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What Is a Bond, What Is the Bond Market, and How Does It All Work?

What Is a Bond Anyway?

A bond is a piece of paper (well, a computer blip these days) that “bonds” borrowers and lenders. The borrower rents money from the lender and agrees to pay a certain rate of interest for the rental, normally at pre-arranged times, typically every six months. Thus, a bond is the original amount of the loan plus a series of rental cheques or interest payments. Eventually, the lease is up and the landlord gets the property (capital) back and can re-lease it or hold on to it.

Benchmark Bonds

A benchmark bond is an actively traded bond that is used to determine the prices of less actively traded bonds. The media report benchmark prices so that the investing public can see the direction of bond prices. As well, issuers of new bonds use them as reference points to price their issues. The Bank of Canada regularly adds to existing benchmark issues at the key maturity dates: two, five, ten, and thirty years. This contributes to a smoothly functioning marketplace. Investment dealers also use these benchmark bonds to hedge market risk.

Here is the anatomy of an actual bond, the Canada 3.5 percent due June 1, 2020. For purposes of illustration, we will assume a principal value of $100,000. In other words, $100,000 is the amount that the lender will receive back at maturity. I will use this bond in different chapters of the book. This is a benchmark issue, with $13.1 billion outstanding. This bond pays interest semi-annually, so we may display the internal workings of this bond as follows: the interest payments are the principal value ($100,000) times the coupon rate (3.50 percent) divided by 2, since the interest is paid twice a year. Therefore, each payment is $1,750.

So, an investor who bought and held this bond until maturity, without reinvesting any of the interest payments, would have received a total of $131,500.

If the investor held this bond inside an RRSP or held it in a taxable account but did not need the interest, each of these interest payments would need to be reinvested. I am introducing the concept of reinvestment at this stage, as it is a very important component of bond yields. Bond yield calculators assume that each interest payment will be reinvested at the purchase yield, clearly not a real world assumption, but it does provide consistency, as all bonds are measured the same way. Don’t worry; we will examine all of this later in more detail.

At one time, investors in bonds received beautiful lithographed letter-sized pieces of paper as evidence that they had made this loan. Today, most of these physical pieces of paper have disappeared, replaced by the “book-based” system, whereby the Central Depository for Securities (CDS) maintains the records of who owns what. Your evidence of ownership is the contract you receive from your financial institution and your monthly statements.

Most bonds are issued with a coupon rate, which is the rate of interest investors will be paid. How is this rate determined? It is a product of the length of time to the maturity date, the general level of interest rates, and the creditworthiness of the borrower. Unlike a mortgage, which is a specific relationship between an individual and a lender, there may be hundreds of holders of the same bond, as individual bond issues may range from $15 million to $20 billion.

What Is the Fixed-Income Market, and How Does It Operate?

The fixed-income market, or bond market, operates in what we call an “over-the-counter” manner. To understand what this means, let us first examine how the equity market functions. When investors purchase, say, one hundred shares of TransCanada PipeLines, they purchase them from other investors who are selling the shares at the same price. These trades take place on a public stock exchange, where prices are clearly visible. Both the buyers and the sellers pay a fee (or commission) to their respective IAs. The financial institutions (for example, investment dealers or brokers), hereafter called FIs, merely facilitate this transfer from the buyer to the seller; they do not assume any principal position and thus do not risk their principal or capital. Therefore, retail equity transactions are called agency transactions, since the FIs merely act as agents.

The bond market functions in an entirely different fashion. There is no visible public market, and almost every trade is done on a principal basis and is quote-driven. That is, the FI’s bond traders are using the firms’ capital to maintain inventories and make markets in the broad spectrum of fixed-income securities.

Consider TransCanada PipeLines for a moment. It has one class of common shares with 699 million shares outstanding as of March 14, 2011, with a market capitalization of $27 billion. At the same time, it had 62 bond issues outstanding, of all different sizes, maturities, and characteristics, ranging in maturity from 2011 to 2067 and in coupon from 3.40 to 12.20 percent, having a combined face value of $16.9 billion. Many of them are held in large percentages by the investing institutions, rendering them illiquid. Very few of these issues trade every day, so if you are interested in investing in one of them, your IA will ask the retail bond-trading desk, which will likely not have them and will turn to the wholesale bond-trading group, which will then attempt to make a market for that particular bond.

