Chapter
6
Fixed-Income Securities:
Features and Types
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6
Fixed-Income Securities:
Features and Types
CHAPTER OUTLINE
What is the Fixed-Income Marketplace?
• The Rationale for Issuing Fixed-Income Securities
What are the Basic Features and Terminology of Fixed-Income Securities?
• Basic Terminology
• Describing Bond Features
• Liquid Bonds, Negotiable Bonds and Marketable Bonds
• Strip Bonds
• Callable Bonds
• Extendible and Retractable Bonds
• Convertible Bonds and Debentures
• Sinking Funds and Purchase Funds
• Protective Provisions of Corporate Bonds
What are Government of Canada Securities?
• Marketable Bonds
• Treasury Bills
• Canada Savings Bonds
• Canada Premium Bonds
• Real Return Bonds
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What are Provincial and Municipal Government Securities?
• Guaranteed Bonds
• Provincial Securities
• Municipal Securities
What are Corporate Bonds?
• Mortgage Bonds
• Collateral Trust Bonds
• Equipment Trust Certificates
• Subordinated Debentures
• Floating-Rate Securities
• Corporate Notes
• Domestic, Foreign and Eurobonds
• Preferred Securities
• High-Yield Bonds
What are some Other Fixed-Income Securities in the Marketplace?
• Bankers’ Acceptances
• Commercial Paper
• Term Deposits
• Guaranteed Investment Certificates
• Fixed-Income Mutual Funds and ETFs
How to Read Bond Quotes and Ratings?
Summary
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LEARNING OBJECTIVES
By the end of this chapter, you should be able to:
1. Describe the fixed-income market and discuss the rationale for issuing debt instruments.
2. Define the terms used in transactions involving bonds, describe bond features, explain the use of a
sinking fund and a purchase fund, and describe the protective provisions found in a bond indenture.
3. Compare and contrast the types of Government of Canada securities.
4. Compare and contrast the different types of provincial government securities and municipal
debentures.
5. Identify the different types of corporate bonds and describe their features.
6. Describe the features of other fixed-income securities, including bankers’ acceptances, commercial
paper, term deposits and guaranteed investment certificates.
7. Interpret bond quotes and summarize and evaluate bond ratings.
INVESTING IN DEBT
Governments, corporations and many other entities borrow funds to finance and expand their operations.
In addition to bank lending and private loans, these entities also have the option of issuing fixed-income
securities in the financial markets. From the investor’s perspective, purchasing a fixed-income security
essentially represents the decision to lend money to the issuer. Investors become creditors of the issuing
organization and do not gain ownership rights as they would with an equity investment.
Many investors overlook the fixed-income market. Trading activity on the TSX and other international
stock markets grabs most of the investing public’s attention. Trading in bonds, Treasury bills and other
fixed-income securities tends to be less enticing because these are not the very public price spikes that are
seen in, for example, the shares of small capitalization companies.
Most investors would be surprised to learn the extent of the fixed-income market. To put it in perspective,
the dollar amount traded on Canada’s bond markets consistently averages about ten times that of total
equity trading in any given year. In spite of that value and because they are less visible than the equity
markets, bond and fixed-income markets generally remain off the radar screens of most investors. Further,
investors generally lack an understanding of the features, characteristics and terminology of the fixedincome market.
In this first chapter on fixed-income securities, we look at the terminology, describe the reasons
governments and corporations issue fixed-income securities, and describe the features and characteristics
of the securities available in the fixed-income markets.
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KEY TERMS
After-acquired clause
Guaranteed Investment Certificates (GICs)
Bond
Instalment debenture
Callable bond
Maturity date
Canada Premium Bonds (CPBs)
Moody’s Canada Inc.
Canada Savings Bonds (CSBs)
Mortgage
Canada yield call
Par value
Collateral trust bond
Payback period
Conversion price
Principal
Convertible bonds
Purchase fund
Coupon rate
Real return bonds
Debenture
Redeemable bond
DBRS
Retractable Bond
Election period
Serial bond
Equipment trust certificate
Sinking funds
Eurobonds
Standard & Poor’s Bond Rating Service
Extendible bonds
Strip Bond
Extension date
Subordinated debentures
Face value
Term to maturity
First mortgage bond
Treasury bills
Fixed-income securities
Trust deed
Floating-rate securities
Yield
Forced conversion
Zero coupon bond
Foreign bonds
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CANADIAN SECURITIES COURSE • VOLUME 1
WHAT IS THE FIXED-INCOME MARKETPLACE?
Fixed-income securities represent debt of the issuing entity. The terms of a fixed-income security
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 most
case, 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, including
bonds, debentures, money market instruments, mortgages, and even preferred shares, reflecting
widely different borrowing needs as well as investor demands. Borrowers modify the terms of a
basic fixed-income security to suit both their needs and costs, and to provide acceptable terms to
various lenders.
Many Canadians are concerned about high government debt levels. We know that corporate debt
can lead to bankruptcy and personal debt can keep individuals from getting ahead financially. It
is useful to explore the rationale for borrowing money. There are two main reasons:
•
To finance operations or growth
•
To take advantage of operating leverage
If a government spends more on programs and other payments than it receives in tax revenue, it
must make up the difference by borrowing money. Most governments borrow by issuing fixedincome securities. Government borrowing is an example of issuing fixed-income securities to
finance operations.
The Rationale for Issuing Fixed-Income Securities
Unlike governments, companies have more options when they find themselves spending more
on expenses than they receive in revenue; issuing fixed-income securities is only one option.
They can also use cash on hand, raise cash by selling assets, borrow from the bank, or issue
equity securities. The choice of financing method will depend on the costs associated with each.
Companies generally prefer to raise money from the lowest-cost source possible.
In many cases, companies do not issue fixed-income securities to finance year-to-year cash
shortfalls. These will usually be financed with cash on hand or bank borrowing. A company that
consistently finds itself using more cash than it takes in will not be in business for too long.
Most companies issue fixed-income securities to finance growth. This usually means using the
proceeds of a fixed-income issue to add to or expand the companies’ current operations, 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 another company or other specific assets, they
will usually state that the proceeds will be used for “general corporate purposes.” This typically
means that the company will invest the proceeds in current operations.
Companies also borrow to take advantage of operating leverage. If companies believe they can
earn a greater return on cash invested in their business than it would cost to borrow money, they
can increase the return on shareholders’ equity by borrowing money. This is what is meant by
financial leverage. The analysis that determines whether to use leverage is made on an after-tax
basis. This increases the leverage potential of bonds because, unlike dividends on equity securities,
the interest payments on bonds are a tax-deductible expense for the corporation.
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Example: Suppose a company wants to open a new plant to increase production capacity. It could
borrow $1 million for the plant at 10% interest, at a cost of $50,000 a year after 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-tax profits are projected to be less than $50,000 a year,
the company will either abandon the project or find a cheaper source of funds.
WHAT ARE THE BASIC FEATURES AND TERMINOLOGY OF
FIXED-INCOME SECURITIES?
