With your host Hank Cunningham
Accretion – see amortization.
Accrued interest – interest that adds up daily between interest payment dates. It is paid to investors on interest payment dates or on the settlement date if investors sell between interest payment dates.
Amortization – from the Latin "a mort," to death. This refers to the process where as time passes, your fixed income investment moves inexorably to its face value or maturing value.
Ask – the price at which a bond trader is willing to sell a certain fixed income instrument. Offer is sometimes used to mean the same thing but can lead to confusion because if you ask someone to make you an offer, they might think you want a bid. Stick to Ask.
Balloon – the maturing principal of a bond issue.
Bank of Canada – Canada's central bank. Its responsibilities focus on the goals of low and stable inflation, a safe and secure currency, financial stability and the efficient management of government funds and the public debt.
Bank Rate – The minimum interest rate at which the Bank of Canada extends short-term loans.
Basis point – in bond lingo, this is how everything gets measured (e.g., so many basis points over Canadas). A basis point is one one-hundredth (or 1/100) of 1%. Thus, if the Bank Rate falls 25 basis points, that is the same as 25/100 =1/4 of 1%.
Bellwether – essentially the same as benchmark although its use refers to those issues media and market commentators refer to when describing the bond market's direction. For example, the bellwether long Canada, the 8s of 2023, rose $1 in active trading. The bellwether is thus a proxy for the market itself. Because of an active crowd of followers and speculators, an issue may remain a bellwether while being replaced as a benchmark! Make sense? For many years the Canada 8% bond, due June 1, 2023, was the bellwether issue for the long-term market, even when it rose to $135 when interest rates fell. The major dealers would use it for speculative purposes, to hedge inventories, and to price both other new issues and their own long-term bond inventories. Market commentators would point to this one bond to give an idea of how the market was behaving. Speculators, both individual and institutional, continued to play this issue even after the market had gone up 20 points.
Benchmark – refers to bonds by which others are valued. Earlier in the book, the process of creating benchmarks is described. The Bank of Canada (and some provinces) issue and reissue bonds at strategic maturity points (typically 2, 3, 5, 10 and 30 years). In so doing, these bonds issues become sizeable enough that they trade freely with tight bid-ask spreads. When issuers bring new bonds to market, the presence of these issues makes pricing easier since accurate market yields are readily available as references or benchmarks. Retail investors are wise to stick to these benchmark or global issues, as retail desks are more likely to maintain inventory in and have lower transfer prices for such bonds since the turnover is higher.
Of course benchmarks are sent to pasture to be replaced by new ones. This is so since the passage of time leaves gaps at the key maturities (e.g., a 5-year bond becomes a 4-year bond one year later).Or interest rates may change significantly, leaving the benchmark issue with too high or too low a coupon for practical use.
Bid – what a bond trader is willing to pay for a certain bond.
Bond – a security issued by a government or corporation paying fixed or floating interest payments. There is thus a bond between borrower and lender. It is also used in a broader sense to describe the bond market. S ee also debentures.
Bond trader – an individual who makes markets in bonds. Most of the bonds that traders trade mature before they do!
Bonus – what bond traders are paid for skilful trading.
Book – once you have selected your IA, you become part of his or her book of business. This refers to the number of clients and the amount of assets in total that the clients have. Ask about an IA's book: how many clients, size of assets, turnover, number of sales assistants, composition etc.
Book-based – refers to the electronic record keeping of who owns what. The days of physical securities, actual pieces of paper, are almost totally over.
Broker – what you are after dealing with a bad one. Terms such as investment advisors (IAs), financial advisors, investment executives (IEs), financial planners (FPS) have been introduced to give a warm and fuzzy feeling to your investment making decisions.
Callable – This is important, as this term normally works against you. Suppose you borrow money from your friendly bank when interest rates are 20%. Wouldn't it be nice to be able to refinance the loan when rates fell to 10%! Of course. This is called a call feature, where the borrower may prematurely pay off the loan. As a lender, you do not want this to happen. If you call the peak in interest rates accurately, buying long-term bonds at attractive yields for, say, 20 years, the last thing you want is to get your money back in 10 years should rates fall, forcing you to reinvest at the then prevailing lower yields. This is what callable means. Only the borrower may call the issue. Today, most bond issues are non-callable for financial advantage. Past callable issues still trade and are often quoted in the weekend newspapers. The quoted yield is much higher than other bonds but reflects the fact that they may be called soon. The bigger the gap between the coupon rate on a callable bond and existing market rates, the greater the certainty that the issue will be called and refinanced. Examine your portfolios carefully. Almost all the callable bonds outstanding were issued when rates were much higher than they are today. Sell them and reinvest in a non-callable issue.