It is somewhat like a grocery store or convenience store. To help individual investors, retail fixed-income departments stock their shelves with inventories of the various bond and money market products. There are special sales at times, and of course the investment dealers will showcase the products that they want you to buy. When inventories run out or become low, the retailers go to the institutional department to get restocked. As retailers have all kinds of costs — communications, technology, salaries, rent, and financing the inventories, to name a few — prices are marked up from the institutional price. I can tell you that the price markups are very small at most investment dealers. As with grocery stores, you can comparison shop by opening accounts at different investment dealers or discount brokers. Recently, I conducted a survey of online bond trading at the five major dealers to further assist you in your do-it-yourself dealings. You will find the details on page 58.

Quotations for bonds often confuse investors. The base denomination for bonds (other than stripped bonds) is $1,000. This is called the “face,” “book,” or “par” value. It is the principal amount that you invest and will receive back at maturity. We quote bonds on a percentage of face value. When you see a bond quotation, it may be, for example, $98. This means that the bond is trading at 98 percent of the face value. In other words, the $1,000 bond is worth $980.

As well, bonds (except for stripped bonds) trade with accrued interest attached. The value of that accrued interest is not included in the price. The seller of the bond that you are buying expects, and deserves, to receive the interest accruing from the last interest payment. The buyer pays that accrued interest in addition to the purchase price. This is because the new owner of the bond will receive the full interest payment when it is eventually paid, even though he or she is entitled to only the interest accruing from the date of purchase to the settlement date of the sale.

Assume, for example, that you sold a bond, there were three months before the next payment, and you did not receive the accrued interest. The next owner of the bond would then receive the full six months’ interest payment when it came due. Therefore, the next owner’s money earned double for that period and yours earned nothing! Since it is impractical and inconvenient to wait until the payment is received before selling the bond, the interest owing to the seller is calculated and paid by the new owner on the settlement date.

Let us re-examine the above example: a bond paying 4 percent semi-annually with a face value of $10,000 is sold at 98 percent of face value with 90 days of accrued interest owing to the vendor. The seller of the bond receives $9,800 of the original principal plus the accrued interest owed from the last payment date. If this bond had been held for a full year, the investor would have received $400 in interest (4 percent of $10,000). We divide $400 by the number of days in a year to calculate how much interest accrues daily: $1.09589 accrued per day. Now we take this number and multiply by 90 to arrive at how much accrued interest is owed to the seller: $98.63 of accrued interest. Therefore the seller receives the $9,800 plus the $98.63 of accrued interest for a total of $9,898.63.

BID, ASK, OFFER

The terms bid, ask, and offer create some confusion. When you are selling a bond, the investment dealer provides you with a bid. If you are buying, you need to know what the dealer is asking for the bonds or where he offers it. It becomes confusing when you say that you want an offer for these bonds. That could mean that you want a bid. Stick to bid and ask.

So, what happens to the buyer? Assuming the buyer pays the same percentage of face value, he or she pays exactly the same as the vendor receives. In the real world, the two prices will not be the same as a result of commissions being charged. The accrued interest will be the same. As we recall, the bond market functions as a principal market where the investment dealers make markets in bonds using their firm’s capital. Thus, there will be a difference in the “bid,” what a trader is willing to pay for a bond, and the “ask,” which is the price at which a trader is willing to sell. As well, the IA needs to make a living, so he or she takes the bid or ask price from the trader (depending on whether the client is selling or buying), subtracts or adds the commission, and then gives the client a net price. Note that no commission is added or deducted in a fee-based account.

Getting back to the buyer: when the next interest payment is due, the buyer will receive the full six-month payment ($200). Subtracting the $98.63 interest previously paid, the buyer has netted $101.37 of accrued interest for the period that he or she has owned the bond. Should this new owner keep the bond through successive payment dates, he or she would receive the full $200 each six months until the bond is sold or it matures.

Also, you will notice that prices for bonds range from discounts, say $90 (or 90 percent of face value), to premiums, such as $110 (or 110 percent of face value). Why is this? Interest rates move up and down, and bond prices move inversely to yields. (Not a week goes by without someone asking me which way bond prices go when yields go up. They go down. Bond prices and yields move in opposite directions, and you will understand why when you read the chapter Basic Math.)