A bond is a long-term, fixed-obligation debt security that is secured by physical assets. The
details of a bond issue are outlined in a trust deed and written into a bond contract. Bonds are
considered fixed-income securities because they impose fixed financial obligations on issuers –
the payment of regular interest payments and the return of principal on the date of maturity. If
the bond goes into default, which means the issuer can no longer meet these fixed obligations,
the trust deed provisions allow the bondholders to seize specified physical assets and sell them
to recover their investment. These physical assets could be a building, a railway car, or any other
physical property owned by the issuing company.
A debenture is a type of bond that promises the payment of regular interest and the repayment
of principal at maturity but may be secured by something other than a physical asset. For
this reason, debentures are also referred to as unsecured bonds. In contrast to regular bonds,
debentures are typically secured by a general claim on residual assets or by the issuer’s credit
rating.
In this chapter, we follow the industry practice of referring to both types as bonds, unless the
difference is important. For example, government bonds are never secured by physical assets, and
so technically are really debentures, but in practice they are always referred to as bonds.
Basic Terminology
Exhibit 6.1 summarizes the important characteristics of a bond.
EXHIBIT 6.1 SUMMARY OF THE MAIN CHARACTERISTICS OF A BOND
A $1,000, 6%, semi-annual coupon bond due May 1, 2025 will pay $30 to the bondholder on May 1
and on November 1 of each year until maturity. The semi-annual payment of $30 represents the fixed
obligation the issuer is required to make for the life of the bond. The yield on the bond on May 1, 2012
is 5.2% and trades at a price of 107.491 for a total cost of $1,074.91.
Where:
$1,000
The face or par value of the bond – the principal amount the bond issuer contracts
to pay at maturity to the bond holder. Upon maturity, the issuer will pay back to the
investor the principal amount of $1,000.
6%
The coupon rate – the rate at which the bond issuer pays regular interest. Most
bonds pay fixed coupon rates.
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CANADIAN SECURITIES COURSE • VOLUME 1
EXHIBIT 6.1
SUMMARY OF THE MAIN CHARACTERISTICS OF A BOND – Cont’d
May 1, 2025
The maturity date – the date at which the bond matures and the principal amount of
the loan is paid back to the investor holding the bond. On May 1, 2012, the term to
maturity in the example above is 13 years.
107.491
The price of the bond – bond prices are quoted using an index with a base value of
100. In the example above, the bond is quoted at a price of 107.491, which means
each $100 of face value will cost $107.491 to purchase.
Based on the quoted price of 107.491, the price of a $1,000 face value bond is
currently 107.491% of its face value, or $1,074.91 (107.491/100 x $1,000). Another
way of thinking about the price: a $1,000 face value bond has 10 units of $100 face
value, and therefore costs 10 x $107.491.
5.2%
The yield – the bond yield is an approximate measure of the annual return on the
bond if it is held to maturity.
Describing Bond Features
Interest on Bonds: While most bonds pay a fixed coupon rate, bonds with variable coupon rates
are typically referred to as floating-rate securities. The coupon indicates the income that the
bond investor will receive from holding the bond, and is also referred to as interest income, bond
income or coupon income.
Interest payment provisions may also take other forms:
•
Coupon rates can change over time, according to a specific schedule (e.g., step-up bonds,
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 the form of
a return based on future factors, such as the change in the level of an equity index. 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 (for the purposes of this course, one should assume
that bonds pay interest semi-annually unless stated otherwise). In all cases, the amount of interest
at each payment date is equal to the coupon rate divided by the number of payments per year.
Denominations: Bonds can be purchased only in specific denominations. The most commonly
used denominations are $1,000 or $10,000. Larger denominations may be issued to suit the
preference 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 millions of dollars.
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Bond pricing: A bond trading at a quoted price of 100 is said to be trading at face value, or par.
A bond trading below par, say at a price of 98, is said to be trading at a discount (the 98, based
on the index of 100, indicates the bond is trading at 98% of par). A bond trading above par, say
at a price of 104, is said to be trading at a premium.
The yield of a bond should not be confused with the coupon rate; they are two different things.
While the coupon rate, along with the face value and maturity date, do not change, the price and
yield of a bond fluctuates from day to day. 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.
Categorizing bonds: 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 five to ten years are called medium-term bonds, and long-term bonds have a term to maturity
greater than ten years. Table 6.1 shows these categories.
TABLE 6.1
CATEGORIZATION OF BONDS BY TERM TO MATURITY
Money Market
Short-Term Bonds
Medium-Term Bonds
Long-Term Bonds
Up to one year
term to maturity
From one up to 5 years
remaining to maturity
From 5 to 10 years
remaining to maturity
Greater than 10 years
remaining to maturity
Application: If a bond was issued eight years ago with an original term of 15 years, it is no longer
referred to as a 15-year bond. Because eight years have passed and only seven remain in the life of the
bond, it is referred to as a seven-year bond. This means a bond that is classified as a long-term bond
when first issued will, over time, become a medium-term bond, a short-term bond and eventually a
Money Market security (provided the bond is not called before its maturity date).
Money market securities are a special type of short-term fixed-income security, generally with
terms of one year or less. Certain high-grade short-term bonds may trade as money market
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 commercial paper.
Liquid Bonds, Negotiable Bonds and Marketable Bonds
Liquid bonds are bonds that trade in significant volumes and for which it is possible to make
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 been signed,
and so on). That a bond be negotiable is not much of an issue anymore, as most bonds are
book-based now and certificates are not issued.
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Marketable bonds are bonds for which there is a ready market. For example, a private placement
or other new issue may be marketable (clients will buy it) because its price and features are
attractive. It would not necessarily be liquid, however, since most private placements do not have
an active secondary market.
Strip Bonds
A strip bond or zero coupon bond is created when a dealer acquires a block of high-quality
bonds and separates the individual future-dated interest coupons from the rest of the bond
(known as the underlying bond residue). The dealer then sells each coupon as well as the
residue separately at significant discounts 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
compounded rate of return when they mature at par. Similar to Treasury bills, the income is
considered interest rather than a capital gain and tax must be paid annually on the income, even
though the interest income on the bond is not received until the instrument matures. For this
reason, it is often recommended that strip bonds be held in a tax-deferred plan such as an RRSP.
Example: An investment dealer might buy $10 million face value of a five-year, semi-annual pay
Government of Canada bond with a coupon of 5.50%, intending to strip the bond for sale to clients.
With this bond, the dealer can create 10 different strip coupons, each with a face value of $275,000
($10 million × 0.055 × 1/2) and each with a different maturity date, as each coupon will have its own
maturity date. The face value of each strip coupon is equal to the dollar value of each interest payment
on the regular bond. The bond’s principal repayment can be sold as a residual with a face value of
$10 million.
The strip coupons are then sold at a discount to the $275,000 face value. For this example, let’s
assume that it sells today for $204,626 (bond price calculations are covered in Chapter 7). An investor
buying this strip bond today and holding it until maturity receives $275,000 in five years time. The strip
bond does not generate any other regular income flow during this five-year period for the investor.
Callable Bonds
Bond issuers often reserve the right, but not the obligation, to pay off the bond before maturity,
either to take advantage of lower interest rates, or simply to reduce their debt when they have the
excess cash to do so. This privilege is known as a call or redemption feature. 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 or redeemed.
In Canada, most corporate and provincial bond issues are callable. Government of Canada bonds
and municipal debentures are usually non-callable.
