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Chapter

Fixed-Income Securities: Features and Types

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Fixed-Income Securities: Features and Types
CHAPTER OUTLINE
The Fixed-Income Marketplace The Rationale for Issuing Fixed-Income Securities Size of the Fixed-Income Market Fixed-Income Terminology and Features Interest on Bonds Face Value and Denomination Price and Yield Term to Maturity Liquid Bonds, Negotiable Bonds and Marketable Bonds Callable Bonds Sinking Funds and Purchase Funds Extendible and Retractable Bonds Convertible Bonds and Debentures Protective Provisions of Corporate Bonds Government of Canada Securities Marketable Bonds Treasury Bills Canada Savings Bonds Provincial and Municipal Government Securities Guaranteed Bonds Provincial Securities Municipal Securities

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Corporate Bonds Mortgage Bonds Collateral Trust Bonds Equipment Trust Certicates Subordinated Debentures Floating-Rate Securities Corporate Notes Strip Bonds Domestic, Foreign and Eurobonds Preferred Securities Other Fixed-Income Securities Bankers Acceptances Commercial Paper Term Deposits Guaranteed Investment Certificates

Bond Quotes and Ratings Summary

LEARNING OBJECTIVES
By the end of this chapter, you should be able to: 1. Describe the xed-income market and discuss the rationale for issuing debt instruments. 2. 3. 4. 5. 6. 7. Dene 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. Compare and contrast the types of Government of Canada securities. Compare and contrast the different types of provincial government securities and municipal debentures. Identify the different types of corporate bonds and describe their features. Describe the features of term deposits and guaranteed investment certicates. Interpret bond quotes and summarize and evaluate bond ratings.

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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 investors 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 publics attention. Trading in bonds, Treasury bills and other fixed-income securities tends to be less enticing because there are not the very public price spikes that are seen in, for example, the shares of Nortel or Microsoft. Most investors would be surprised to learn the extent of the fixed-income market. To put it in perspective, the dollar amount traded on Canadas 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, In the on-line investors generally lack an understanding of the features, characteristics and terminology of the fixed-income Learning Guide market.

for this module, complete the In this first chapter on fixed-income securities, we look at the terminology, describe the reasons Getting Started governments and corporations issue fixed-income securities, and describe the features and characteristics of activity. the securities available in the fixed-income markets.

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KEY TERMS
After-acquired clause Bond Callable bond Canada Savings Bonds (CSBs) Canada yield call Collateral trust bond Conversion price Convertible bonds Coupon rate Debenture Dominion Bond Rating Service Election period Equipment trust certicate Eurobonds Extendible bonds Extension date Face value First mortgage bond Fixed-income securities Floating-rate securities Forced conversion Foreign bonds Guaranteed Investment Certicates (GICs) Instalment debenture Maturity date Moodys Canada Inc. Mortgage Par value Payback period Principal Purchase fund Real return bonds Redeemable bond Retractable Bond Serial bond Sinking funds Standard & Poors Bond Rating Service Strip Bond Subordinated debentures Term to maturity Treasury bills Trust deed Yield Zero coupon bond

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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 usually 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.

Size of the Fixed-Income Market


Perhaps because it is not as highly publicized as the stock market, many people do not realize just how large the fixed-income market really is. For example, a total of $205 billion in new debt was issued in 2007, and this was 10.7% higher than the previous high of $185.2 billion raised in 2006. Furthermore, Canadian secondary market debt trading in 2007 totalled $7 trillion, or approximately 4 times the total equity trading of $1.7 trillion and over 4 times Canadas GDP of nearly $1.6 trillion.

FIXED-INCOME TERMINOLOGY AND FEATURES


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 issuers 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.

Interest on Bonds
Many bonds pay regular interest at a rate known as the coupon rate. The coupon rate may be fixed, such as 6% a year, or may be variable and will change in reference to a benchmark interest 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.

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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. 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.
EXAMPLE: A $1,000, 6%, semi-annual coupon bond due May 1, 2024 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.

Face Value and Denomination


The amount the bond issuer contracts to pay at maturity (the maturity value) is known as the face or par value. These terms are also used to describe the maturity value of each bond holders position. 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. To accommodate smaller investors, Canada Savings Bonds are issued in denominations as small as $100. The smallest corporate bond denomination is usually $1,000.

