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How Do I Get Started?

It is likely that you already have a relationship with an FI and/or an IA. It may be a bank, a bank-owned investment dealer, an independent brokerage firm, a mutual fund company, a financial planning company, a life insurance company, or a trust company. All of these entities, through their IAs or agents, first attempt to sell you their products, even if they are not suitable for you. Very few IAs (my guess is 10 percent) actually have your best interests in mind. Therefore, you will have to arm yourself with all the knowledge you can and find an experienced IA to act for you.

Your IA’s firm will have lots of educational material available and there are a plethora of websites to help you along. I have included this list in Appendix A. These websites offer all kinds of analytical tools. The daily newspapers offer some commentary, and television shows such as CNBC and the Business News Network (BNN) have expert commentators on a regular basis, including me. There are books available, and your IA’s firm will likely offer daily, weekly, and monthly bond market commentary. Over time, all of this information will stand you in good stead as you will have a good knowledge base.

So, armed with all this knowledge, you should be able to get your broker/advisor to do what you want, shouldn’t you? Not necessarily! Each pillar of the financial services industry (banks, trust companies, mutual fund companies, life insurers, investment dealers, and advisors/planners) has a vested interest in selling you what is in its best interest, not yours. Rare is the organization (or individual) that actually listens well enough to ascertain the needs of the client and takes care to make sure those needs are met, even at the expense of a sale that might produce greater near-term reward.

How and where do you find such people? The number one method is referral, from an IA’s satisfied clients or from lawyers, accountants, and friends. Ask, ask, ask, and eventually you will find someone who will help you. At some point, you will likely receive what are called cold calls. These come from IAs just starting out who are trying to build their books. It is in your best interest to find IAs with experience and well-established books of business so that you are well served. It is a further bonus if they offer fee-based services and thus are not driven by the need to generate commissions on every trade. It is possible that you may not find such IAs or your account may not be large enough for them. The major investment dealers offer superb training for new IAs, which includes the fixed-income markets. Therefore, you may find a newer IA who might be suitable for you, but remember to ask, ask, ask.

IAs’ books of business refer to how many clients they have and what the assets of those clients total.

This market remains a decentralized or over-the-counter market. With myriad issues to choose from and with mammoth trading volume and institutional dominance, it becomes extremely important to select the right firm and then the right adviser. The choice of a firm must be made before you pick an adviser. Extra time spent on this decision can mean significantly enhanced returns and thus a higher standard of living and more comfortable retirement!

The first step is to determine whether an investment dealer or organization takes the retail fixed-income business and its participants seriously. Look for FIs who advertise a special focus on fixed-income needs. Develop basic questions to ask would-be financial advisors. Here are some common questions, as well as the answers you should be looking for.

Q: Is the retail fixed-income desk a captive of the wholesale desk or is it master of its own destiny?

A: To properly serve individual investors, the retail fixed-income desk should be focused on providing IAs and their clients with good advice and competitive pricing.

Q: Is it a stand-alone profit centre or is the desk’s compensation linked to the overall growth of the firm’s fixed-income business?

A: A desk that is motivated to grow the business of the IAs will offer the best overall service.

Q: What percentage of your business is fixed-income?

A: It should be in the 20 percent to 50 percent range.

Q: How is the Bank Rate set?

A: You should be told that it’s set at regularly scheduled meetings of the Bank of Canada (bankofcanada.ca).

Q: Assuming I have $100,000 in my RRSP, what kind of fixed-income portfolio would you recommend in individual securities?

A: IAs should mention stripped bonds (zero coupons), corporate bonds, real return bonds, and the concept of laddering, perhaps Exchange Traded Bond Funds (ETFs), and should not suggest bond mutual funds.

Q: What is the difference between semi-annual and annual yield?

A: It depends on the level of nominal rates. It is an important question, since GICs, for example, are quoted in annual yield terms while most bonds are offered in semi-annual terms. Most firms will convert one to the other for fair comparison. It is in your best interest to ensure that you are being offered an apples-to-apples comparison, since annual yields may appear to be higher than semi-annual yields when, in fact, they may be the same or even lower.

Q: How much commission do you charge on bond trades?

A: If they answer at all, it should be between 0.5 percent and 1 percent. They may be fee based, which is expensive for fixed-income portfolios.

Q: Do you know what duration is?

A: This is important as it represents the risk and volatility of a bond. It is the average term of a bond, including the interest payments.