STANDARD CALL FEATURES
A standard call feature allows the issuer to call bonds for redemption at a specified price on
specific dates or during specific intervals over the life of the bond. The call price is usually set
higher than the par value of the bond. This provides a premium payment for the holder, as it is
somewhat unfair to take away from the investor an investment from which he or she expected to
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receive a stated income for a certain number of years. The closer the bond is to its maturity date
before it is redeemed, the less the hardship for the investor. In recognition of this principle, the
redemption price is often set on a graduated scale and the premium payment becomes lower as
the bond approaches the maturity date.
Provincial bonds are usually callable at 100 plus accrued interest. Accrued interest refers to the
interest that has accumulated since the last interest payment date. Accrued interest belongs to the
holder of the bond.
Example: DEF Corporation’s call feature (for other than sinking fund purposes) is shown in Table 6.2.
In this example, if you owned a $1,000 debenture of this issue and your debenture was called:
•
•
•
after May 1, 2012, and before or on April 30, 2013, you would receive $1,036.80 plus
accrued interest;
after May 1, 2013 and before or on April 30, 2014, you would receive $1,024.60 plus
accrued interest; and
so on, with the premium gradually reduced according to Table 6.2.
TABLE 6.2
EXAMPLE OF A CORPORATE DEBT CALL FEATURE
DEF Corporation 7.375% debentures due May 1, 2016. Not redeemable before May 1, 2012.
Thereafter, redeemable on 30 days’ notice up to the 12 months ending May 1 of each year, as follows:
2012
103.68
2013
102.46
2014
101.23
2015
100.00
Thereafter redeemable at par to maturity.
For callable bonds, the period before the first possible call date (during which the bonds cannot
be called) is known as the call protection period.
CANADA YIELD CALLS
Most corporate bonds are issued with a call feature known as a Canada yield call. These allow
the issuer to call the bond at a price based on the greater of (a) par or (b) the price based on the
yield of an equivalent-term Government of Canada bond plus a yield spread. A yield spread is
simply an additional amount of yield. Generally, this spread is less than what the spread was when
the bond was issued, and remains constant throughout the term of the issue.
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CANADIAN SECURITIES COURSE • VOLUME 1
EXHIBIT 6.2
CANADA YIELD CALL
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, so 200 basis points equals 200/100 or 2%.) The corporate
bond contains a Canada yield call of +50, meaning that the bond can be called at a price based on a
yield of 50 basis points over Canada bonds, with a minimum call price of par.
The following year, with 9-year Canada bonds yielding 4.75%, the company decides to call the bonds.
Given the Canada yield call of +50, the company must call their bonds at a price based on a yield of
5.25% (which is 4.75% + 0.50%), regardless of where their bonds have been trading in the market
before the call. At 5.25%, the price of this 9-year, 7% coupon bond would be $112.42 per $100 par
value.
Application: This calculation is explained in Chapter 7, Calculating the Fair Price of a Bond. After
reviewing Chapter 7, turn back to the Canada Yield Call example above and try your hand at
calculating the call price of $112.42.
Table 6.3 summarizes the corporate bond’s major characteristics at the time of issue and at the
time the bond is redeemed by the issuer.
TABLE 6.3
EXAMPLE OF A CANADA YIELD CALL
When Issued
When called 1 year later
10 years
9 years
$100
$100
Coupon Rate
7%
7%
Yield
7%
5.25%
Price
$100
$112.42
Term to Maturity
Face Value
Note that while the term to maturity has changed, the actual date of maturity as well as the face
value and coupon remain unchanged. Since the corporation is required to use a yield of 5.25%
to calculate the redemption price, the redemption price is significantly higher than its face value.
Note also from earlier discussions in the chapter the relationship between the yield, the coupon
rate and the price of the bond. When the yield and coupon rate are the same, the price of the
bond is par or 100. When the yield falls below the coupon rate, the price of the bond rises higher
than par.
Extendible and Retractable Bonds
Some corporate bonds are issued with extendible or retractable features.
Extendible bonds and debentures are usually issued with a short maturity term (usually five
years), but with an option for the investor to exchange the debt for an identical amount of
longer-term debt (usually ten years) at the same or a slightly higher rate of interest by the
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extension date. In effect, the maturity date of the bond can be extended so that the bond
changes from a short-term bond to a long-term bond.
Example: GHI International Inc. 7% Extendible Junior Bonds, Series B2.1, due July 26, 2015, are
extendible to July 26, 2035 from July 26, 2015 at a rate of 7.125%.
Retractable bonds are the opposite of extendible bonds. These bonds are issued with a long
maturity term (usually at least ten years), but give investors the right to turn in the bond for
redemption at par several years sooner (usually five years) by the retraction date.
Example: JKL Inc. 4% bonds due June 30, 2025, are retractable at par on June 30, 2015.
With both extendible and retractable bonds, the decision to exercise the maturity option must
be made during a time period called the election period. In the case of an extendible 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 the appropriate trustee or agent of the debt
issuer either to extend the term of the bond or to allow it to mature on the earlier date. If the
holder takes no action, the bond automatically 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 agent before the
retraction date of his or her decision to shorten the term of the bond, the debt remains a longer
term issue.
Convertible Bonds and Debentures
Convertible bonds and debentures combine certain advantages of a bond with the option of
exchanging the bond for common shares. In effect, a convertible security allows an investor to
lock in a specific price (the conversion price) for the common shares of the company. The right
to exchange a bond for common shares on specifically determined terms is called the conversion
privilege.
Convertibles have the characteristics of regular bonds, in that they have a 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 bonds into common shares at the holder’s
option at stated prices over stated periods.
WHY CONVERTIBLES ARE ISSUED
The addition of a conversion privilege makes a bond more saleable or attractive to investors. It
tends to lower the cost of the money borrowed and may enable a company to raise equity capital
indirectly on terms more favourable than those possible through the sale of common shares.
The convertible bond permits the holding of a two-way security. In other words, it combines
much of the safety and certainty of the income earned on a bond with the option to convert it
into common shares and benefit from any increase in their value. The convertible 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 the
common shares.
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CHARACTERISTICS OF CONVERTIBLES
For most convertible bonds, the conversion price is gradually raised over time to encourage early
conversion. A properly drawn trust deed provides that, if the common shares of the company
are split, the conversion privilege will be adjusted accordingly. This is known as protection against
dilution.
Convertible bonds may normally be converted into stock at any time before the conversion
privilege expires. However, some convertible debenture issues have a clause in their trust deeds
that stipulates “no adjustment for interest or dividends.” This clause excuses the issuing company
from having to pay any accrued interest on the convertible bond that has built up since the last
designated interest payment date. Similarly, any common stock received by the bond holder from
the conversion will normally entitle the holder only to dividends declared and paid after the
conversion takes place.
Convertibles are normally callable, usually at a small premium and after reasonable notice.