This is to put them in line with currently issued bonds. If the price on our Canada 3.5 percent bond due June 1, 2020, was exactly $100, then its yield to maturity would be 3.5 percent. If market yields moved to 6 percent, no one would buy this bond at 3.5 percent, so we adjust its market price to $83, which equates to a yield to maturity of 6 percent. Conversely, if yields fell to 2 percent for this maturity, this bond would be re-priced to $112.13. We will examine in detail how these prices are actually calculated in the chapter Basic Math. Don’t worry.

Individual quotations on bonds (bids and asks) are not readily visible, although there are determined attempts underway to increase the transparency of the bond market. Online or discount brokers have offerings of fixed-income securities, while in the case of FIs, the IAs can see their firms’ inventories displayed electronically from their internal systems and can relay these to their customers. In addition, there are three public sites with up-to-date bond prices on a reasonable cross-section of the bond market:

 www.canadianfixedincome.ca provides free access to a broad list of bond prices. Further, individual investors may subscribe to Bondview, which offers a more complete view of the marketplace, for $19.95 per month.

 www.canpxonline.ca offers hourly updates on benchmark Government of Canada bonds. Eventually, they plan to introduce Canada’s equivalent to the U.S. Trace system whereby all corporate bond trades will be displayed with a time delay.

 www.canadianbondindices.com offers a plethora of information on fixed-income markets, including live updates, some trading volume statistics, as well as performance numbers.

There are daily quotations in newspapers and more extensive lists in the weekend press, but they are not all-inclusive; they typically represent institutional pricing (greater than $1 million in size), and they are just a snapshot at a certain point in time. While they are useful indicators of where bond prices were, bond prices will be different when you attempt to buy or sell, since they fluctuate far more than investors (and IAs) realize. In any event, retail investors will not be able to transact at these prices for two basic reasons: first, they are dealing in retail quantities; second, since the bond market is a principal market, as we now know, a bond trades on a net basis (that is, with no visible commission added).

Let us consider that there might be a different (i.e., higher) price for a retail fixed-income transaction by individual investors than for a wholesale purchase by a giant financial institution. Returning to our grocery shopping analogy, individuals normally find the shelves adequately stocked for their relatively small purchases. If the store did not maintain adequate inventories, the management would have to shuttle back and forth from the wholesale warehouse. The warehouse sells in bulk quantities, so the store manager must decide how much to buy, balancing the needs of the customers with the prices for different quantities of merchandise. After adding the merchandise to the shelves, the manager now raises the wholesale price to retail to account for various factors such as heat, lighting, salaries, insurance, spoilage, and taxes.

A retail fixed-income department operates in a similar fashion. I do not run to the wholesale, or institutional, market for every $10,000 worth of bonds that I sell. Instead, I will sell them “short” (that is, sell now and buy later), or I might suggest another bond that I do have in inventory. In practice, I buy in bulk various fixed-income products from the wholesale market and add them to my “shelves,” which I call my inventory. Once I do that, I incur market risk, which I offset by hedging. Hedging involves neutralizing market risk so that I do not incur capital gains or losses as the market prices change. I also incur yield-curve risk and credit risk. I also maintain state-of-the-art computer and communication equipment. As well, there are the other basic costs, such as remuneration! Also, since most bonds do not trade every day, I resort to “matrix” pricing to at least provide a quotation. How do I do that? I do that by comparing one of those bonds to an actively traded benchmark issue, such as a Government of Canada bond of similar maturity, and adding a yield spread to that bond based on where I know or believe that they have been trading recently. I then compute a price. It is as if I know there are some TransCanada PipeLines (TRP) bonds down in the factory, but rather than keep you waiting, I price them and sell them to you now and go buy them later because I know what my relative cost will be. If I know that the “factory” contains none of what I am asked to sell, I will search everywhere for them or, more likely, suggest a similar bond.

Even given all this, the markups from the wholesale fixed-income market to the retail market are amazingly small, meaning that individual investors can be well served by the fixed-income market.

TRANSFER PRICE

The transfer price is the price at which the fixed-income trading department transfers it to the IAs. To get paid, they must add a commission to this price in the case of an investor purchase, unless the transaction is in a fee-based account.