Q: What is the size of your book and how many clients do you have?

A: A minimum size of $100 million and perhaps 250 clients would indicate a successful IA and one who, therefore, would not need to do frequent transactions to make a living. Ask if they are willing to do a price comparison test with other FIs. It may not be easy to get these answers, but persist. Ask friends, read the financial papers, listen, observe.

Q: If I find the right advisor, how easy or difficult is it to move my account from my existing financial institution?

A: Naturally, FIs are not keen to see customers leave and so they do not make it easy to do so. In days gone by, it was a genuine hassle to move your account. Now the rules have changed and your account must be moved, in cash or kind, within days or the FI faces fines. It also helps that almost all securities are book-based, so this transfer becomes a simple matter of a computer transfer — plus the inevitable paperwork, of course. The FI that you are moving to will expedite the transfer.

To move your account, first open a new account with the new FI. Once that is done, complete, with the help of your new IA, a Request for Transfer Form, which serves notice to your former firm that you would like to transfer your account. The former firm must reply within two days and deliver all the securities and cash, within ten days. For a complete description of this process, visit www.IIROC.ca and look in the Investor Education section.

The absolute worst part of this process is the treatment that you may receive from the FI that you are leaving. There are horror stories of the departing IA being attacked verbally and his clients being given the full court press to stay. Typically, the departing IA’s accounts are divided among some more junior IAs and they really go after these clients. Sometimes, incentives are offered in the way of fee reductions and the like. If you really like your IA, go with him/her to the new FI. IAs do not move often, largely as a result of this treatment.

The advisors you are seeking are not likely to be rookies. They are most likely to have more than ten years of experience with a large, balanced book of clients. They will be working for an FI that has a comprehensive inventory of individual fixed-income products and a variety of tools to make your investing easier. Most major FIs have websites replete with prices, calculators, portfolio-building strategies, and, of course, offerings of all the various products.

There are also an increasing number of institutional bond salespeople who, late in their careers, become retail advisors. They can be of immense assistance to the individual investor given their knowledge of the entire fixed-income spectrum, as well as their ability to take advantage of how the bond market functions. If you are talking to a branch manager of an FI, ask if there is an IA there who specializes in fixed-income products or has a strong knowledge of and a client base in these products. Typically, IAs with only a passing knowledge of bonds are timid and unsure in approaching the trading desk personnel, who, to such IAs, appear to be a bunch of fast-talking, untrustworthy types. Unsure of themselves and of how to interact with the market, they may shy away. However, skillful handling of the information, services, and expert personnel of the typical well-staffed fixed-income department by a person steeped in the knowledge of how this market functions can produce measurable rewards for fortunate clients. Knowledgeable IAs will have access to bargain lists, and will know of important economic releases and the upcoming borrowing calendar. These IAs are well placed to add income and yield to your portfolios. The experienced advisor also gains the respect of the traders, lets them know what his or her specific areas of interest are, and thus gets calls when specific offerings appear.

Following are some representative questions and comments that IAs will use with their bond-trading department.

Q: My client can buy those bonds cheaper somewhere else.

A: This is a loaded one; most of these apparent discrepancies can be explained because this is not an apples-to-apples comparison. In other words, the client (or IA) may be comparing the identical security, but one yield may be quoted in annual terms and the other one in semi-annual terms. At 5 percent this difference is 6.25 basis points even though the price is the same (see the chapter on basic math). As well, the comparison may be hours or days old, and bond prices do change minute by minute. The securities being compared may not be exactly alike; there may be slight differences in maturity, credit, or features that may affect the relative yield between different fixed-income products. Another explanation could be that another investment dealer is offering a special sale. Worse yet, advisors may be trying to get a lower transfer price (the price at which the trading department transfers bonds to IAs). This is the IAs’ cost and they add a markup to earn a commission. If they do obtain a lower price from the trader, that improvement is not necessarily passed on to clients. Needless to say, traders become wise to ploys such as these and handle the offending parties appropriately.

The relevance of this is that it is an over-the-counter market and there are inefficiencies. Clients may receive, or say that they receive, better prices from another FI. It may be because one IA is charging more commission than the other or that one firm’s bond desk is running a special on a certain bond. It does underscore the point that the more experienced your IA is, the better the treatment you will receive.

Q: Why can I not buy this bond at the same price as quoted in the weekend newspaper?