Call loan – how investment dealers finance themselves. Also called overnight money. Dealers post their inventory as collateral. This rate is every bit as important as the Bank Rate—ask your IA what the overnight rate is sometime! The Bank of Canada influences money market rates by altering the amount of cash in the system.
Cold-call – the opposite of a hot tip. Actually, it refers to a phone call, not solicited by the party being phoned, from an IA; typically, it is a new IA or a junior or someone whose business has fallen. Sales managers give quotas to such IAs and so they interrupt people at work or at home in order to impress upon them that they should move their entire investment portfolio immediately to these starving, but brilliant advisors! Anyone who has to make cold calls is not successful. If it suits you, ask them a few skill-testing questions or for some performance stats!
Compound interest – interest earned by reinvesting interest payments; or interest on interest, to put it another way.
Convertible bonds – issued with a coupon rate and a maturity date like most bonds, but also carrying a feature which gives investors the right to convert their debt to equity on specific terms.
Convexity – who cares? It is the second derivative of duration.
Credit – from the Latin credere , "to believe". When you invest in a fixed income security, you believe that the borrower will pay you back.
Credit rating – the likelihood that a borrower will pay you back. Credit rating agencies assess the financial strength of issuers. The most well known are Standard and Poors, Moody's, and Dominion Bond Rating Service.
Debenture – a "bond" issued with no specific collateral to back it. Strictly speaking, government bonds are actually debentures.
Defeasance – offsetting a future liability with an asset of similar maturity and amount. Strips are commonly used to defease a future debt as they can be invested to a precise future value.
Discount rate – a symbolic rate. Nominally, a rate at which a central bank will advance funds to approved borrowers. It is an instrument of monetary policy; a change in the Discount rate is a signal to the market place that the central bank wants market rates to move in the direction signaled. As well, in the event of emergencies, where a credit crunch is taking place, loans will actually take place at the discount window. Small "d" discount refers to a rate applied to a future sum to arrive at a present value. It also refers to bonds trading at less than their face value or par value. Confused yet?
Duration – the average life of your fixed income investment. A 10-year bond is not a 10-year bond. What? All those pesky interest payments shorten the average term. The bigger the interest payments, the shorter the duration. Got it yet? For a zero coupon bond, maturity and duration are the same since there are no cash flows to worry about. Duration is tossed around by bond cognoscenti as a way of measuring risk.
Face value – the stated nominal value of your fixed income investment. For example, you invest $98,000 in a bond that matures to $100,000. The $100,000 is the face value of the bond. The market price may go above or below that value, but that is what will be returned to you.
Fixed – a rate of interest paid by a borrower on a bond that stays constant or fixed .
Flat – refers to a yield curve where yields are the same at all maturities. Also can mean that a bond is trading with no accrued interest, either because the settlement date coincides with the coupon payment date or else because the issuer is not able to make interest payments.
Floating – a rate of interest that is adjusted at specific intervals using a specific formula. For example, every three months at three month treasury bills plus 25 basis points.
GICs – G-I-Cs, also pronounced "geeks". These are securities issued by banks so that they can lend your money out at a higher rate.
Hedge – a dog's best friend? What IAs do when asked a tough question? What bond traders do to protect their inventories from market fluctuation. Typically, it involves selling short benchmark issues against long positions.
IDA – Investment Dealers Association (ida.ca). A self-regulatory body for all the investment dealer members (similar to the inmates running the asylum!)
IDB – Interdealer broker. An intermediary that facilitates trade between investment dealers by posting anonymous bids and offerings.
Institutions – where some traders end up! Large financial organizations, namely life insurance, pension funds, mutual funds, governments, and banks, make up the bulk of bond market activity. They represent the individual investor since they are trading other people's money—your pension, mutual fund units, bank deposits, etc.
Interest – what you had when you bought this book! Money paid to investors by borrowers for lending them money. Similar to a landlord/tenant relationship. Interest payments are thus analogous to rent payments.
Inventory – to facilitate the retail and institutional customers, investment dealers maintain inventory of "shelf products", financed with their own capital and which are offered at hopefully competitive prices.
Investment dealers – organizations that provide a wide range of services to both issuers of securities and those who invest in them. They provide market making ability in money and bond markets, underwriting capability and brokerage services, among others.
