Government of Canada Security YieldsYield Curve

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Long10753212 mos6 mos3 mos1 MonthYears to Maturity

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a) Benefits of Bond Switches

At times, an investor may sell one bond and replace it with another, to capture someadvantage. These types of trades are called bond switches. A summary of the possiblebenefits from bond switches follows:

Net Yield Improvement

Bond switching may offer opportunities to improve after-tax yield without adverselyaffecting quality. For example, a high-tax-bracket investor will be better off in deep-dis-count bonds than in high-coupon bonds, even if the gross yield is the same, because thetax rate on the discount portion of the yield will be based on the capital gains rate andtherefore lower. On the other hand, a low-tax-bracket investor would be better off in ahigh-coupon bond.

Example: In Year 0, John Smith, an investment advisor, met with Mary Chan, aninvestor in a 50% income tax bracket to discuss Mary’s inherited portfolio. In the bondsection of her portfolio, John noticed $40,000 OneProvince 10% bonds due in Year 18,priced at 98. John suggested that Mary sell these bonds and use the proceeds to buyTwoProvince 7.5% bonds due in Year 12, at 79.25. John explained that because Marywas in a high tax bracket, the switch would improve her after-tax yield. More of thereturn would be provided by the capital gain on the deep discount bonds, on which alower rate of tax applies (capital gains tax versus tax on interest income). Using theapproximate yield to maturity method, the after-tax yields on the two issues, using a50% capital gains rate, are:

TwoProvince 7.5% bonds due in Year 12, bought at 79.25 = 5.63%

OneProvince 10% bonds due in Year 18, sold at 98 = 5.14%

Therefore, the gain in net yield on the securities is 0.49%

Term Extension or Reduction

Bond switching offers profitable opportunities in this area because of changing yieldcurves and to changing requirements.

Example: A sale of $25,000 FTR Corp. 11% bonds, due March 1, 2004, at 98 and asubsequent purchase of PZX Corp, 11.25% bonds, due Sept. 1, 2009, at 98.5 wouldresult in an extension of the term by five and a half years at little cost. The proceedsfrom the sale are more or less equal to the cost of the purchased bonds, while the yieldis also relatively unchanged. The only question is whether PZX Corp. has the samecredit standing as FTR Corp. This would have to be checked carefully in advance.

Improvement in Credit

Bond switching can improve the yield for corporate bonds, where the prospects forentire industries or particular companies can change radically and quickly.

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Portfolio Diversification

Price changes in a portfolio, or the impact of new cash income or cash requirementsmay make it necessary to review the diversification of the portfolio to ensure that risksare spread out.

Example: A small mutual fund with $10 million in assets divided equally betweenGovernment of Canada bonds and equities would have to be careful to keep a balancedportfolio, if new sales of units suddenly brought an additional $4 million into the fund.To retain the same balance as before, no more than $2 million of the new amountshould be invested in bonds. Preferably this would be in types of bonds that are notalready held in the fund, to retain adequate diversification.

Cash Take-Outs

Cash take-outs are possible when the proceeds from the sale of a bond are greater thanthe cost of the bond bought with the proceeds. Sometimes it is possible to do this with-out adversely affecting yield or quality.

Example: A sale of $40,000 of the OneProvince bonds (described above) at 98 wouldproduce pre-tax proceeds of $39,200, excluding accrued interest. If Mary then reinvest-ed in $40,000 of the TwoProvince bonds at 81.25, the cost would be $32,500, notcounting accrued interest. Consequently Mary could have a pre-tax cash take-out ofabout $6,700.

b) Bond Switching Tips

In bond switching, it is important to remember:

• During periods of higher interest rates, the prices of longer-term bonds usually fallmore than the prices of shorter-term bonds. Conversely, when interest rates fall,prices of longer-term bonds tend to rise the most;

• Low-coupon bonds tend to fluctuate more in price than high-coupon bonds; and

• Transaction costs can affect the value of switches, especially those involving stripbonds and less liquid issues.

