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Introduction to Bonds

When a corporation or government wishes to borrow money from the public on a long-term debt basis, it usually does so by issuing and selling debt securities - notes, debentures, and bonds. Bonds are securities and can be readily bought and sold either over-the-counter or on a major stock exchange. The prices of bonds are established in the marketplace by negotiations between buyers and sellers. Bond prices are expressed on an index with a base of 100. A bond trading at 100 is trading at face value (or par), whereas a bond trading at 97 is trading at a discount (or below par). Similarly, a bond trading at 102 is trading at a premium (or above par).

Learn more about what to look for in a bond issue to maximize the pre-tax yield

Terminology of a Bond

The Government of Canada may issue $1,000, 6%, 25-year bonds paying interest semi-annually.

Face value = $1,000

Coupon rate = 6%

Time to maturity = 25 years

Coupons = $1,000 x 6% x ½ = $30 paid semi-annually

Bonds vs Debentures

A bond is secured debt whereas a debenture is unsecured debt; however the term bond is often used generically to refer to both secured and unsecured debt. It is normally an interest-only loan where the borrower pays the interest every period (usually semi-annually), but none of the principal is repaid until the end of the loan.

Government of Canada Bonds

The federal government is the largest single issuer in the Canadian bond market. The Government of Canada issues bonds in its own name and also guarantees principal and interest on bonds issued by federal crown corporations, including Canada Mortgage and Housing Corporation, Farm Credit Corporation, the Canadian Wheat Board, Export Development Corporation, and the Business Development Bank of Canada.

Government of Canada bonds form the single largest and most liquid sector of the Canadian bond market and are typically the most conservative type of bond investment. These bonds have the highest credit rating available (excluding supranationals) and are actively traded in all major capital markets. Secondary market activity for Government of Canada bonds takes place in the over-the-counter market between investment managers and dealers. Dealing spreads vary according to economic factors prevalent at the time and depend on the term-to-maturity of the individual bond.

Provincial Bonds

Next to the Government of Canada, provincial and municipal governments and their agencies make up the second largest sector in the Canadian bond market. Provincial governments actively issue bonds to fund deficits which provide for public works and social welfare expenditures. As many of these projects are long-term in nature, debt issued in this sector of the market tends to be longer in maturity. Actively traded provincial bonds account for about 20% of the total bond market; active municipal issuance represents about 2% of the market. Market size in each sector has grown consistently over the last ten years.

Interest is payable on a semi-annual basis, with yields calculated on a 365-day year. Provincial bonds are available in increments of $1,000.

Most provincial bonds trade at a yield spread over that of a Government of Canada bond of equivalent maturity. For example, a Province of Ontario bond maturing in ten years may trade at a higher yield spread than that of a 10-year Government of Canada bond. Such a yield spread over Government of Canada bonds takes into account a provincial instrument of generally lower credit quality and reduced liquidity.

Municipal Bonds

Municipal bonds are not automatically guaranteed by the provinces in which they are domiciled, except in a few rather specific cases. If they were guaranteed by their provinces, then all municipalities would be rated the same as the province that guaranteed them. Such a guarantee by the provinces would in turn lower the provinces' ratings. Instead, municipal bonds may vary in ratings depending, among other factors, on the tax revenues it can raise to pay the interest on its debt issues.

Terms to maturity generally range from a few months to 30 years. The most liquid issues are the larger recent issues with terms of 5, 10, and 30 years.

Corporate Bonds

Businesses rely on a variety of means to raise funds in order to finance operations and projects. To raise capital, a business can borrow from banks, issue common or preferred stock, or issue debt. In fact, corporate bonds, debentures, notes and commercial paper have been used to finance business innovations since before World War I. The four types of corporate debt differ in their terms, covenants and security, but all four are generically referred to as "corporate bonds".

In order to recover both the interest and the principal due to them in the case of default, corporate bondholders have a prior legal claim (to both income and assets of the corporation) over common and preferred stockholders. Within this broad category of 'prior claim,' however, each issue has its own ranking with respect to priority. A bond classified as senior debt, for example, will rank ahead of subordinated debt. A first mortgage bond will rank ahead of a debenture. A corporate note will have the least claim among the group of prior claimants.

While bonds in most other sectors have common characteristics and generally deviate only as to term and coupon, each corporate issue should be regarded as unique. A careful analysis of corporate bond variables is therefore essential.

Foreign Bonds

Foreign bonds, also called Yankee bonds, are bonds that are offered by Canadian entities but are issued in U.S. currency and pay U.S.-denominated interest. The issuers include federal and provincial governments, government agencies, and many Canadian corporations.

Two distinguishing features of these bonds is that they pay interest in U.S. currency and fully qualify as Canadian content when held within an RRSP or RRIF.

Foreign bonds issued by Canadian entities are ideal for investors who require a regular source of U.S. funds, to be used for time spent south of the border or for investors who have business dealings in U.S. currency. By holding these bonds, investors can avoid currency risk and costs associated with currency conversion.

Depending on the issuer, credit risk may be a factor in the selection of a foreign bond - investors should ensure they check the credit rating of the issuer prior to purchase. Also worth considering is the risk that the U.S. currency will depreciate over the term of the investment, as measured against the Canadian dollar, thus reducing the return on investment to the investor. If sold prior to maturity, the bond value will be subject to market conditions at the time of sale. If interest rates increase or there is a credit quality downgrade, the price of the foreign bond may fall.

Eurobonds

Eurobonds are bonds issued in the European market by a broad range of international issuers who wish to access capital outside their own domestic markets. Issuers include governments or government agencies, as well as banks, and national or multi-national corporations. While the majority of underwriters are located in Europe, investors and issuers can be from anywhere in the world. Most Canadian provinces have issued Eurobonds as well as many large Canadian corporations.

For investors, the main attraction of Eurobonds is that they typically are denominated in a foreign currency, offering the opportunity for currency diversification.

Foreign entities may issue Eurobonds in Canadian dollars to take advantage of lower Canadian interest rates. A Canadian investor buying such an instrument may benefit from a higher yield without any currency risk. However, these bonds are not as liquid as domestic issues, so they are more suited for investors willing to hold them to maturity.



The information contained herein is considered accurate at the time of posting. CIBC, CIBC World Markets Inc. and CIBC Investor Services Inc. reserve the right to change any of it without prior notice. It is for general information purposes only. Clients are advised to seek advice regarding their particular circumstances from their personal tax advisors.

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