This type of pricing is necessary since, and returning to the TRP example, there may be just one class of common shares outstanding, but there could be sixty or so different bond issues of different maturities, sizes, and features. There is just not enough liquidity to display a bid and an ask all the time in the same fashion as the equity market. The FI “makes a market” in the various instruments, willing to be long or short to accommodate investor interest. In addition, governments of all types borrow money in the bond market, and, of course, they do not have any common shares to trade!

The bottom line is that the bond market functions as a clearing house between borrowers and lenders. For IAs to earn a living, in the case of client purchases, they raise the ask price received from the bond department and get paid the differential as a commission. Again, this does not occur in the case of fee-based accounts. This is not visible to the investor, although this may soon change. I will talk about initiatives in this area in the transparency discussion. The opposite occurs when clients sell, with IAs deducting from the bond desk’s bid to create a commission. This is referred to as a “haircut” in the business, as you’ve just had a trimming!

Furthermore, the less-liquid bonds, such as corporates and zero coupons, are most frequently quoted on a matrix basis. Since many of these instruments do not trade every day, they are priced in reference to an instrument that does. For the most part, Government of Canada bonds of different key maturities constitute the benchmarks by which other securities are priced. While I have included more on benchmarks later, I think it is important to mention them now, as the majority of fixed-income securities offered to investors are priced in relation to them.

The Bank of Canada is committed to building up very large and therefore liquid benchmark issues at the key maturities: two, three, five, ten, and thirty years. They are vital not only in pricing bids and offerings, but also in pricing new provincial and corporate issues when they come to market. The benchmarks form a valuable base level from which other bonds may be valued. For example, let us take a provincial bond: the Province of British Columbia 3.70 percent due December 18, 2020. It is valued by the market at 74 basis points above the relevant benchmark, the Canada 3.5 percent due June 1, 2020. (1 percent is divided into 100 pieces, each of which is called a basis point. In this case, the B.C. bonds at 74 basis points higher in yield than the Canadas are 74/100 of 1 percent higher. You will encounter the term “basis points” frequently throughout the book.) To trade these, a trader will observe where the Canadas are trading, add the 74 basis points to the benchmark yield, and then calculate the price for the B.C. bond. Let us say that the Canada 3.5 percent June 1, 2020, is trading at $102.49 to yield 3.1 percent. Now we add the 74 basis point spread and arrive at a yield of 3.84 percent for the B.C.s, which produces a price of $98.87.

Thus, as the liquid, actively traded benchmark issues change in price and yield, so do all the matrixed bonds. The yield spread between the benchmarks and these bonds fluctuates in reaction to supply and demand factors, changes in the yield curve, and changing credit risk perceptions.

The role of investment dealers, then, is to make markets in a wide-ranging list of bonds, bidding for bonds for which there are no apparent buyers or short-selling bonds where they are not sure there are sellers. FIs sell bonds short all the time, either to accommodate demand when they know there will be a seller of the same bond soon, or to hedge long positions (quantities of bonds that they already own). They may also short-sell bonds if they think they have become expensive compared with some other bond. Thus, they are a buffer between the differing needs of a cross-section of bond market participants. These longs and shorts are all held in the dealers’ inventories, which are typically segregated by type (money market, short-term Canadas, mid-term Canadas, long-term Canadas, provincials, strips, and corporates). The dealers hedge these inventories with offsetting transactions in the benchmark issues (or in the futures market) to eliminate or reduce market risk. Bond trading volumes are enormous, averaging approximately five times the daily amount of equity trading (approximately $38.4 billion). Why is this? First of all, the amount of bonds outstanding is huge, exceeding $1.9 trillion in Canada.

Corporations and governments issue bonds all the time for various reasons, such as rolling over maturing debt, paying off bank lines, funding deficits, and building new factories. Investors of all kinds (governments, pension funds, mutual funds, trust companies, life insurance companies, foreign investors, and individual investors) all have varying fixed-income needs, and these needs change over time. Some of these investors trade for speculative reasons; others think they can outsmart their peers by aggressive trading; while still others merely match the term of their assets and liabilities. In addition, new issues come to market that may be more attractive than bonds already owned. As well, bonds mature, making money available for reinvestment, or as they shorten in term over time, investors may wish to sell them in order to buy ones with a longer term to maturity.

What Does the Bond Market Look Like?