Astute bond investors can take advantage of interest rate swings by either shortening orlengthening the average term of the bond portfolio. This means holding a portion of thebond portfolio in long-term low-coupon bonds when yields are in the downward phaseof the interest rate cycle and bond prices are rising. The investor can then reverse theposition when yields rise and bond prices fall.

By doing this successfully, a bond investor will make an additional pre-tax return inaddition to the average coupon income. However, success will depend on his or herability to forecast the bond market correctly.

• Technical factors related to supply and demand, yield and price spreads for varioustypes of bonds will often make bond switches attractive.

• Sinking fund or purchase fund operations often cause temporary distortions in themarket that make certain bond switches advantageous.

• A sharp rise in the underlying common stock of a convertible debt issue or a debtissue with attached warrants could result in the debt issue selling at a substantialpremium above par. In this case, a switch to another debt issue might be profitable.

• The market price of a convertible debt issue might drop once a previously indicateddate for a change in conversion terms had passed. This might be a good opportuni-ty for a bond switch.



POST-TEST

E. DELIVERY, SETTLEMENT AND REGULATION1. Bond Delivery

When a securities transaction has been confirmed, the change in legal ownership of thesecurities is effective immediately. However, payment for purchased securities does nothave to be made until some time later, and the securities do not have to be delivereduntil the end of this time period, called the settlement period. The length of the settle-ment period varies depending on the type of security.

Table 5.10 presents a summary of settlement periods for various fixed-income securities.

TABLE 5.10

Bond Settlement Periods

Type of Security Settlement

G of C Treasury Bills Same day

All G of C Bonds and G of C Guaranteed Bonds Second clearing day after the transaction takeswith a term of three years or less to maturity, place.or to the earliest call date, where a transaction is completed at a premium, except as described below.

All G of C Bonds and G of C guaranteed bonds Third clearing day after the transaction takes placewith a term to maturity of more than three years (or to the earliest call date where a transaction is completed at a premium) and all other bonds,debentures, or other certificates of indebtedness except as described below.

A trade in a mortgage-backed security made First clearing day on or after the fifteenth calendarfrom the third clearing day before month-end day of the monthcalendar day to the eleventh calendar dayof the following month inclusive.

2. Clearing and Settlement

In the past, debt securities were issued in coupon-bearing form⎯an actual certificatewas produced, and detachable coupons were attached to the residual principal payment.On each coupon payment date, investors would “clip” the coupon and submit it to abank or other financial institution for payment from the issuer. At maturity, the samewould be done with the residual principal. These types of bonds were known as bearerbonds, and some (though not many) still exist today.

However, the risk of losing certificates was a concern, because bearer bonds could besold or transferred by the holder, whether or not he or she was the rightful owner.Eventually, as an added layer of protection from theft, the registration of certificates wasrequired. These so-called registered bonds bore the name of the rightful owner andcould be sold or transferred only when the owner signed the back of the certificate. Inaddition, coupon payments were mailed to the registered owner of the bond.

However, the evolution of bond markets has led to greater investor demand for greaterliquidity, and issuers have also looked for cheaper and faster ways of bringing issues tomarket. Today, rather than physical certificates, most bond issues around the globe areissued in a book-based format only, with depository, trade clearing, and settlement serv-ices provided by participating clearing providers. In Canada, the national provider ofthese services is the Canadian Depository for Securities Limited (CDS).

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3. Regulation of Bond Trading

The details and mechanics of the unlisted, high-grade market in Canada are regulatedby the Investment Dealers Association of Canada (IDA), in conjunction with theToronto Bond Traders’ Association and the Montreal Bond Traders’ Association.Membership in both Montreal and Toronto Bond Traders’ Associations are open to anymember of the Investment Dealers Association of Canada, the bond departments of anychartered bank, or any other financial institution that submits an application acceptableto the board of governors.

The three associations set the rules and regulations of trading. However, the IDA, as thesenior association, reserves the right of final decision. Although the IDA has no directauthority for either of the bond traders’ associations, which are completely independentorganizations, the ultimate power is vested in the IDA through a provision of theTrading and Delivery Regulations.