Jobbers – approved money market dealers who MUST bid for each week's treasury bill auction. They are Bank Of Montreal, CIBC, Deutsche Bank Securities, Laurentian Bank, Merrill Lynch Canada, National Bank Financial, RBC Dominion Securities, Scotia Capital and Toronto Dominion Bank.
Junk bonds – the refuse of the bond market. Refers to bonds issued by companies whose credit ratings have fallen below levels considered not safe for investors. Their relative and absolute high yields reflect how risky they are.
Leverage – what you use to get better prices by threatening to take your business elsewhere. Refers to buying bonds on margin. Long Canadas are marginable at 4% for investment dealers and typically 10% for individuals. That represents considerable leverage.
Liquidity – what traders seek after work! The relative ease by which investors may buy or sell bonds.
Long position – a bond position owned in inventory by an investment dealer.
Management fees, or MERs – what you pay a mutual fund manager to gamble with your money.
Margin – money loaned to you by an FI to finance a leveraged position.
Mark up – the amount that IAs add to the transfer price from their bond desk in order to get paid.
Matrix – a cool movie. Refers to establishing a price for a bond by linking it to another, more actively traded issue in order to provide a quote.
Maturity – something that bond traders seldom reach! It is the point in time at which your fixed income investment comes to an end and your principal or face value is returned to you.
Monetary policy – carried out by the Bank of Canada, it refers to policy that either stimulates or restricts money supply growth by either lowering or raising interest rates or by expanding or contracting bank reserves.
Money market – a bazaar for dough! It refers to fixed income securities issued with a term to maturity of one year or less. It is also applied to those bonds issued with a maturity date longer than one year but whose maturities have now reached less than one year owing to the passage of time.
Mutual funds – entities that take your money and mingle it with a whole lot of other people's money and pay themselves handsomely in the process. They give you that cosy, mutual feeling.
Offer – See ask. Opposite of a bid. It is the price at which a trader is willing to sell a bond.
Off the run – this refers to a bond issue that is not a benchmark issue. It may have a very high or low coupon, it may be a small, illiquid issue, its ownership may be concentrated in few hands or it may have a feature or features that make it unattractive to trade—the bid-ask spread will be wider for such an issue, as dealers either do not wish to hold them in inventory or if they do, find it difficult to sell them quickly. This sometimes works in the favour of the client but not often, as the transfer price is typically higher than it would be if the issue was "on the run".
Over the counter – essentially means "not centralized". Unlike the equity market, which has a recognizable physical location to trade stocks, the bond market is decentralized, with no one meeting place; transactions occur verbally or electronically between market participants (Bank of Canada, chartered banks, investment dealers, mutual funds, individuals). Bonds trade on a "principal" basis. Unlike with equities, where buyers and sellers meet to trade a stock and charge each client a commission, bonds trade on a net basis. By this is meant that dealers maintain inventories of fixed income products, financing them with their own capital, and attempt to sell said inventories at slightly higher prices than they paid. Thus at the retail level, it is similar to a retail store. The dealers maintain "shelf product", mark up from wholesale to compensate for risk, cost of capital, etc., have bargain days, and so on. They must maintain competitive pricing since they are selling the same line of goods as their principal competitors.
On the run – not a fugitive trader! This is an actively traded bond whose coupon rate is close to current yield levels so that its price is close to par.
Par – known by IAs as an acceptable golf score, it also refers to a price of $100. Bonds mature at par or 100% of their face value.
Performance – what your investments return.
Present Value – what that birthday gift is worth. What an amount of money due in the future is worth today after applying a discount rate.
Primary Dealers – Those investment dealers chosen by the Bank of Canada to bid for new issues and to make orderly secondary markets for Government of Canada issues.
At present there are 11 Primary Dealers: BMO Nesbitt Burns, Casgrain and Co., CIBC World Markets, Deutsche Bank Securities, Merrill Lynch Canada, J.P. Morgan Securities Canada, Laurentian Bank Securities, National Bank Financial, RBC Dominion Securities, Scotia Capital and Toronto Dominion Bank.
Positive – also upward-sloping, refers to a "normal" yield curve, one where the longer the term to maturity the higher the yield.
Principal – what you lend. It is returned to you at maturity date.
Principle – what you hope your IA has lots of.
Reconstitution – the reverse of stripping: putting a bond back together again.