A: This is a very common question. The newspaper quotations are snapshots of market prices at a particular instant, typically 4:00 p.m. the previous business day. They are quotations representing only the market for transactions larger than $1 million and before any brokerage or commissions are added. The large lists of bond quotations in, for example, the weekend Toronto Star or the Globe and Mail are matrix-priced, meaning that each bond is not priced individually but in relationship to the benchmark issues. In such cases, there is no allowance for any idiosyncrasies or features of a bond that could affect its price. What happens is that a keen client, eager to learn the ways of the bond market and therefore studiously following everything, discovers a few really high-yielding bonds in the weekend paper and phones an IA on Monday morning to scoop up these bargains before those slow-moving bond traders catch on. The advisor, of course, smelling a sale, rushes to the bond desk asking for offerings without a shred of thought. In almost every case, these bonds have certain features — usually call features — that mean that the issuer may redeem those bonds before maturity and the advertised yield in the newspaper may not be realized. (The papers may not have the inclination or the space to show the yield to call.) In addition, the issue may also be small, or a private placement, in the hands of foreigners, or the whole issue could have been stripped with no public float at all. There is a public site (www.canadianfixedincome.ca) where you can obtain live wholesale markets. These are also not prices at which individuals will be able to transact, but they do offer valuable market information.

Q: My client just inherited $350,000. What do I do?

A: A good retail fixed-income desk will ask the IA more questions as to quality and maturity preferences and then construct a customized portfolio. If an IA just recommends a bond fund, then this IA is not doing his or her job.

How to Get Along With a Bond Desk

I have seen all aspects of human behaviour in managing retail fixed-income trading desks. I have built and managed three retail-oriented fixed-income trading desks since 1988. The first was for Dean Witter Canada, which was eventually sold to Midland Walwyn, which got taken over by Merrill Lynch, whose retail arm was sold off to CIBC Wood Gundy, where many of the Dean Witter IAs had come from when Wood Gundy got out of retail. What a business! The second one was built for First Marathon Securities, which needed a retail-oriented bond-trading desk to service the fixed-income needs of its rapidly growing Correspondent Network, which today clears and trades for a very large number of financial organizations: some small investment dealers, some large ones, some investment counselling firms, and some investment subsidiaries of very large FIs. First Marathon was purchased by the National Bank in 1999 and merged with Lévesque, Beaubien. NBCN became the abbreviation for the National Bank Correspondent Network. And finally, the third was another retail-focused fixed-income trading desk, this time for Blackmont Capital Inc., an independent investment dealer focused on the individual investor. MacQuarie,a prominent Australian bank, bought Blackmont from CI Financial and renamed it MacQuarie Private Wealth. To all of MacQuarie’s IAs, my former department offers a complete array of fixed-income securities via an online, real-time order entry system. It also offers customized portfolio design, market commentary, and research. As well, it offers fixed-income securities to some of the more than two hundred IIROC members that do not have their own inventories.

Each of these trading desks has had the same philosophy — to be in charge of its own destiny and to be driven and compensated primarily by the growth in the retail fixed-income business. In this way, IAs know that their bond-trading desk is served by helping their business to grow.

On the one hand, I have observed thoughtless, short-term-oriented IAs adversely affecting clients’ returns while alienating the trading desk at the same time. On the other, I have had the pleasure of working with enlightened, informed, intelligent, long-term-oriented IAs who reap huge benefits for their clients by adroit use of the market and the desk. No more than 10 percent of any sales force falls into this latter category — hence my focus on selecting the right advisor.

I have seen and heard it all: IAs looking for an ask when they really wanted a bid; strange trades initiated at month end with the sole motive of generating commission; outright lies (e.g., saying XYZ broker is offering something cheaper), pleading for a lower price only to keep the difference and not pass the savings on to the client; apples and oranges comparisons, days or hours apart; confusing annual and semi-annual yield, yelling and screaming when the price cannot be matched or has changed. To a person, these IAs say they cannot trust the desk and are getting ripped off, when really it is they who are hurting themselves and their clients through this time-wasting, counterproductive behaviour.

Trading desks make or take a thousand calls a day and execute more than a thousand trades per day. They know what they are doing, what the prices are right now. Some IAs attempt to outsmart them; what they should be doing is being straight with them, and they will receive the same treatment in return. IAs should also be spending more time with their clients. I am always amazed when an acquaintance tells me that not only does he not understand what his money is invested in, but that he does not see his advisor routinely, perhaps once a year at best! At stake here is the return to the client, as consistently bad behaviour makes us leery of certain IAs, and therefore their clients will suffer.