In practice, all operating decisions are made by the bond traders’ associations and arenormally accepted by the IDA. The board of governors or directors of the bond traders’associations have a system by which disputes can be heard quickly and settled effectivelyso that the over-the-counter bond market is not delayed pending the decision. Bondtraders’ liaison sub-committees exist in both the Ontario and Quebec districts and,along with the permanent staff of the association, maintain close liaison with the offi-cers of the two bond traders’ associations.

The IDA’s rules on Trading and Delivery Regulations are substantially the same as theTrading and Delivery Regulations of the two bond traders’ associations. They govern allelements of trading and delivery, including the sizes to be traded, trading units, accruedinterest, good delivery, buy-ins, and general regulations for trading and delivery ofbonds, debentures, and unlisted stocks.

Canadian chartered banks that are members of the Toronto and Montreal Bond Traders’Associations are subject to the same rules and regulations as investment dealer membersof those bodies.

4. Accrued Interest

Most bonds pay interest twice a year, on the same month and day as the maturity dateand exactly six months later. For example, if a bond’s maturity date is February 15,2009, interest will be paid every February 15 and every August 15 until maturity. SomeEurobonds pay annually and some provincial and corporate bonds pay monthly.

It is possible, however, to purchase bonds on almost any day. An investor could pur-chase the above bond on August 1 of any year, hold it for two weeks, and receive a fullsix months’ worth of interest. This is not equitable to the previous bondholder, whomay have held the bond for five and a half months and received no interest. Accruedinterest, then, is the amount of interest built up during the previous holding period. Itis paid at the time of purchase from the buyer to the previous holder.

Interest accrues from the day after the previous interest payment date up to and includ-ing the day of settlement. The client who buys a bond pays the purchase price plus theinterest that has accrued or accumulated since the last interest date. This interest isregained if the bond is held until the next interest payment date, or if the bond is soldin the meantime, resulting in accrued interest being paid to the seller.



The amount of accrued interest is found by a simple arithmetical calculation using threenumbers:

• The principal amount;

• The rate; and

• The time period.

The amount is based on the par amount purchased or sold. Even though the bond mayhave been purchased at a premium or a discount, interest is always based on par value.Also, the rate at which interest accrues is the coupon rate of the bond, not its yield.

Different types of bonds use different formulas to calculate accrued interest. The differ-ences relate primarily to the method used to determine the time period over which theaccrued interest is calculated, known as the day-count convention. The most straightfor-ward day-count convention, actual/365 (“actual over 365”), is used to calculate accruedinterest for Government of Canada bonds and provincial bonds, and it is the only onewe present in this course.

Example: A fictitious 8% Government of Canada bond, due to mature March 15, 2010,and a principal amount of $200,000 will be used as an example. Assume the bond waspurchased on Tuesday, May 6, 2003. Interest was last paid on March 15, 2003.Therefore the first day of accrued interest is March 16, 2003. The settlement date forthis transaction would be May 9, 2003, according to Table 5.10, which indicates threebusiness days settlement for this type of bond, because it matures more than three yearsfrom the transaction date. The number of days of accrued interest for this transaction,between March 15, 2003, and May 9, 2003, is:

March 16 – 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16 days

April . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .30 days

May . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 days

TOTAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55 days

Notes:

(a) Include March 16 and May 9, but not March 15.

(b) If the year is a leap year, the client is entitled to an extra day’s accrued interest in February.Nevertheless, the practice is to base the interest calculation on a 365-day year.

The amount of accrued interest for the above example is:

Par Amount Coupon Rate Time Period

Because of the variation in the number of days in a calendar month, the calculation ofaccrued interest can result in an amount greater than half a year’s interest payment. Insuch cases, accrued interest is calculated on the basis of the full amount of the coupon,less one or two days, as the case may be.