Price and Yield


After being issued, bonds are bought and sold between investors in the secondary market at a stated price and a quoted yield. Bond prices are quoted using an index with a base value of 100. A bond trading at 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.
EXAMPLE: If you buy a bond with a $10,000 face value at a price of 95, it will cost you

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

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Given the price of a bond, it is possible to calculate a yield for the bond. For most bonds, the yield is an approximate measure of the annual return on the bond if it is held to maturity. For example, if you bought a bond with a yield of 5% and held it to maturity, your annual return would be approximately 5%. The yield of a bond should not be confused with the coupon rate; they are two different things. 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.

Term to Maturity
The maturity date is the date at which the bond matures, or expires, and the principal is paid back to the investor holding the bond at maturity. The remaining life of a bond is called its term to maturity.
EXAMPLE: If a bond was issued three years ago with a term of ten years, it is no longer referred to as a ten-year bond. Because three years have passed and only seven remain in the life of the bond, it is referred to as a seven-year bond.

Bonds can be grouped into three categories according to their term to maturity. Short-term bonds have less than five years remaining in their term. Bonds with terms of 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 Up to one year term to maturity

Short-Term Bonds From one to 5 years remaining to maturity

Medium-Term Bonds From 5 to 10 years remaining to maturity

Long-Term Bonds Greater than 10 years remaining to maturity

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.

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 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: CHC Helicopters 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, 2009, and before or on April 30, 2010, you would receive $1,036.88 plus accrued interest; after May 1, 2010 and before or on April 30, 2011, you would receive $1,024.58 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

CHC Helicopter 7.375% debentures due May 1, 2014. Not redeemable before May 1, 2009. Thereafter, redeemable on 30 days notice up to the 12 months ending May 1 of each year, as follows: 2009 2010 2011 2012 Thereafter redeemable at par to maturity. 103.68 102.46 101.23 100.00

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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.
EXAMPLE: A 10-year corporate bond is issued at par with a coupon and yield of 7%, which represents a yield spread of 200 basis points above the current 5% yield on 10-year Canada bonds. (A basis point equals one one-hundredth of a percentage point.) The corporate bond contains a Canada yield call of +50, meaning that the bond can 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 the bonds at a price based on a yield of 5.25% (which is 4.75% + 0.50%), regardless of where the 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 (This calculation is explained in Chapter 7, Calculating the Fair Price of a Bond).

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: Talisman Energy 6.89% debentures, due June 17, 2010, have a mandatory sinking

fund. The company must retire $1,000,000 of the principal amount on June 17 every year, from 2006 to 2010 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. 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: Domtar Inc. 10% debentures, due April 15, 2011, have a purchase fund. Beginning on July 1, 1992, the company must make all reasonable efforts to purchase at or below par 1.125% of the aggregate principal amount during each quarter, cumulative for eight quarters. The purchase fund normally retires less of an issue than a sinking fund.

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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 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: 407 International Inc. 7% Extendible Junior Bonds, Series 00-B1, due July 26, 2010, are extendible to July 26, 2040 from July 26, 2010 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: CP Ships 4% bonds due June 30, 2024, are retractable at par on June 30, 2009.

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 holders 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. Convertibles can also be used to interest investors in providing capital for companies if investors would not otherwise be interested in buying relatively low-yielding or non-dividendpaying common shares.

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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 companys 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.

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, because forced conversion can improve the companys debt-equity ratio and make new debt financing possible. 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 First Capital Realty that were due February 28, 2008, had a forced conversion clause. Until February 28, 2008, the bonds were 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 were not redeemable before March 1, 2004. The company has the option to pay the principal amount on redemption or maturity, or to pay the investor in common shares. The price of the 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 companys redemption offer, which could force them 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. Lets 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 $880 because it can be converted into 40 common shares that trade at $22 (40 $22 = $880). The same holds true if the price of the ABC common shares starts to rise. If the common shares now trade at $27, the price of the bond will rise accordingly to $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 $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). The price of the bond will follow comparable bonds if the ABC common shares trade below the conversion price and will follow the underlying stock if the price of the stock rises above the conversion price.