FORCED CONVERSION
Forced conversion is an innovation built into certain convertible debt issues to give the issuing
company more scope in calling in the debt for redemption. This redemption provision usually
states that once the market price of the common stock involved in the conversion rises above a
specified level and trades at or above this level for a specific number of consecutive trading days,
the company can call the bonds for redemption at a stipulated price. The price is much lower
than the level at which the convertible debt would 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 for several
reasons:
•
•
•
a forced conversion can improve the company’s debt/equity ratio. A high debt/equity ratio
may indicate that a company has borrowed excessively, increasing the financial risk of the
company
a forced conversion relieves the issuer of having to make mandatory interest payments on
debt once investors convert their debt into equities
a forced conversion can also help to make room for new debt financing if needed
However, it is not so disadvantageous to the debt holder that it detracts from an issue when it is
first sold. Once the price of the convertible debt rises above par, subsequent prospective buyers
should check the spread between the prevailing purchase price and the possible forced conversion
level.
Example: The 7% convertible bonds of RFC Inc. that are due February 28, 2020, have a forced
conversion clause. Before February 28, 2015, the bonds are convertible into 44.033 common
shares for each $1,000 of face value. This gives them a conversion price of $22.71 a common share
($1,000/44.033). The bonds are not redeemable before February 1, 2013. The company has the option
to pay the principal amount on redemption or maturity, or to pay the investor in common shares. The
number of common shares will be obtained by dividing $1,000 by 95% of the weighted average trading
price for 20 consecutive trading days on the TSX, ending five days before maturity or the date fixed
for redemption.
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This is considered to be a forced conversion clause, because the client must choose whether to
convert the bond into common shares at $22.71 a share or accept the company’s redemption
offer, which could force the investor to pay a considerably higher price per share. For example, if
the weighted average price was $27, the company would divide $1,000 by $25.64 (95% of $27)
to arrive at 39 shares. The investor would receive 39 shares, compared to 44.033 shares if they
had chosen to convert before the forced conversion was imposed by the issuer.
MARKET BEHAVIOUR OF CONVERTIBLES
The market price of convertible bonds is influenced by their investment value as a fixed-income
security and by the price of the common shares into which they can be converted. When the stock
price of the issuing company is below the conversion price, the convertible behaves like any other
fixed-income security with the same credit rating, term to maturity, yield, etc. However, because these
debentures can be converted into common shares, their price behaves differently than comparable
fixed-income securities when the price of the underlying stock rises above the conversion price. The
conversion price is the bond price divided by the number of shares the debenture can be converted
in to.
Let’s take an ABC 6% convertible bond that trades at $980 and can be converted into 40 ABC
common shares that currently trade at $22 a share. Even if interest rates rise sharply and comparable
bond prices fall, the ABC bond will have a conversion value of at least $880 because it can be
converted into 40 common shares that trade at $22 (40 shares × $22 = $880).
If the common shares now trade at $27, the price of the bond will rise accordingly to at least $1,080,
even if comparable bonds still trade at $980. The reason is simple: the investor holds a security that
can be sold today for $1,080 (40 shares × $27) if converted.
The conversion price is the bond price divided by the number of shares the debenture can be
converted in to. In this example, the conversion price of the ABC convertible is $24.50 ($980/40).
Sinking Funds and Purchase Funds
Some issuers must repay portions of their bonds for redemption before maturity, either by
calling them on a fixed schedule of dates (via a sinking fund obligation) or by buying them in
the secondary market when the trading price is at or below a specified price (through a purchase
fund).
Some corporate bonds have a mandatory call feature for sinking fund purposes. Sinking funds
are sums of money that are set aside out of earnings each year to provide for the repayment of all
or part of a debt issue by maturity. Sinking fund provisions are as binding on the issuer as any
mortgage provision.
Example: ABC 6.89% debentures, due June 17, 2015, have a mandatory sinking fund. The company
must retire $1,000,000 of the principal amount on June 17 every year, from 2011 to 2015 inclusive. Any
debentures purchased or redeemed by the company other than through the sinking fund can be paid
to the trustee as part of the sinking fund obligation. The debentures are redeemable for sinking fund
purposes at the principal amount plus accrued interest to the date specified.
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Some companies have a purchase fund instead of a sinking fund. Under such an arrangement,
a fund is set up to retire a specified amount of the outstanding bonds or debentures through
purchases in the market, if these purchases can be made at or below a stipulated price.
Occasionally, a bond will have both a sinking fund and a purchase fund.
Example: DEF Inc. 5.5% debentures, due April 15, 2031, have a purchase fund. Beginning on July 1,
2011, the company must make all reasonable efforts to purchase at or below par 1.125% of the
aggregate principal amount during each quarter.
Since sinking fund provisions are binding, whereas purchase funds retire bonds only under the
right market conditions, purchase funds normally retire less of an issue than a sinking fund.
Protective Provisions of Corporate Bonds
In addition to principal repayment features, corporate bonds may also have general covenants
that secure the bond and make it more likely that the investor will receive all that he or she is due.
These clauses are called protective provisions or covenants, and are essentially safeguards in the
bond contract to guard against any weakening in the security holder’s position. The object is to
create a strong instrument that does not force the company into a financial straitjacket
Some of the more common protective covenants found in Canadian corporate bonds are listed
below:
•
Security: In the case of a mortgage, or asset-backed or secured debt, this clause includes
details of the assets that support the debt.
•
Negative Pledge: This clause provides that the borrower will not pledge any assets if the
pledge results in less security for the debt holder.
•
Limitation on Sale and Leaseback Transactions: This clause protects the debt holder
against the firm selling and leasing back assets that provide security for the debt.
•
Sale of Assets or Merger: This clause protects the debt holder in the event that all of the
firm’s assets are sold or that the company is merged with another company, forcing either the
retiring of the debt or its assumption by the new merged company.
•
Dividend Test: This provision establishes the rules for the payment of dividends by the firm
and ensures equity will not be drained by excessive dividend payments.
•
Debt Test: This provision limits the amount of additional debt that a firm may issue by
establishing a maximum debt-to-asset ratio.
•
Additional Bond Provisions: This clause states which financial tests and other
circumstances allow the firm to issue additional debt.
•
Sinking or Purchase Fund and Call Provisions: This clause outlines the provisions of the
sinking or purchase fund, and the specific dates and price at which the firm can call the
debt.
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Complete the following Online Learning Activity
Terminology Review
Can you tell a bond from a debenture? In this activity you will review bond
terminology. As an investment advisor you need to be familiar with key terms
used in the industry since you will be involved with the trading of fixed-income
securities and may be required to explain these securities and their features to
clients.
Complete the Terminology Review
w to check your knowledge of key
fixed-income security terms.
WHAT ARE GOVERNMENT OF CANADA SECURITIES?
The Government of Canada issues marketable bonds in its own name. It also allows Crown
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-term notes that
are “direct obligations of Farm Credit and as such will constitute direct obligations of Her Majesty in
right of Canada. Payment of principal and interest on the Notes 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 maturity date and a
specified interest rate, they are transferable, which means that they may be traded in the market.
This is in contrast to instruments such as Canada Savings Bonds (CSBs) and Canada Premium
Bonds (CPBs), which are not transferable and not marketable.
Marketable Bonds
The federal government is the largest single issuer of marketable bonds in the Canadian bond
market, having direct marketable debt of about $460 billion outstanding as of August 31,
2012, excluding Treasury bills (Source: Bank of Canada). All Government of Canada bonds are
non-callable, that is, the government cannot call them for redemption before maturity.