The bond market is largely invisible, being decentralized, over-the-counter, and with no post-trade disclosure in Canada yet. The United States has its Trade Reporting and Compliance Engine (TRACE) system and we are studying this approach now. I discuss this in more detail in the section on transparency beginning on page 51. It resembles an onion with a series of layers. At the heart of the Canadian bond market is the Bank of Canada, which is in charge of monetary policy and open-market operations in the foreign exchange, money market, and bond markets.

Next come the money market “jobbers,” whose role is to ensure the orderly maintenance of the money market, including the issuance of Government of Canada treasury bills. The money market is defined as securities issued with a term to maturity of one year or less. Treasury bills are obligations issued by the various governments. They are issued at a discount from their face value and mature at their face value so all the yield is in the amortization from that discounted amount.

Primary Dealers for Bonds

BMO Nesbitt Burns, Inc.

Casgrain and Co., Ltd.

CIBC World Markets Inc.

Desjardins Securities

Deutsche Bank Securities Ltd.

HSBC Securities (Canada)

Merrill Lynch Canada Inc.

Laurentian Bank Securities Inc.

National Bank Financial Inc.

RBC Dominion Securities Inc.

Scotia Capital Inc.

The Toronto Dominion Bank

Then we have the primary dealers, many of whom are also jobbers. Among other things, they are required to bid for the auction of the Government of Canada’s primary bond issues. They do the bulk of the underwriting of new provincial and corporate debt, make markets in the complete array of fixed-income products, and service the fixed-income needs of the various institutional and retail investors by maintaining extensive inven-tories and bidding and offering on all sizes of blocks of bonds. Individual trades can be in the hundreds of millions or as little as $5,000. The lion’s share of the daily $38.42 billion trading volume takes place among the Big Six investment dealers (at the time of writing, they were RBC Dominion Securities, TD Securities, CIBC World Markets, BMO Nesbitt Burns, Scotia Capital, and National Bank Financial) and their institutional and global customers. The market for individual investors is approximately 2 to 3 percent of this total. The other 97 to 98 percent is in the institutional area, where the bank-owned dealers (plus a few non-bank-owned dealers, such as Merrill Lynch Canada, Desjardins Securities, Casgrain and Co., Laurentian Securities, Penson, and HSBC) make wholesale markets in all the various fixed-income products to serve the investment needs of their institutional customers. These customers include life insurance companies, chartered banks, pension funds, mutual funds, investment counsellors, governments, and foreign investors.

It is worth pausing to note that the money that these institutions have for investment represents the aggregate savings of individuals like you! Your money is mixed in with everyone else’s, thus giving the institutions very large sums of money to invest and trade. A large percentage of this money is invested in fixed-income securities to satisfy actuarial requirements, match liabilities, and guarantee fixed returns. With large blocks of money to invest, these institutions command and receive the best prices. The investment dealers vie for this business: competitive tendering for bids and offerings is the norm, and individual trades exceeding $100 million are commonplace.

Naturally, all of the bank-owned dealers serve individual investors, since they all have national sales forces of IAs. There are another 210 members of the self-regulatory body which goes by the unwieldy title of Investment Industry Regulatory Organization of Canada (IIROC), who transact fixed-income securities. There are large, independent firms such as Blackmont Capital (now MacQuarie Private Wealth), Canaccord, and GMP Capital, as well as a host of small- and medium-sized investment dealers such as Odlum Brown, Haywood Securities, and Dundee Securities.

Each of these firms has to find fixed-income products somewhere in order to satisfy their customers’ needs. The bank-owned dealers help to meet these needs. They offer, via electronic delivery, retail quantities and prices of the various fixed-income products. TD Securities, Merrill Lynch, and RBC Dominion Securities are prominent in this area. In addition, Penson, Laurentian Securities, and HSBC also contribute to market making in this space. As well, a company called Perimeter CBID aggregates prices and offerings from a number of contributors and makes them available to all these same small dealers and entities. Several of the larger independents, such as MacQuarie, Dundee, Canaccord, and Odlum Brown, have their own specific fixed-income trading departments staffed by experienced personnel. They have sufficient capital and technology resources to assemble, maintain, and offer a wide range of fixed-income securities to meet the needs of their IAs’ customers.