The amount of accrued interest owed to a seller or payable by a purchaser is shown onthe confirmation contract that each receives. A straightforward example of a contractconfirming the purchase of a debt security from a client is shown here:

$ ,.

$ , .200 0008 00100

55365

2 410 96× × =

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ABC SECURITIES

100 MAIN STREETYOUR TOWN,YOUR PROVINCE

W1X 2Y3

Mr. John Smith Date:Tuesday, May 6, 200325 Centre Street Investment Advisor: 7-486Your Town,Your ProvinceW1B 6C7

CONFIRMATION OF PURCHASE from you of the following securities as principals

Quantity Security Price Amount$200,000 Government of Canada 8% bonds 98.00 $196,000.00

due March 15, 2010Interest: March 16, 2003, to May 9, 2003 2,410.96

$198,410.96

Settlement date: May 9, 2003

A straightforward example of a contract confirming the sale of the same debt security toanother client is shown below:

ABC SECURITIES

100 MAIN STREETYOUR TOWN,YOUR PROVINCE

W1X 2Y3

Ms Ruby Johnson Date:Tuesday, May 6, 200325 Groove Street Investment Advisor: 7-486Your Town,Your ProvinceW1F 6G7

CONFIRMATION OF SALE to you of the following securities as principals

Quantity Security Price Amount$200,000 Government of Canada 8% bonds 99.00 $198,000.00

due March 15, 2010Interest: March 16, 2003, to May 9, 2003 2,410.96

$200,410.96

Payment:As above by settlement date: May 9, 2003

Note that the 1% difference between the purchase price and the sale price represents theinvestment dealer’s spread on the transaction.



F. BOND INDEXES1. Uses of Bond Indexes

An index measures the relative value and performance of a group of securities over time.Most people are familiar with stock indexes, such as the S&P/TSX Composite Index.While stock indexes have been around for well over 100 years, bond indexes are relative-ly new and have been around only since the early 1970s.

Bond indexes are generally used in three ways:

• As a guide to the performance of the overall bond market or a segment of that market;

• As a performance measurement tool, to assess the performance of bond portfoliomanagers; and

• To construct bond index funds.

2. Scotia Capital Canadian Bond Market Indexes

Scotia Capital offers a comprehensive set of Canadian bond indexes. As of December2004, the Scotia Capital Universe Bond Index consisted of 920 issues, with a total mar-ket value of approximately $530 billion, representing a full cross-section of governmentand corporate bonds. All Canadian dollar-denominated investment grade bonds with aterm to maturity of one year or more are eligible for inclusion in the index. The bondsin the index are grouped into sub-indexes in different combinations according towhether they are government or corporate bonds, their time to maturity, and the bondrating (for corporate bonds only).

The Universe Bond Index measures the total return on bonds in Canada, including real-ized and unrealized capital gains, and the rein-investment of coupon cash flows. It is acapitalization-weighted index, with each bond held in proportion to its market value.

Scotia Capital also maintains indexes of Canadian money market securities, Canadianhigh-yield bonds, and more.

Figure 5.2 illustrates the Universe Bond Index returns since 1980.

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FIGURE 5.2

Scotia Capital Universe Bond Index Returns1980 to 2004

3. Merrill Lynch Global Indexes

U.S. investment bank Merrill Lynch also maintains a comprehensive set of bond marketindexes. Not only does Merrill Lynch track the different segments of the U.S. bondmarket with many indexes and sub-indexes, but it also monitors the performance of thebond markets for several other countries and regions, including Canada, Europe, Japan,Australia, and emerging markets. Each of these markets is also broken down into manymarket segments.

4. Other Index Providers

In Canada, RBC Dominion Securities, CIBC Wood Gundy and Standard and Poor’salso maintain a comprehensive set of Canadian bond market indexes, as do U.S. invest-ment banks Lehman Brothers, Salomon Smith Barney and JP Morgan for both U.S.and international bond markets. Morgan Stanley Capital International (MSCI), a wellknown provider of global equity market indexes, also maintains several global bondmarket indexes.

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