When comparing the bonds issued by Canadian issuers (corporations, federal, provincial and
municipal governments), investors assign the highest quality rating to federal government
bonds. However, foreign investors compare the quality of Canadian issues to the issues of other
governments. The relative risk of investing in each country is reflected in the yields of their bonds
and the yields fluctuate in response to political and economic events.
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Treasury Bills
Treasury bills are short-term government obligations. They are offered in denominations from
$1,000 up to $1 million and have traditionally appealed to large institutional investors such
as banks, insurance companies, and trust and loan companies, and to some wealthy individual
investors. When the government started offering them in denominations as low as $1,000, their
appeal broadened to retail investors with smaller amounts of money to invest. Treasury bills are
particularly popular when their yields exceed the yield on Canada Premium Bonds and other
retail instruments, such as commercial paper.
Treasury bills do not pay interest. Instead, they are sold at a discount (below par) and mature
at 100. The difference between the issue price and par at maturity represents the return on the
investment, instead of interest. Under the Income Tax Act, this return is taxable as income, not as
a capital gain.
Every two weeks, Treasury bills are sold at auction by the Minister of Finance through the Bank
of Canada. These bills have original terms to maturity of approximately three months, six months
and one year.
Canada Savings Bonds
Canada Savings Bonds (CSBs) are a secure savings product issued and fully guaranteed by the
Government of Canada. The bonds are issued with a three-year term and pay a fixed interest
rate or coupon that is adjusted at the start of each new period. Canadians who invest in CSBs
have the flexibility to redeem their bonds at any time throughout the year. When redeemed, the
bondholder receives the face value plus interest earned for each full month that has elapsed since
the issue date.
Beginning in November 2012, CSBs can only be purchased through the Payroll Savings Program.
This program allows employees to purchase CSBs at their place of work through automatic
payroll deductions. More than 10,000 organizations across Canada participate in the Payroll
Savings Program, including all levels of government, universities, school boards, hospitals, and
corporations.
Canada Premium Bonds
Similar in structure to CSBs, Canada Premium Bonds (CPBs) represent a secure investment
fully guaranteed by the Government of Canada. Like CSBs, the bonds are issued with a
three-year term with interest rates on the bonds set at the start of each period. The bonds are
redeemable at any time throughout the year with the bondholder receiving the face value plus
interest earned up to the last anniversary date of issue at the time or redemption.
In contrast to CSBs, CPBs can be purchased directly through most financial institutions across
Canada, including banks, credit unions and caisses populaires, trust companies and most
investment dealers. CPBs typically pay a higher rate of return than CSBs.
CSBs and CPBs are not transferrable and therefore have no secondary market. As a result, CSBs
and CPBs do not rise and fall in price as market conditions change. Also, no interest is earned
on CSBs or CPBs redeemed within the first three months following the issue date. The sales
campaign for CSBs and CPBs runs from early October to December 1st each year.
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In the current low interest rate environment, CSBs and CPBs pay low rates of return (often
less than inflation) and have fallen out of favour with investors. Together, these bonds currently
represent only a small fraction of the federal government’s borrowings.
Real Return Bonds
The Government of Canada also issues real return bonds (RRB). A RRB resembles a
conventional bond because it pays interest throughout the life of the bond and repays the original
principal amount on maturity. Unlike conventional bonds, however, the coupon payments
and principal repayment are adjusted for inflation. RRBs have a fixed real coupon rate. At
each interest payment date, the real coupon rate is applied to a principal balance that has been
adjusted for the cumulative level of inflation since the date the bond was issued. The cumulative
level of inflation is known as the bond’s inflation compensation.
Example: The Government bonds carry a 4.25% coupon, were priced at 100 at issue date, and
provide a real yield of about 4.25% to maturity on December 1, 2021. Both the semi-annual interest
payments and the final redemption value of each bond are calculated by including an inflation
compensation component.
If inflation (as measured by changes in the CPI) had been 1.5% over the first six-month period
after issue, the value of a $1,000 RRB at the end of the six months would have been $1,015.
The interest payment for the half-year would be based on this amount ($1,015) rather than
the original bond value of $1,000. At maturity, the maturity amount would be calculated by
multiplying the original face value of the bond by the total amount of inflation since the issue
date.
RRBs have risen in popularity since they were first issued, as understanding of their structure has
become more widespread and the net benefit of government-guaranteed inflation protection is
better recognized as a valuable component in constructing a portfolio of securities.
WHAT ARE PROVINCIAL AND MUNICIPAL GOVERNMENT
SECURITIES?
Provincial “bonds,” like Government of Canada “bonds,” are actually debentures. They are
simply promises to pay and their value depends upon the province’s ability to pay interest and
repay principal. No provincial assets are pledged as security. All provinces have statutes governing
the use of funds obtained through the issue of bonds.
Provincial bonds are second in quality only to Government of Canada direct and guaranteed
bonds because most provinces have taxation powers second only to the federal government.
Different provinces’ direct and guaranteed bonds trade at differing prices and yields, however.
Bond quality is determined by two primary factors: credit quality and market conditions. The
credit quality of a province – the degree of certainty that interest will be paid and the principal
repaid when due – depends on such factors as the amount of existing debt in the province per
capita, the level of federal transfer payments, the stability of the provincial government and the
wealth of the province in terms of natural resources, industrial development and agricultural
production.
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Guaranteed Bonds
Many provinces also guarantee the bond issues of provincially appointed authorities and
commissions.
Example: The Ontario Electricity Financial Corporation’s 8.5% notes, due May 26, 2025, are
“Irrevocably and Unconditionally Guaranteed by the Province of Ontario.” Provincial guarantees
may also be extended to cover municipal loans and school board issues. In some instances, provinces
extend a guarantee to industrial concerns, usually as an 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 banks purchase them, both at tender and by negotiation, usually for resale.
In addition to issuing bonds in Canada, the provinces (and their enterprises) also borrow
extensively in international markets. Unlike the federal government, whose policy is to borrow
abroad largely to maintain exchange reserves, the provinces resort to foreign markets to take
advantage of lower borrowing costs, based on the foreign exchange rate and financial market
conditions.
Issues sold abroad are underwritten by syndicates of dealers and banks similar to those that
handle foreign financing for federal government Crown Corporations. In recent years, issues
have been sold, for example, payable in Canadian dollars, U.S. dollars, euros, Swiss francs and
Japanese yen.
Provincial Securities
Some provinces offer their own savings bonds. As with CSBs, there are certain characteristics that
distinguish these instruments from other provincial bonds and make them suitable 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 any time).
Some provinces issue different types of savings bonds. For instance, there are three types of
Ontario Savings Bonds (OSBs): a step-up bond (interest paid increases over time), a variable-rate
bond, and a fixed-rate bond.
Municipal Securities
Today, the instrument that most municipalities use to raise capital from market sources is the
instalment debenture or serial bond. Part of the bond matures in each year during the term of
the bond.
Example: A debenture of $1 million may be issued so that $100,000 becomes due each year 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 been paid off.
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Installment debentures are usually non-callable: the investor who purchases them knows
beforehand how long he or she may expect to keep funds invested. Also, if the money is needed
at future specific dates, it can be invested in an instalment debenture so that it will be available
when it is needed.