Contrast this with informed IAs who realize that the desk is on their side — at least a tool for them to use, at best an active partner in helping improve their business. They trust the traders and realize that there are bargains to be had at different times as well as (with the market knowledge of the desk) assistance in timing purchases to again help clients achieve superior yield. These astute IAs are more aware of pending release times for important, market-moving news and new-issue timing. With proper desk contact, IAs learn of temporary sell-offs or rallies to take advantage of. Trusting the desk or at least being straight with it yields huge advantages. Contrast this with the mistrustful IAs who play petty games with the traders, getting their backs up. In fact, through frequent communication with the desk, IAs may pick up gratuitous tips or advice to further their clients’ (and their own) after-tax standard of living.

You want to seek out an IA who has a sound working knowledge of the fixed-income markets and who does a high percentage of business in fixed-income. Listen to the IA describe how he or she gets along with the desk; if it’s not mentioned, ask. The answer will reveal a lot. Human nature is important; traders are human and will respond favourably to professional treatment. Of course, trading desks are not perfect. One mistake or misunderstanding in an over-the-counter market may colour one’s opinion for a long time. However, a quick glance at the commission statistics will reveal in almost every case that the IAs who give the desk a hard time are in the lowest quartile of production. They waste too much time playing games with the desk and not enough time taking care of their clients. The top quartile of producers do not waste their time or the traders’ time through childish antics. Every retail organization where I have worked has these IAs. It is the same as with a lot of other businesses, where 10 percent of the IAs handle 90 percent of the business. You want to find one of those IAs. The other 90 percent complain and play games and just waste too much time on unimportant issues.

Transparency, Transfer Prices, Markups, and Commissions

Transparency: that which is transparent; a transparent object or medium

Despite efforts to make the bond market more transparent, there is still a dearth of websites where bond prices may be obtained. With the explosion in internet usage, investors are now used to finding and using useful sites. The following three organizations offer free quotes and also offer a subscription service for greater access and visibility.

CI Financial owns Perimeter CBID, which is a marketplace where several liquidity providers make available bids and offerings on a wide selection of fixed-income securities. Perimeter CBID operates a public website: www.canadianfixedincome.ca. Besides offering live markets on approximately 2,500 bonds, it also contains the previous day’s closing prices, actively traded corporates, and featured quotations. For $19.95 per month, investors may subscribe to Bondview, which offers a more in-depth view of CBID’s marketplace. CBID is not perfect, as it does not have all the liquidity providers, but it does present an accurate view of the retail bond market.

The TMX owns PC Bond, purchased from Scotia Capital. It has the most complete data base for bond prices and performance in Canada. The programs and analytics are aimed squarely at institutional customers, being far too expensive for individual investors. However, their wonderful site, www.canadianbondindices.com, has a wealth of information suitable for individual investors. It offers the performance of the different sectors of the bond market on a daily and historical basis. It offers live prices on a variety of government and corporate bonds along with information as to volume traded. They do not offer a subscription service.

CanPX is a joint venture of the primary dealers in Canada plus certain inter-dealer brokers. It provides a composite display of real-time bids and offerings on a variety of bonds. It is geared to the wholesale market, also, but their website offers hourly updates on the benchmark Government of Canada treasury bills and bonds. On a subscription basis, and only available through Gmarkets (www.gmarkets.ca) are two subscriptions: All governments for $125 per month and their corporate bonds for the same amount. I recommend the corporate bond subscription, as this is the most current list of corporate bonds available. In addition, GMarkets has their own product called Pilot, which is a comprehensive view of all aspects of the financial markets. It costs $485 per month but is well worth it.

Another excellent source for individual investors is the Bank of Canada’s site: www.bankofcanada.ca.