My former firm, Blackmont Capital, for example, has a department of four professionals who have enough capital to maintain inventories of sufficient size to adequately serve the needs of their entire sales force. They manage these aggregates on a fully hedged basis to eliminate market risk for the firm and to offer competitive prices at all times. With an online, real-time trading system at their disposal, they can offer their own inventory plus fixed-income securities that they do not own. This is possible owing to the presence of actively traded, large bond issues for which there exists a known market.

Knowing what spread they trade at in relation to one of the benchmark issues makes it easy to offer a security without owning it. In fact, the benchmark prices are fed electronically into this system as they change, ensuring that the IAs’ customers are always seeing live prices. Also, in a typical sales force, some clients are selling securities that others will be buying. Knowing this, the trading department will keep and hedge the sold securities for later resale to its own sales force rather than to “the street,” the large market-making investment dealers mentioned earlier. This is an efficient way to do business, and customers benefit through better prices. Running to and from the wholesale market for every small transaction is very expensive. Yet, that is what the smaller dealers must do, as they do not have the personnel, capital, or the inclination to keep an inventory themselves.

It is also worthwhile pointing out the different philosophies of the various investment dealers with respect to how they treat individual fixed-income investors. Most of the bank-owned dealers treat their retail customer base as a captive audience and therefore charge more for individual bonds than the smaller, more focused firms. What you need to know is whether the FI you are dealing with treats the retail fixed-income market as a profit centre or not. The best ones work at growing the business through value-added service and competitive prices. Make a point of ascertaining what approach your FI uses.

Also, there are interdealer brokers (IDBs) whose role is to act as middlemen, facilitating anonymous trades among the jobbers, primary dealers, and investment dealers. The most prominent ones in Canada are Shorcan (owned by the TMX) and Freedom (owned by Cantor Fitzgerald and the Canadian banks). The trades are done anonymously so that the dealer in question does not give up any trade secrets to his counterparties (read competitors). Also, it means that each dealer does not have to make multiple phone calls to attempt a transaction. The IDB displays everyone’s bids and offerings electronically and pockets a brokerage fee on each transaction. These parties trade among themselves to offset transactions done with clients.

Last, we come to the individual investor whose needs are served by the different FIs. Individuals have their own specific reasons for purchasing fixed-income products directly: to generate income, to plan for retirement, and to provide safety of principal. They may need income in a foreign currency, they may wish to speculate on the price movement of bonds, or they might want to invest some money for future educational needs. Direct investment by individuals in the bond market, including GICs and ETFs, totals several hundred billion dollars.

The Case for Bonds

Why go through the bother of purchasing individual fixed-income securities? Why not take the easy route and invest in a nice bond mutual fund or ETF? The answer to the second question is that it is not in your best interest to do so! Mutual bond funds and ETFs simply do not offer the certainty required in retirement planning; their performance is erratic, and the management fees are too high. I speak from experience. For five years I managed what is now the largest mutual bond fund in Canada.

Sadly, there are too few IAs with sound enough working knowledge of fixed-income markets. The line of least resistance for them is to recommend bond mutual funds because they are an easier sell and the fees are attractive. However, they are not the ideal choice for the individual investor. Here are five reasons to choose individual fixed-income products.

Planning. Fixed-income products have specific maturity dates. That is, you know the exact date at which your principal will be returned to you and what your yield will be for the term that you hold this security. Contrast this with bond mutual funds: They do not have a specific maturity date, nor do they have a specified income level. Investors do not know what their investment will be worth at any moment or what it will be worth when they actually need their money back. Bond fund managers are constantly tinkering with their portfolios, shortening term, extending term, and trading for capital gains. This is not conducive to effective planning.

Fees. Bond funds charge management fees averaging approximately 1.66 percent per annum! ETFs offer lower management expense ratios (MERs). This takes a serious bite out of an investor’s income and return. Contrast that with individual products, where there is a one-time fee at the time of purchase (averaging 1/2 to 1 percent) with no further fees until they mature and the money is reinvested or if they are sold before maturity.