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 better investment risk than a
municipality built around one major industry.
WHAT ARE CORPORATE BONDS?
Corporations have more choices than governments to raise capital. They can sell ownership of
the company by selling stocks to investors or by borrowing money from investors. Generally
speaking, corporate bonds have a higher risk of default than government bonds. This risk
depends upon a number of factors: the market conditions prevailing at the time of issue, the
credit rating of the corporation issuing the bond, and the government to which the bond issuer is
being compared to, among other things.
There are many types of corporate bonds with different features and characteristics to choose
from. The most common types of corporate bonds are discussed below.
Mortgage Bonds
A mortgage is a legal document containing an agreement to pledge land, buildings or equipment
as security for a loan and entitling the lender to take over ownership of these properties if the
borrower fails to pay interest or repay the principal when it is due. The lender holds the mortgage
until the loan is repaid, at which point the agreement is cancelled or destroyed. The lender cannot
take ownership of the properties unless the borrower fails to satisfy the terms of the loan.
There is no fundamental difference between a mortgage and a mortgage bond except in form.
Both are issued to allow the lender to secure property if the borrower fails to repay the loan.
The mortgage bond was created when the capital requirements of corporations became too large
to be financed by the resources of any one individual lender. However, since it is impractical for
a corporation to issue separate mortgages securing different portions of its properties to different
lenders, a corporation can achieve the same result by issuing one mortgage on its properties to
many lenders.
First mortgage bonds are the senior securities of a company, because they constitute a first
charge on the company’s assets, earnings and undertakings before unsecured current liabilities are
paid. It is necessary to study each first mortgage issue to determine exactly what properties are
covered by the mortgage.
First mortgage bonds are generally regarded as the best security a company can issue, particularly
if the mortgage applies to “all fixed assets of the company now and hereafter acquired.” This last
phrase, known as the “after-acquired clause,” means that all assets can be used to secure the
loan, even those acquired after the bonds were issued.
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Collateral Trust Bonds
A collateral trust bond is one that is secured, not by a pledge of real property, as in a mortgage
bond, but by a pledge of securities, or collateral. Collateral trust bonds are issued by companies
such as holding companies, which do not own much in the way of fixed 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 practice of pledging securities with a bank to secure a personal
loan.
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. CP Locomotives, for example,
issues these kinds of bonds, using its locomotives and train cars (i.e., rolling stock) as security.
The investor owns the rolling stock under a lease agreement with the railway, until all of the
stock has been paid off. These certificates are usually issued in serial form, with a set amount that
matures each year.
Subordinated Debentures
Subordinated debentures are junior to other securities issued by the company or other debts
assumed by the company. The exact status of an issue of subordinated debentures is described in
the prospectus.
Floating-Rate Securities
Floating-rate securities (also known as variable-rate securities) automatically adjust to
changing interest rates, and they can be issued with longer terms than more conventional issues.
Floating-rate securities have proved popular because they offer protection to investors during
periods of volatile interest rates. For example, when interest rates are rising, the interest paid on
floating-rate debentures is adjusted upwards at regular intervals of six months, which improves
the price and yield of the debentures. The disadvantage of these bonds is that when interest rates
fall, the interest payable on them is adjusted downwards at six-month intervals. A minimum
rate on the bonds can provide some protection to this process, although the minimum rate is
normally relatively low.
Corporate Notes
A corporate note is a short-term unsecured promise made by a borrower to pay interest and
repay the funds borrowed at a specific date or dates. Corporate notes rank behind all other fixedinterest securities of the borrower.
Domestic, Foreign and Eurobonds
Domestic bonds are issued in the currency and country of the issuer. If a Canadian corporation
or government issued bonds in Canadian dollars in the Canadian market, these would be
domestic bonds. This is the most common type of bond.
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Foreign bonds are issued outside of the issuer’s country and denominated in the currency
of the foreign country where issued. This allows issuers access to sources of capital in many
other countries. For example, Rogers Cable Inc., a Canadian company, has issued U.S. dollardenominated bonds in the U.S. market; these bonds are considered foreign bonds in the U.S.
market. (Bonds denominated in yen and issued in Japan by non-Japanese issuers are known as
Samurais, just as bonds denominated in U.S. dollars and placed in the U.S. market by non-U.S.
issuers 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-pay bonds offer investors increased opportunity for portfolio diversification while
providing the issuer with cost-effective access to capital in other countries.
Eurobonds are issued in a foreign market and are denominated in a currency other than
that of the market where the bonds are issued. They are issued in the Eurobond market or
the international bond market and can be issued in any number of different currencies. The
Eurobond market is a large international market with issues in many currencies, including
Canadian dollars, and attracts both international and domestic investors looking for alternative
investments. For example, the Province of Ontario has issued Australian-dollar-denominated
bonds in the Eurobond market, attracting investors around the globe, including Canadian
investors seeking foreign currency exposure.
If a Canadian corporation or government issued Eurobonds denominated in Canadian dollars,
they would be called EuroCanadian bonds. If they were denominated in U.S. dollars, they would
be Eurodollar bonds. Other examples are shown in Table 6.4.
TABLE 6.4
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
European Market
Cdn$
Eurobond (EuroCdn bond)
Canadian
U.S.
U.S.$
Foreign (Yankee) bond
Preferred Securities
Preferred securities are very long-term subordinated debentures, and are sometimes called
preferred debentures. The characteristics of these securities fall between standard debentures 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.
•
They often trade on an exchange.
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Preferred securities pay interest, have better yields than standard debentures, and offer better
protection of principal than preferred shares. However, there is some risk involved, since if the
issuer defaults, preferred securities have a lower priority than other debentures. Issuers may also
defer interest payments for a number of years, while the security holder will be taxed on this
accrued unpaid interest yearly.
High-Yield Bonds
Investment grade bonds refer to bonds issued by high-quality issuers such as the federal
government, provincial governments and select corporations. Investment grade bonds are those
considered to have adequate credit quality and an acceptable capacity for the payment of financial
obligations. These bonds carry a credit rating of BBB from DBRS (or BBB- from S&P, or Baa3
from Moody’s) and higher (credit ratings are discussed below).
High-yield or speculative bonds are considered non-investment grade. These bonds have a
higher risk of default as they are deemed to have greater uncertainty over the repayment of their
financial obligations. However, these bonds typically pay higher coupons and have higher yields
to compensate investors for the added risk.
CURRENT MARKET CONDITIONS FOR HIGH-YIELD BONDS
With interest rates and the yields on investment grade bonds at historically low levels, investors
looking to improve their portfolio returns have sparked an increased demand for high-yield debt
securities. As markets and the types of products available evolve, investors looking to improve
portfolio returns can access high-yield bonds through mutual funds and exchange-traded funds that
specialize in speculative bond investments.
WHAT ARE SOME OTHER FIXED-INCOME SECURITIES IN
THE MARKETPLACE?
