The Bond Market

Learning Objectives 3
Overview of the Bond Market 3
Important Characteristics 4

Bond Valuation 5
Estimating Changes in Bond Prices 7
Understanding Bond Quotations 8
Calculating Accrued Interest

Buying and Selling Bonds 10

Electronic Bond Trading Systems in Canada 10
Settling Trades 11

Holding Period Returns and Bond Yields are Different 11

Additional Features that Impact Returns 12

Callable Bonds 12
Extendible Bonds 12
Retractable Bonds 12
Floating Rate Bonds and Fixed-Floaters 13

Composition of the Canadian Bond Market 13

Bond Market Indices 13

Types of Bonds 15
Government of Canada Bonds 15
Provincial Government Bonds 15
Municipal Bonds 16
Corporate Bonds 16

Credit Ratings and Default Risk 17

DBRS Bond Rating Definitions 19

Protective Covenants 20
Positive Covenants 20
Negative Covenants 21

Other Types of Bonds 21

Real Return Bonds 21
Stripped Coupons 22

1
 Maple Bonds 22
Yankee Bonds 22
Eurobonds 22
Samuarai Bonds 22
Bulldogs 22
Convertible Bonds 23

Key Terms 23

Charts
1 Composition of the Canadian Bond Market 3
2 US and Canadian Government Bond 10 year Interest Rates 5
3 Relationship Between Bond Prices and Yields to Maturity 7
4 Canada and US Yield Curves 9
5 Percent of Canadian Bonds by Issuer Type 14
6 Percent of Total Domestic Bond Markets 15
7 Corporate Spreads 17
8 Bond Credit Ratings 18
9 Financial Ratios 20

Appendix 24
Primary Dealers - Government of Canada Bond Auctions
Announcement of Government of Canada Bond Auction and Results
Supplementary Material

2
THE BOND MARKET

Learning Objectives:

1. Describe the basic characteristics of a bond

2. Understand the different types of bonds that are available in the Canadian market

3. Understand bond valuation and how to calculate a bond’s price and yield to maturity

4. Explain the factors that impact bond prices and yields

Overview of the Bond Market

Our previous chapter discussed short term fixed income securities that trade in the money market. We
learned that governments and corporations issue money market securities to borrow funds for working
capital and to meet other short term financing needs. We also learned that investors purchase money
market securities when they need to invest a short term cash surplus and when they need liquidity to
cover unexpected cash outflows.

Many borrowers who issue money market securities also require long term funding to pay for capital
expansion or acquisitions. Corporations finance their long term projects by issuing bonds, which are
fixed income securities that mature in more than one year, and also by selling shares of their business to
raise equity capital. Governments are significant issuers of bonds, especially during periods of fiscal
deficit. As of mid 2012, bonds issued by governments accounted for 69% of the total value of bonds
outstanding in the Canadian market.

CHART 1

Source: iShares, DEX Bond Universe

3
Investors who purchase bonds include financial intermediaries such as pension funds, insurance
companies and mutual funds, and individuals who have long investment horizons and want to earn
returns that exceed the rates available on money market securities.

In this chapter, we will discuss the types of fixed income securities that issuers sell in the financial
markets to raise long term debt capital. Equities will be discussed later in chapter XX.

Important Characteristics

Bonds are securities that represent a debt owed by the issuer to an investor. The issuer, usually a
government or a corporation, is legally obliged to make periodic interest payments to investors and to
repay the principal amount borrowed (par or face value) on the bond’s maturity date. Bonds differ from
money market securities in two important ways:

 They are issued for terms to maturity that exceed one year.

 They are not sold on a discount basis. Instead, the issuer makes separate interest payments to
the investor, either annually or semi-annually, depending on the type of bond. The final interest
payment is made on the maturity date when the principal amount (par value or face value)
borrowed is also repaid.

The amount of interest that investors receive is based on the bond’s stated “coupon rate” and its face or
par value, and it is usually fixed for the entire term to maturity of the bond. That’s why bonds are called
“fixed income securities”. The coupon rate is the percentage of a bond’s face value that that investors
receive annually as interest. The minimum denomination for bonds is $1,000 face value, the same as it is
for money market securities.

The coupon rate is set when the bond is first issued, based on default risk, the initial term to maturity of
the bond, and the level of interest rates in the financial market on the issue date. A fixed coupon rate is
advantageous for borrowers because it allows them to finance long term projects at a predetermined
interest rate.

European bonds pay interest annually, while bonds issued in Canada and the United States usually make
semi –annual interest payments (called “coupon payments”), based on half the stated coupon rate. One
interest payment, called “a coupon payment”, is always made on the day and month of the maturity
date. The last payment, made on the bond’s maturity date, consists of the final coupon payment and
repayment of the face or principal value, as shown below.