One of the main reasons — if not the main one — why investors either do not know enough about fixed-income markets or are too timid to venture into them is the lack of transparency of this giant market. As we have discussed, there is no central location for the bond market. Instead, it operates on an over-the-counter, decentralized basis. There is no ticker tape showing trades as they take place, nor is it easy to obtain a quotation. In other words, most of the bond market is opaque, not transparent. Whether transparency is the proper word or not is debatable. Prices of the most liquid bonds, Government of Canadas, are highly visible and widely quoted on a number of websites (www.candeal.ca and canadianfixedincome.ca are two). I feature Perimeter CBID’s live quotes on my website, www.inyourbestinterest.ca, and there are many provincial and corporate prices in addition to the benchmark Canadas. Of course, they represent a tiny percentage of all the bonds outstanding (some 60,000 issues) but at least it is a start. Regulators are pushing for more transparency and I am on a committee of IIROC that is exploring improvements in this area. By now, most clients can see the yields of the bonds that they have traded on their transaction statements. There is a strong push to reveal the commissions charged on each fixed-income transaction. Although most fellow committee members oppose this, I am in favour of it. Investors know how much they are charged for equity trades, so why would they not get to see how much they are paying for a bond trade? There really is not much to hide, as the fees charged on bond transactions are generally fair and do not vary significantly from equity commissions.

Policy 5 is a code of conduct for IDA member firms trading in wholesale domestic debt markets. It was developed at the behest of the Department of Finance and the Bank of Canada. Its purpose is to “ensure the integrity of Canadian debt markets and thereby to encourage liquidity, efficiency and the maintenance of active trading and lending and promote public confidence in such debt markets.” You can read the entire policy at www.iiroc.ca.

In recent years, Policy 5B was added. This was aimed directly at the retail fixed-income markets. It requires all investment dealers to have written policies and procedures in place for dealings with individual investors in the Canadian retail debt market. In particular, each investment dealer must have in place a recommended commission or markup for each fixed-income product that they trade. Such a grid would look like this.

While not generally available, you can ask for and expect to receive a copy of your FI’s grid. At the very least, your IA should be able to tell you what the grid is. As you can see, these are fair commissions (generally, the longer the term, the higher the commissions). This is for two reasons. First, the longer the maturity the less the yield is affected for a given commission, and second, it rewards the IA, as most bonds, especially strips, are buy and hold securities.

Other proposals are being pushed forward that would require retail bond-trading desks to maintain records demonstrating that their dealing prices are fair. This is a long way from implementation, but it is clear that the push is on to ensure that the retail fixed-income investor will be assured of getting a fair shake.

A huge hurdle facing bond market transparency has to do with the fact that IAs and their clients are captive to their firm’s bond-trading desk. The Big Six — RBCDS, TD Securities, Scotia Capital, BMO Nesbitt, CIBCWM, and National Bank Financial — are loath to give up their monopoly and trade flow. I am positive that they will not do so unless legislation is enacted requiring them to participate in a commingled marketplace for bonds. It seems to me that if every dealer who wanted to could provide their bids and offerings to a centralized system, and also allow their clients access to the same system, that would solve the transparency debate once and for all. I am also positive that this is going to be snail-like in its progress, as the Big Six have nothing to gain from it; the whole retail fixed-income business is not a very high priority for them. Regulators do run the risk of imposing so many costs and rules on the investment dealers that the dealers will move their clients away from this already expensive business.

The retail fixed-income business has shrunk dramatically as a percentage of investment dealers’ revenues as a result of plummeting nominal yields and the surge in (alas) structured products. Sadly, these products (chronicled in the product chapter) are not created in your best interest, but rather are designed to put big fees into the hands of the investment banking groups and big commissions in the hands of the IAs. As I stress, to be a do-it-yourselfer in the world of bonds, you will need to find a knowledgeable IA with a large book of business such that he/she does not need to do a lot of transactions with you to make a living. Otherwise, and I have heard from many of you, you can open an online account with a discount broker. To assist you, I have conducted my own hands-on survey of the various online fixed-income suppliers, which you will find on page 58.

The investment dealers make their markets in bonds using their own capital, unlike the stock market, where most trades occur on an agency basis (buyer and seller meet and a transaction takes place without the investment dealer needing to use capital).

Why does this difference exist, and what is being done about it? First of all, the majority of the outstanding fixed-income issues do not trade every day, with the noticeable exception of the very liquid Government of Canada benchmark issues. The reason they do not trade more frequently is that a provincial government or a corporation issue bonds of various types, maturities, and amounts. Some issues end up being owned by a few large investing institutions, leaving no “float” (refer back to the TRP example on page 29) Others may be stripped and sold as zero coupon securities. Also, some issues are too small. Foreign investors may acquire a large percentage of an issue.