Bankers’ Acceptances
A banker’s acceptance (BA) is a commercial draft (i.e., a written instruction to make payment)
drawn by a borrower for payment on a specified date. A BA is guaranteed at maturity by the
borrower’s bank. As with T-bills, BAs are sold at a discount and mature at their face value, with
the difference representing the return to the investor. They trade in $1,000 multiples, with a
minimum initial investment of $25,000, and generally have a term to maturity of 30 to 90 days,
although some may have a maturity of up to 365 days. BAs may be sold before maturity at
prevailing market rates, generally offering a higher yield than Canada T-bills.
Commercial Paper
Commercial paper is an unsecured promissory note issued by a corporation or an asset-backed
security backed by a pool of underlying financial assets. Issue terms range from less than three
months to one year. Most corporate paper trades in $1,000 multiples, with a minimum initial
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investment of $25,000. Like T-bills and BAs, commercial paper is sold at a discount and matures
at face value. Commercial paper is issued by large firms with an established financial history.
Rating agencies rank commercial paper according to the issuer’s ability to meet short-term debt
obligations. Commercial paper may be bought and sold in a secondary market before maturity at
prevailing market rates and generally offers a higher yield than Canada T-bills.
Term Deposits
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
Guaranteed Investment Certificates (GICs) offer fixed rates of interest for a specific term
(longer than with a term deposit). Both principal and interest payments are guaranteed. They
can be redeemable or non-redeemable. Non-redeemable GICs cannot be cashed before maturity,
except in the event of the depositor’s death or extreme financial hardship. Interest rates on
redeemable GICs are lower than standard GICs of the same term, since they can be cashed before
maturity.
Recently, banks have been customizing their GICs to provide investors with more choice. For
instance, investors can choose a term of up to ten years, depending upon the amount invested
(for less than a month, it must be a large amount). Investors can also choose the frequency of
interest payments (monthly, semi-annual, annual or at maturity) and other features. Many GICs
offer compound interest.
Note that the Canada Deposit Insurance Corporation (CDIC) does not cover GICs of more 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, or can 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 (for example,
a five year $5,000 GIC can be divided into one-, two-, three-, four- and five-year terms of
$1,000 each). As each portion matures, it can be reinvested or redeemed. This diversification
of terms reduces interest rate risk.
•
Instalment GICs: an initial lump sum contribution is made, with further minimum
contributions made weekly, bi-weekly or monthly.
•
Index-linked GICs: these guarantee a return of the initial investment upon expiry and
some exposure to equity markets. They are insured by the CDIC. They may be indexed to
particular domestic or global indexes or to a combination of benchmarks.
•
Interest-rate-linked GICs: these offer interest rates linked to the changes in other rates such
as the prime rate, the bank’s non-redeemable GIC interest rate, or money market rates.
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Some banks have also developed GICs with specialized features, such as the ability to redeem
them in case of medical emergency, or homebuyers’ plans, where regular contributions
accumulate for a down payment.
Fixed-Income Mutual Funds and ETFs
The demand for fixed-income mutual funds and exchange-traded funds (ETFs) that specialize
in bonds has grown significantly over the past decade, largely due to equity market uncertainty
and the interest rate environment. These managed products provide investors with easy access
to a diversified portfolio of debt securities for both domestic and global markets that would be
difficult for individual investors to replicate. These products also include other attractive features
like professional investment management, liquidity and low investment costs. Fixed-income
mutual funds and ETFs are particularly attractive for investors who have a limited amount of
money to invest or who find investing in individual bonds too complex.
Complete the following Online Learning Activity
Fixed-Income Securities
The Government of Canada, provincial and municipal governments, and
corporations all issue fixed-income securities and each of these issues has
specific features. In this exercise, you will review the types of products that
these institutions offer and then compare and contrast these products and
their features.
Complete the Fixed-Income Securities exercise to learn about the
types of fixed-income securities different institutions offer to
investors.
HOW TO READ BOND QUOTES AND RATINGS?
A typical bond quote in a newspaper might look like this:
Issue
Coupon
Maturity Date
Bid
Ask
Yield
ABC Company
11.5%
July 1/28
99.25
99.75
11.78%
This quote shows that, at the time reported, an 11.5% coupon bond of ABC Company that
matures on July 1, 2028, 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 would cost $5,000 × 0.9975 = $4,987.50,
plus accrued interest.
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Some financial newspapers publish a single price for the bond. This may be the bid price, the
midpoint between the final bid and ask quote for the day, or an estimate based on current interest
rate levels. Convertible issues are usually grouped together in a separate listing.
In Canada, DBRS (formerly Dominion Bond Rating Service), Moody’s Canada Inc. and the
Standard & Poor’s Bond Rating Service provide independent rating services for many debt
securities. These ratings can help investors assess the quality of their debt holdings and confirm
or challenge conclusions based on their own research and experience. Table 6.5 provides a brief
overview of the rating scale of DBRS for long-term obligations. The definitions indicate the
general attributes of debt bearing any of these ratings. They do not constitute a comprehensive
description of all the characteristics of each category.
Similar services in the U.S. have provided ratings on a ranked scale for many years. Investors
closely watch these ratings. Any change in rating, particularly a downgrading, can have a direct
impact on the price of the securities involved. From a company’s point of view, a high rating
provides benefits, such as the ability to set lower coupon rates on issues of new securities.
Ratings classify securities from investment grade through to speculative and can be used to
compare one company’s ability to meet its debt obligations with those of other companies. The
rating services do not manage funds for investors, buy and sell securities, or recommend securities
for purchase or sale.
TABLE 6.5
DBRS RATING SCALE FOR LONG-TERM OBLIGATIONS
Rating
Description
AAA
Highest credit quality. The capacity for the payment of financial obligations is
exceptionally high and unlikely to be adversely affected by future events.
AA
Superior credit quality. The capacity for the payment of financial obligations is
considered high. Credit quality differs from AAA only to a small degree. Unlikely
to be significantly vulnerable to future events.
A
Good credit quality. The capacity for the payment of financial obligations is
substantial, but of lesser credit quality than AA. May be vulnerable to future
events, but qualifying negative factors are considered manageable.
BBB
Adequate credit quality. The capacity for the payment of financial obligations is
considered acceptable. May be vulnerable to future events.
BB
Speculative, non investment-grade credit quality. The capacity for the payment of
financial obligations is uncertain. Vulnerable to future events.
B
Highly speculative credit quality. There is a high level of uncertainty as to the
capacity to meet financial obligations.
© CSI GLOBAL EDUCATION INC. (2013)
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CANADIAN SECURITIES COURSE • VOLUME 1
TABLE 6.5
DBRS RATING SCALE FOR LONG-TERM OBLIGATIONS – Cont’d
Rating
Description
CCC/CC/C
Very highly speculative credit quality. In danger of defaulting on financial
obligations. There is little difference between these three categories, although CC
and C ratings are normally applied to obligations that are seen as highly likely to
default, or subordinated to obligations rated in the CCC to B range. Obligations in
respect of which default has not technically taken place but is considered inevitable
may be rated in the C category.
D
A financial obligation has not been met or it is clear that a financial obligation
will not be met in the near future or a debt instrument has been subject to a
distressed exchange. A downgrade to D may not immediately follow an insolvency
or restructuring filing as grace periods or extenuating circumstances may exist.
Source: DBRS Web Site, www.dbrs.com (Information is accurate as at time of publishing.)