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 holders 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.

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Complete the on-line activity associated with this section.

Sale of Assets or Merger: This clause protects the debt holder in the event that all of the firms 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.

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), 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 $262.1 billion outstanding as of April 30, 2005 (excluding Treasury bills). 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. In the past, Canadian bonds have had higher yields than those of the U.S. Between 1995 and 2000, Canada had lower yields with respect to the U.S. At all maturities, Canadian yields are currently higher than U.S. yields.

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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 Savings 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


Unlike other bonds, Canada Savings Bonds (CSBs) can be purchased only between October and April of each year, but can be cashed by the owner at any bank in Canada at any time. Since they are not transferable and hence have no secondary market, CSBs do not rise and fall in price and may always be cashed at their full par value plus any accrued interest. Thus, although they are not marketable, they are liquid. CSBs are not sold in bearer form but must be registered in the name of: An individual (adult or minor) The estate of a deceased person A trust for an individual

Registration provides proof of purchase, but it also ensures that an individual does not hold more than the maximum amount that he or she is allowed to purchase. (For each series, individual purchases are limited to a certain maximum; the amount varies from series to series.) Purchasers must be bona fide Canadian residents with a Canadian address for registration purposes. Although the ownership of a CSB cannot be transferred or assigned, chartered banks may accept assignments of CSBs as collateral for loans. Individuals, estates of deceased persons and trusts governed by certain types of deferred savings and income plans are allowed to acquire CSBs.
REGULAR INTEREST CSBS

Since 1977, CSBs have been available in two forms: a regular interest bond and a compound interest bond. The regular interest bond pays annual interest, either by cheque or by direct deposit into the holders bank account on November 1 each year. It is issued in denominations of $300, $500, $1,000, $5,000 and $10,000. Registered owners may hold only five each of the $300 and $500 bonds. Regular interest bonds may be exchanged for compound interest bonds of the same series only during a specified period after the original purchase.

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If the holder of a new CSB issue cashes the bonds in the first three months after the issue date, he or she normally receives their face value without interest. Interest payments on regular interest CSBs is taxable as regular income at the investors marginal tax rate.
COMPOUND INTEREST CBSS

Compound interest CBSs has been a standard feature since the 1977 series. It allows the holder to forgo receiving interest each year so that the unpaid interest can compound. The holder earns interest on the accumulated interest. The minimum denomination of this type of bond is $100. The compound interest is calculated each November 1, and is accrued in equal monthly amounts over the next twelve months. At redemption, the holder receives the face value plus the total of the earned interest. CSBs should be redeemed early in the month to ensure that the holder receives the maximum amount of interest accrued. For example, an investor redeeming a bond on October 2 will receive the interest owed as of September 30. Another investor waiting until October 29 will also receive the interest owed as of September 30, effectively missing out on a months interest. For income tax purposes, holders of compound interest CBSs must report compound interest as taxable income in the year in which it is earned rather than the year in which they receive it. This is a disadvantage for the holder, as the holder must pay tax on the income without actually receiving the cash.
CANADA PREMIUM BOND (CPBS)

Canada Premium Bonds (CPBs) are very similar to CSBs, but offer a higher interest rate than other CSBs on sale at the same time. They can be redeemed only once a year without penalty, on the anniversary of the date of issue and for 30 days thereafter and are available with regular or compound interest options.
PAYROLL SAVINGS PLAN

The Bank of Canada sells Canada Savings Bonds on a payroll savings plan through more than 12,000 organizations in all parts of Canada. These organizations include all levels of government, universities, school boards, hospitals, crown corporations and private companies. Close to a million Canadians purchase CSBs through payroll deduction each year.
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 bonds inflation compensation.

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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 semiannual interest payments and the final redemption value of each bond are calculated by including an inflation compensation component. If inflation (as measured by 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 (4.25% of $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.