Performance. The long-term results of “professional” bond fund managers are not impressive, for a couple of reasons. First, it is a well-documented fact that no one is 100 percent sure of where interest rates are going. All forecasters, traders, and market commentators are right some of the time, but nobody is right all of the time. However, this does not stop portfolio managers from guessing using a technique with the more elegant name of “rate anticipation trading.” It only takes a couple of bad guesses for performance to suffer. Second, there is indexing in the bond fund management business, too, as brave portfolio managers huddle around the different bond indices in order to look good in the performance game and earn those bonuses for their professional management. They strive to beat the index as well as more than half of their peers so they will be able to market above-average performance. Also, consider that bond funds are required to calculate an annual return since they do not have a fixed maturity date. Investors owning individual bonds do not have to worry about annual returns since their yield and maturity date are known at the time of purchase. A good analogy is a baseball game. Individual investors in specific fixed-income securities know the outcome of the game before it starts even though the score (the annual return) may vary by inning. Bond fund holders have to worry every inning since they may have to leave the stadium before the end of the game without knowing the outcome.

It is difficult to have negative performance in the bond market.

Here are the annual performance results from 2002 for the broad Canadian Government Index and the Canadian Corporate Index as provided by Merrill Lynch Canada.

Corporate bonds just barely turned in a positive return in 2008 while the only negative performance came from government bonds in 2009. The principal reason for bonds to return positive returns on a consistent basis is the interest paid on bonds and the reinvestment of that interest. Granted that bond yields fell on a net basis since 2002, nevertheless there were lots of negative months. The bond market is one market where investors are advised not to sell into weakness.

Following is a table showing a group of Canada and corporate bonds with three-, five-, seven-, and ten-year maturities. Using current market yields, I increased the yield by 100 basis points or one full percent for a one- and two-year period. For good measure, I increased the yield by 200 basis points for the two-year period.

A few things stand out. For one, the lower the starting yield, the more negative the return for a given increase in yield. This makes sense as the income to be reinvested is less than that of higher yielding bonds. Thus, the corporate bonds would outperform all the government bonds for these scenarios.

The two-year total returns exceed the one-year returns for the same yield movement because there is one more year of compounding and because the bonds are now shorter in maturity by two years and thus less volatile.

Maturity Selection. Bonds come in a wide range of maturities, from thirty days to more than thirty years, allowing for appropriate retirement planning and ladder building (more on this in Chapter 8). Bond funds and ETFs do not have maturity dates so investors do not know how much money they will have when they need to redeem their units.

Liquidity. Bonds can be sold at any time, should raising money become important or should other opportunities present themselves. Daily trading volume averages over $38 billion, with the major investment dealers maintaining bids and asks on the complete array of fixed-income products that have been issued. Mutual funds can only be redeemed daily.

Bond Indices

There are several bond indices in the Canadian bond market. One of the most widely used for bonds in Canada is the DEX Universe Bond Index™ produced by PC Bond (www.canadianbondindices.com). This index encompasses some 1,103 different bond issues totalling some one trillion dollars and is constantly being rebalanced so that it fairly represents the overall bond market. As of December 31, 2010, it consisted of 46 percent in federal bonds and federal guaranteed bonds, 27 percent in provincials and municipals; and 27 percent in corporates. The corporates are further weighted by credit rating. The average duration was 6.27 years. Duration is a term that refers to the average term of the bond, taking into account the weight of the interest payments. Thus, duration is shorter than the term to maturity and is a measurement of the volatility of a bond. (More on this later.) This index is further divided into maturities with 45 percent being one to five years, 24.2 percent from five to ten years, and the balance of ten years and longer at 30.8 percent. There are many other sub-indices as well.

For the twelve months ending August 31, 2011, this index returned 5.35 percent while Canadian-managed bond funds returned a median of 3.50 percent. This gap is partly explained by the fees charged to the fund by the manager. This is called the management expense ratio (MER), which averaged approximately 1.7 percent in this period (source: globefund.com).

What to do then? I referred in the introduction to a strategy called laddering, which is fully explained later. Suffice it to say here that laddering takes the guesswork out of interest rates, reduces fees, and, over time, outperforms the majority of bond fund managers. This is done with individual fixed-income securities of staggered maturities. Basically, it is the most effective way of dealing with reinvestment risk, as your investments are spread out over regular intervals. This approach eliminates the need to guess which way interest rates are going, as investing in bonds of different maturities avoids the risk incurred if all your funds were invested in one maturity and interest rates were very low when that investment matured. There will be more on this important method in Chapter 8.

It is in your best interest to take control of your financial future by arming yourself with the knowledge of how to invest in individual fixed-income products. Doing this will offer you greater certainty as to the future value of your money and cost you less in fees.