Complete the following Online Learning Activity
Bond Quotes and Ratings
It is important to be able to interpret bond quotes and bond ratings because
this information will help you make better investment decisions. In this activity
you will interpret bond quotes and practise making investment decisions based
on bond ratings.
Complete the Bond Quotes and Ratings activity to practice
interpreting bond quotes.
© CSI GLOBAL EDUCATION INC. (2013)
SIX • FIXED-INCOME SECURITIES: FEATURES AND TYPES
6•29
SUMMARY
After reading this chapter, you should be able to:
1.
Describe the fixed-income market and discuss the rationale for issuing debt instruments.
•
2.
Companies use fixed-income securities to finance and expand their operations or to take
advantage of operating leverage.
Define the terms used in transactions involving bonds, describe bond features, explain the
use of a sinking fund and a purchase fund, and describe the protective provisions found in a
bond indenture.
•
There is a great deal of terminology to remember:
– Face or par value is the amount the bond issuer contracts to pay at maturity.
– The coupon is the regular interest income that the bond pays.
– Bonds that trade in the secondary market have a price and a quoted yield.
– The remaining life of a bond is called its term to maturity.
– The maturity date is the date at which the bond matures and the principal is repaid.
– A bond is secured by physical assets in a trust deed written into the bond contract.
– A debenture is secured by something other than a physical asset. The asset secured
may be a general claim on residual assets or the issuer’s credit rating.
•
A strip bond is created when a dealer acquires a block of high-quality bonds and
separates the individual future-dated interest coupons from the rest of the bond. The
bonds are then sold at significant discounts to their face value. Holders of strip bonds
receive no interest payments; instead, the income earned is considered interest rather
than a capital gain.
•
A callable bond gives the issuer the right, but not the obligation, to pay off the bond
before maturity, either to take advantage of lower interest rates or to reduce debt when
excess cash is available.
•
Most corporate bonds are issued with a Canada yield call that requires the issuer to
call the bond at a price based on the greater of par or the price based on the yield of an
equivalent term Government of Canada bond plus a yield spread.
•
A convertible bond gives the holder the option to exchange the bond for common
shares of the issuing company. A convertible bond allows an investor to lock in a
specific price (the conversion price) for the common shares of the company.
© CSI GLOBAL EDUCATION INC. (2013)
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CANADIAN SECURITIES COURSE • VOLUME 1
3.
4.
•
Sinking funds are sums of money taken out of earnings each year to provide for the
repayment of all or part of a debt issue by maturity. Sinking fund provisions are as
binding on the issuer as any mortgage provision.
•
A purchase fund arrangement establishes a fund to retire a specified amount of the
outstanding bonds or debentures through purchases in the market if these purchases
can be made at or below a stipulated price.
•
Corporate bonds typically include protective covenants that secure the bond and
make it more likely that investors receive their principal at maturity. These protective
provisions are essentially safeguards in the bond contract to guard against any
weakening in the security holder’s position.
Compare and contrast the types of Government of Canada securities.
•
Marketable bonds have a specific maturity date and a specified interest rate, and are
transferable, which means they can be traded in the market. The Government of
Canada issues marketable bonds in its own name.
•
Treasury bills are short-term government obligations with original terms to maturity of
three months, six months and one year. They are offered in denominations from $1,000
up to $1 million.
•
Canada Savings Bonds (CSBs) can be purchased only through the Payroll Savings
Program between early October and November 1st of each year but are cashable at any
time at their full par value plus any accrued interest earned for each full month elapsed
since the issue date.
•
Canada Premium Bonds (CPBs) are very similar to CSBs but offer a higher interest rate
when they are issued. Investors can purchase CPBs through most financial institutions
and are cashable at any time at their full par value plus any accrued interest paid up to
the last anniversary date of the issue.
Compare and contrast the different types of provincial government securities and municipal
debentures.
•
Provincial bonds are actually debentures because they are promises to pay and no
provincial assets are pledged as security. The value of the bonds depends on the
province’s ability to pay interest and repay principal.
•
Provincial bonds are second in quality only to Government of Canada bonds because
most provinces have taxation powers second only to the federal government.
•
Municipalities typically raise capital from market sources through instalment
debentures or serial bonds. Part of the bond matures in each year during the term of the
bond.
•
Broadly speaking, a municipality’s credit rating depends on its taxation resources.
All else being equal, a municipality with many different types of industry is a better
investment risk than a municipality built around one major industry.
© CSI GLOBAL EDUCATION INC. (2013)
SIX • FIXED-INCOME SECURITIES: FEATURES AND TYPES
5.
6.
6•31
Identify the different types of corporate bonds and describe their features.
•
First mortgage bonds are the senior securities of a company because they constitute
a first charge on the company’s assets, earnings and undertakings before unsecured
current liabilities are paid.
•
A collateral trust bond is secured, not by a pledge of real property, as in a mortgage
bond, but by a pledge of securities or collateral.
•
An equipment trust certificate pledges equipment as security instead of real property.
These certificates are usually issued in serial form, with a set amount that matures each
year.
•
Subordinated debentures are junior to other securities issued by the company and other
debts assumed by the company.
•
Floating-rate bonds automatically adjust to changing interest rates. They can be issued
with longer terms than more conventional issues.
•
A corporate note is an unsecured promise made by a borrower to pay interest and repay
the funds borrowed at a specific date or dates. Corporate notes rank behind all other
fixed interest securities of the borrower.
•
Foreign bonds are issued outside of the issuer’s country and denominated in the
currency of the foreign country where issued, allowing the issuer access to sources of
capital in many other countries.
•
Eurobonds are issued in a foreign market and are denominated in a currency other than
that of the market in which the bonds are issued.
Describe the features of other fixed-income securities including bankers’ acceptances,
commercial paper, term deposits and guaranteed investment certificates.
•
A bankers’ acceptance is a short term debt guaranteed by the borrower’s bank that is
sold at a discount and matures at face value.
•
Commercial paper is a one-year or less unsecured promissory note issued by a
corporation and backed by financial assets, sold at a discount and matures at face value.
•
Term deposits offer a guaranteed rate for a short-term deposit (usually up to one year).
There are generally 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 specific term
(longer than with a term deposit). Both principal and interest payments are guaranteed,
and they can be redeemable or non-redeemable. Non-redeemable GICs cannot be
cashed before maturity except in the event of the depositor’s death or extreme financial
hardship.
© CSI GLOBAL EDUCATION INC. (2013)
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CANADIAN SECURITIES COURSE • VOLUME 1
7.
Interpret bond quotes and summarize and evaluate bond ratings.
•
A typical bond quote includes the issuing company, the coupon rate, the maturity date,
the bid and ask price, and the yield on the bond.
•
In Canada, DBRS, Moody’s Canada Inc. and the Standard & Poor’s Bond Rating
Service provide independent rating services for many debt securities. These ratings
can help investors assess the quality of their debt holdings and confirm or challenge
conclusions based on their own research and experience.
Online Frequently Asked Questions
CSI has answered many frequently asked questions about this Chapter.
Read through online Module 6 FAQs.
Online Post-Module Assessment
Once you have completed the chapter, take the Module 6 Post-Test.
© CSI GLOBAL EDUCATION INC. (2013)