PROVINCIAL AND MUNICIPAL GOVERNMENT SECURITIES


A typical provincial bond or debenture issue is used to provide funds for program spending and to fund deficits. These expenditures may be charged over a period of years against the tax revenues of those years, since the province has undertaken the project to provide a continuing benefit over those years. Provinces also issue bonds to finance current social welfare expenditures. All provinces have statutes governing the use of funds obtained through the issue of bonds. Provincial bonds, like Government of Canada bonds, are actually debentures. They are simply promises to pay and their value depends upon the provinces ability to pay interest and repay principal. No provincial assets are pledged as security. 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 factors, credit and market conditions. The credit 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 debt the province owes on a per capita basis compared with that of other provinces. Obviously, Province A with half the debt per capita of Province B commands a higher credit rating than that of B. The level of federal transfer payments. The philosophy and stability of the government. The wealth of the province in terms of natural resources, industrial development and agricultural production. A province rich in natural resources and with well-diversified industries, balanced by good farming communities, should be better able to meet its obligations, particularly during recessions, than a province which depends on limited natural resources, small industrial production or almost totally on 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 Corporations 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.

The bonds of nearly all the provinces are available in a wide range of denominations, from $500 to hundreds of thousands of dollars. The most popular denominations are $500, $1,000, $5,000, $10,000 and $25,000. The term of a provincial bond issue will vary, depending on the use to which the proceeds will be put and the availability of investment funds at various terms. In addition to issuing bonds in Canada, the provinces (and their enterprises) also 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. Provinces may also decide to borrow through issues denominated in, for example, U.S. funds, if the proceeds from the loan will be spent in the U.S. The interest cost (in U.S. funds) is offset by the revenues. Issues sold abroad are underwritten by syndicates of dealers and banks similar to 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. Since 1990, provincial guaranteed issues have been offered in a global bond offering. Global bond offerings are distributed simultaneously in domestic and foreign markets, and settle in different clearing agencies (such as EuroClear or Cedel). These offerings are expected to become an increasingly popular financing mechanism for Canadian governments and corporations.

Provincial Securities
Most 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 variablerate bond, and a fixed-rate bond. In British Columbia, investors can buy BC Savings Bonds in redeemable or nonredeemable (fixed-rate) forms.

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

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. Some municipalities issue term debentures with only one maturity date, but these are generally confined to very large cities such as Montreal, Toronto and Vancouver. At present, the usual practice is to pattern issues according to market preference as to term and repayment scheduling. 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. Municipalities are in the third rank of public borrowers, following the federal and provincial authorities. However, not all municipal credit ratings rank below those of each province. It is not unusual for debenture issues of some large metropolitan areas to be favoured by investors over the securities issued by one or more of the provinces. The high standing of most municipal securities is reflected in the provincial laws regulating the investment of funds by trustees. Managers investing funds held in trust have certain restrictions as to what types of investments they are allowed to choose. They must be very conservative with the funds entrusted to them. Almost without exception, municipal debentures in the province in which they are issued are classified as trustee investments. Some provinces also include in this class the municipal securities issued under the authority of other provinces. Broadly speaking, a municipalitys 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. Similarly, the municipality with good transportation facilities is preferable to one that lacks them. Older municipalities with good repayment records are able to borrow money on more favourable terms than less mature municipalities in newly opened areas. Population and industrial growth, the condition of the towns services, the experience of officials in municipal office, the level of tax collections and debt per capita are also key factors in determining a municipalitys credit rating.

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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. The mortgage is then deposited with a trustee, usually a trust company, which acts for all investors in safeguarding their interests under the terms of the loan contract described in the mortgage. The amount of the loan is divided into convenient portions, usually $1,000 or multiples of $1,000. Each investor receives a bond that represents the proportion of his or her participation in the full loan to the company and his or her claim under the terms of the mortgage. This instrument is a mortgage bond. First mortgage bonds are the senior securities of a company, because they constitute a first charge on the companys 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. Most Canadian first mortgage bonds carry a first and specific charge against the companys fixed assets and a floating charge on all other assets. They 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 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
Since 1979, floating-rate securities (also known as variable-rate securities) have been a popular underwriting device because of the volatility of interest rates. Since these bonds automatically adjust to changing interest rates, 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 very 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, so their yield tends to fall faster than that of most bonds. A minimum rate on the bonds can provide some protection to this process, although the minimum rate is normally relatively low. In a portfolio, floating-rate securities behave like money market securities because, if the rate changes every three months, it is similar to holding a three-month instrument and rolling it over.