Redeemable – similar to callable bonds but with one HUGE difference. Normally issued by corporations, a redeemable bond may be "called" by the issuer but NOT for financial advantage. In other words, the issue may not be redone at a lower coupon rate. Rather, should a company have surplus cash or in the event of a corporate development (takeover, etc.), the bond issue may be retired prematurely.
Reinvestment risk – this is the biggie! There are two basic risks. The first is that the yield to maturity quoted on a bond may not be realized since all interest payments never get reinvested at the same rate. Second, having your entire portfolio mature at the same time is a financial version of Russian Roulette. Rates may have fallen dramatically, leaving you much poorer.
Residuals – what authors are paid! Residuals are actually the principal portion left over after all the interest payments have been stripped away. We do not call them principals because that would be easy to understand!
Registered Retirement Savings Plan (RRSP) – a PLAN that allows individuals to defer tax until retirement.
Semi-annual – for bonds, twice a year. Most bonds pay interest on a semi-annual basis. Do not be tricked into buying any biennial pay bonds!
Short selling – selling a security that one does not own. Typically used by investment dealers to hedge their long positions, to accommodate client demands, or to speculate on falling bond prices.
Sinking fund – there are two types of sinking funds. (No, they do not refer to the performance of your portfolio.) The first is found on older corporate bonds: a sinking fund is a feature that says that a company MUST redeem a certain percentage of an issue each year before maturity. This feature reduces the burden of paying an entire issue off at one date and also reduces the debt in proportion to the depreciation of the asset built or purchased with the proceeds. It also provides for liquidity, since the issuing company provides bids for the bonds; however, should interest rates fall, the company redeems the bonds at par or face value, again not a welcome development for the lender since the bonds should trade at a premium! In the good old days when there was a thriving corporate bond market, with all these features attached, institutional bond jockeys would play the "sinking fund game", corralling large blocks in an attempt to get the sinker to pay a higher price than justified by the credit. Those days are, sadly, no more. Steadily declining rates in the last 12 years have brought home to many the negative side of these various features that may see their investment prematurely terminated. A second type of sinking fund is a general sinking fund. Normally issued by provinces, this feature indicates that the borrower must set aside a certain percentage of money every year but does NOT have to buy that specific one. This adds to liquidity and allows the issuer to invest in bonds (frequently stripped bonds) to allow for the orderly repayment of the bond issue at maturity.
Spread – the difference between the bid side and the offered side of a bond quotation. The shorter the bond and the higher the quality of the bond, the closer or "tighter" the bid-ask spread. Benchmark issues trade tighter than other bonds. Small corporate bond issues with little float may not even have a two-sided market. The spread thus incorporates a trader's feel for how quickly a bond may be sold.
Strips – zeros, residuals, TIGRs, Sentinels, Cougars, they are all the same. They are zero coupon bonds that pay no interest. Excellent for retirement planning, they trade at a discount from par or maturing value; the size of the discount will depend on the amount of time to maturity and the yield to maturity.
Stripping – separating the components of a bond—interest payments and the principal—and selling them all as separate zero coupon securities.
Switches – used to beat your IA for poor performance! They are transactions or trades where one bond is exchanged or traded for another for any one of a number of reasons—to shorten term, extend term, pick up yield, improve quality, etc.
Transfer price – the price at which the bond-trading desk transfers a bond to an IA. In other words, the salesperson's cost. To make a living, the salesperson must add a commission to this cost. The client does not see this since bonds are quoted on a "net" or "all-in" basis. Therefore, there are two factors at work here. The transfer price will vary from one investment dealer to another and is a function of the philosophy and structure of that organization. This is why it is important to ask about a firm's philosophy as to whether or not the retail desk is master of its own destiny or has to pay the wholesale desk something. Clearly, the lower the transfer price, the lower the cost to the client; an FA with the lowest transfer price will increase his business over competitors with higher transfer prices (assuming the same mark-up). Word spreads when a broker has the best prices around. The corollary is that a broker facing a higher transfer price may have to reduce the mark-up in order to remain competitive and thus face lower earnings.
Transparency – the ease of being able to view bond quotes and transactions. The Canadian bond market is more opaque than transparent.
Unit holder – one who owns units in a mutual fund.
Volatility – how much the price of a bond changes for a given movement in yield.
Yield – current, to maturity. Basically, what an investment returns. Current yield of a bond is the coupon rate divided by the price. This is also known as "running yield." However, it is misleading, as bonds have a maturity date and the difference between the market price and the value at maturity must be factored into the yield.
Yield curve – a line drawn joining yields at different maturity dates.