Corporate Notes
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. Finance companies frequently use a type of note called a secured note or a collateral trust note. When an automobile is sold on credit, the buyer makes a cash down payment and signs a series of notes by which he or she agrees to make additional payments on specified dates. The automobile

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dealer takes these notes to a finance company, which discounts them and pays the dealer in cash. Finance companies pledge notes like these as security for collateral trust notes. These notes mature at different times and are sold to financial institutions or to individual investors who have substantial portfolios. Another kind of secured note is the secured term note, which is backed by a written promise to pay. These notes are signed by people who buy automobiles or appliances on an instalment plan. These notes trade on the money market.

Strip Bonds
The strip bond or zero coupon bond first appeared in Canada in 1982. 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 (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. This can cause a problem for the investor as 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. For 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 bonds 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, lets assume the strip has a quoted yield of 6% so 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.

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. Foreign bonds are issued in a currency and country other than the issuers. This allows issuers access to sources of capital in many other countries. For example, Rogers Cable Inc., a Canadian company, has issued U.S.-dollar-denominated bonds in the U.S. market; these bonds are considered foreign bonds in the U.S. market. (Bonds denominated in yen are known as Samurais, just as foreign issues in U.S. dollars and placed in the U.S. market are called Yankee bonds.) Some bonds offer the investor a choice of interest payments in either of two currencies; others pay interest in one currency and the principal in another. These foreign-pay bonds offer investors increased opportunity for portfolio diversification while providing the issuer with cost-effective access to capital in other countries.

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Eurobonds are issued and sold outside a domestic market and are typically denominated in a currency other than that of the domestic market. 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 foreigncurrency 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 634.
TABLE 6.3 TYPES OF BONDS BY CURRENCY AND LOCATION

Issuer Canadian Canadian Canadian Canadian Canadian

Issued Canada Mexico France European Market U.S.

Currency of Issue Cdn$ Pesos U.S.$ Cdn$ U.S.$

Called Domestic bond Foreign bond Eurobond (Eurodollar) Eurobond (EuroCdn bond) (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 2599 years. They are subordinated to all other debentures, but rank ahead of preferred shares. Interest can often be deferred at managements discretion for up to five years. They often trade on an exchange.

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.

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OTHER FIXED-INCOME SECURITIES

Bankers Acceptances
A bankers 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 borrowers 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 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 issuers 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 depositors 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.

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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 GICs term. Laddered GICs: the investment is evenly divided into multiple term lengths (for example, a fiveyear $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 banks non-redeemable GIC interest rate, or money market rates.

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.

BOND QUOTES AND RATINGS


A typical bond quote in a newspaper might look like this:
Issue ABC Company Coupon 11.5% Maturity Date July 1/18 Bid 99.25 Ask 99.75 Yield 11.78%

This quote shows that, at the time reported, an 11.5% coupon bond of ABC Company that matures on July 1, 2018, 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. 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, the Dominion Bond Rating Service, Moodys Canada Inc. and the Standard & Poors 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 6.4 provides a brief overview of the rating scale of Standard and Poors. 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.

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Similar services in the U.S., such as Moodys and Standard & Poors, 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 companys point of view, a high rating provides benefits, such as the ability to set lower coupon rates on issues of new securities. The Canadian rating services carry out credit analysis and provide an independent and objective assessment of the investment grade of securities. The ratings indicate whether an investment is a high or low risk, that is, the likelihood that interest payments will continue without interruption and that the principal will be repaid on time and in full. Ratings classify securities from investment grade through to speculative and can be used to compare one companys 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 6.4 STANDARD AND POORS BOND RATING SERVICE

Rating AAA (Highest Credit Quality)

Description This category is used to denote bonds of outstanding quality with the highest degree of protection of principal and interest. Companies with debt rated AAA are generally large national or multinational corporations that offer products or services essential to the Canadian economy.These companies usually have had a long and creditable history of superior debt protection, in which the quality of their assets and earnings has been constantly maintained or improved, with strong evidence that this performance will continue. Bonds rated AA are very similar to those rated AAA and can also be considered superior in quality.These bonds are generally rated lower in quality than AAA because the margin of asset or earnings protection may not be as large or as stable as it is for those rated AAA. Bonds rated A are considered to be good-quality securities with favourable long-term investment characteristics.The main feature that distinguishes them from the higher-rated securities is that these companies are more susceptible to adverse trade or economic conditions. The protection is consequently lower than for AAA and AA. Th Issues rated BBB are classified as medium- or average-grade investments.These companies are generally more susceptible than any of the A-rated companies to swings in economic or trade conditions. Some internal or external factors may adversely affect the long-term protection of BBB debt.These companies bear close scrutiny, but in all cases both interest and principal are adequately protected at present.

AA (Very Good Quality)

A (Good Quality)

BBB (Medium Quality)

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TABLE 6.4

STANDARD AND POORS BOND RATING SERVICE (Contd)

Rating BB (Lower Medium Quality)

Description Bonds rated BB are considered to be lower-medium-grade securities and have limited long-term protective investment characteristics. Asset and earnings coverage may be modest or unstable. Interest and principal protection may deteriorate significantly during adverse economic or trade conditions.

B (Poor Quality)

Securities rated B lack most qualities necessary for long-term fixedincome investment. Companies in this category generally have a history of volatile operating conditions that have left in doubt the companys ability to adequately protect the principal and interest. Current coverages may be below industry standards and there is little assurance that the level of debt protection will improve significantly. Securities in this category are currently vulnerable to nonpayment, and are dependent upon favourable business, financial and economic conditions for the company to meet its financial commitment on the obligation. In the event of adverse business, financial, or economic conditions, the company is not likely to have the capacity to meet its financial commitment on the debt. The company is highly vulnerable to nonpayment of debt.

CCC (Speculative Quality)

CC (Very Speculative Quality) C (Highly Speculative Quality)

A subordinated debt is highly vulnerable to nonpayment.This rating is used to cover a situation where a bankruptcy petition has been filed or similar action taken, but payments on this obligation are being continued. Bonds in this category are in default of some provisions in their trust deed.The company may be in the process of liquidation. A company that has its rating suspended is experiencing severe financial or operating problems of which the outcome is uncertain. The company may or may not be in default, but there is uncertainty as to the companys ability to pay off its debt.

D (Default)
Review the on-line summary or checklist associated with this section.

Suspended (Rating Suspended)

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SUMMARY
After reading this chapter, you should be able to: 1. Describe the fixed-income market and discuss the rationale for issuing debt instruments. The dollar value of trading in the Canadian secondary debt market is considerably larger than the dollar value of equity trading. Companies use fixed-income securities to finance and expand their operations or to take advantage of operating leverage.

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. 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 issuers credit rating.

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 allows the issuer to call the bond at a price based on the greater of par or the price based on the yield of an equivalentterm Government of Canada bond plus a yield spread. 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.

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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. 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 holders position.

3. 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 between October and April of each year but are cashable at their full par value plus any accrued interest by the owner at any bank in Canada at any time. Canada Premium Bonds (CPBs) are very similar to CSBs but offer a higher interest rate when they are issued. They can be redeemed only once a year without penalty, on the anniversary of the date of issue and for 30 days thereafter.

4. 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 provinces 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 municipalitys 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.

5. Identify the different types of corporate bonds and describe their features. A bankers acceptance is a short term debt guaranteed by the borrowers bank that is sold at a discount and that mature 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 that mature at face value.

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First mortgage bonds are the senior securities of a company because they constitute a first charge on the companys 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 fixedinterest securities of the borrower. 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. Foreign bonds are issued in a currency and country other than the issuers, which allows the issuer access to sources of capital in many other countries. Eurobonds are issued and sold outside a domestic market and are typically denominated in a currency other than that of the domestic market.

6. Describe the features of term deposits and guaranteed investment certificates. 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 depositors death or extreme financial hardship.

7. Interpret bond quotes and summarize and evaluate bond ratings.


Now that youve completed this chapter and the on-line activities, complete this post-test.

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, the Dominion Bond Rating Service, Moodys Canada Inc. and the Standard & Poors 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.

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