4
Illustration: Cash Flows received from a Bond Chart is from Booth & Cleary

The term “bond” is generally used to describe all debt securities that pay coupons and mature in more
than one year. However, there are important differences between bonds and debentures, both of which
meet those two basic criteria. According to legal definitions, a bond is secured or collateralized by
specific real assets owned by the issuer. It differs from a “debenture” which is a form of unsecured debt,
backed only by the creditworthiness of the issuer and a general promise to pay. Sometimes, unsecured
fixed income securities with terms to maturity between 1 and 10 years and issued by corporations are
called notes.

Every bond (or debenture) is a legal contract between the issuer and the investor. Information on the
terms of the contract, including coupon rate and payment dates, maturity date and all conditions, called
“covenants”, that the issuer must fulfill are detailed in a legal document called a “trust indenture”.
Every bond issue has a “trustee”, usually a trust company, that act on behalf of invests to ensure that
the issuer complies with the conditions of the trust indenture.

Bond Valuation

Bond prices change daily, just as stock prices do, and are determined by financial market conditions.
Changes in interest rates lead to changes in the market price of bonds.

CHART 2

5
The price of a bond is the discounted present value of all cash flows that will occur between now and
the maturity date.
T
ParValue T
PB   (1Cr )
t 1
t
T

(1 r )
T

PB = the market price of the bond today

Ct = the amount of the coupon payment at time t

T= the number of coupon payments remaining until the maturity date

Par Value = the face or maturity value of the bond

r = the appropriate discount rate

Before calculating the price of a bond, we must first determine the frequency of coupon payments.
Canadian and US bonds pay interest semi-annually, so there are two coupon payments per year, and
each coupon payment equals the bond’s par value multiplied by the coupon rate/2 . For European
bonds, the coupon payment frequency is annual so each coupon payment equals the par value
multiplied by the coupon rate.

The discount rate r is determined by the level of interest rates (called yields to maturity) in the bond
market. For bonds that pay interest semiannually, r = the yield to maturity/2. Note that this calculation
is determined by bond market convention, and assumes simple interest. For bonds that pay interest
annually, r = the bond’s yield to maturity.

Example:

Calculate the price of a Government of Canada bond with a 15 year term to maturity, a coupon rate of
5% and a 41,000 par value. The yield to maturity in the market today for 15 year bonds issued by the
Government of Canada is 6%.

Solution:

Canadian bonds pay interest semiannually so there are 15 x 2 coupon payments remaining and T=30.

Each coupon payment Ct= 5%/2 times $1,000 = $25

The discount rate r = 6%/2 so

30
$25 $1,000
PB   t
 30
 $902 per $1,000 par value of bonds
t 1 (1  0.03 ) (1  0.03 )

In the bond market, traders would quote the price of this bond as $90.20 per $100 par value.

6
Calculator Solution:

PMT = $25, N = 30, FV = -$1,000, I/Y = 3%; Calculate PV →$902

Estimating Changes in Bond Prices

The bond pricing formula indicates that an increase in the discount rate will cause the price of a bond to
decline. This inverse relationship between bond prices and yields to maturity implies that bonds
generate capital gains when yields fall and suffer losses when yields rise. Consequently, investors who
want to earn the highest possible return on their bond portfolios must forecast changes in interest rates
and purchase bonds that have the highest expected return.

The bond pricing formula provides insight to this process. Since the bond price is the discounted present
value of expected cashflows, a change in the discount rate will have the greatest impact on the present
value of cashflows that occur in the distant future. That implies that bonds with the longer terms to
maturity will gain most when yields fall and lose most when yields rise, as shown in Chart x.

The bond pricing formula also suggests that size of a bond’s cashflows is also important. If two bonds
have the same term to maturity but different coupon rates, the price of bond with the lowest coupon
rate (smallest coupon payment) is more sensitive to a change in the discount rate.

CHART 3 - Relationship between Bond Prices and Yields to Maturity

Source: Twist Financial

7
Modern financial calculators make it easy to calculate the impact of a change in the discount rate on the
price of any bond. However, a measure called “bond duration” can be used to make quick estimates that
incorporate the impact of a bond’s term to maturity and coupon rate. Duration calculations are beyond
the scope of this book, but the duration of many bonds is available from Reuters, Bloomberg and other
online sources of bond prices and yields.

For example, a bond with 10 years term to maturity has a duration of 7 years, so a 100 basis point (100
basis points = 1%) increase in its yield to maturity will cause its price to fall by 7%.

Understanding Bond Quotations

Below are recent bond price quotations, which are available from several online sources, including CBID
http://www.pfin.ca/canadianfixedincome/Default.aspx, Bloomberg and Reuters.

The chart below shows recent market quotations for two bonds issued by the Government of Canada:

Issuer Coupon Rate Maturity Date Bid Price Ask Price Bid Yield

(1) Gov’t of Canada 2.75% June 1, 2022 $108.67 $108.87 1.80%

(2) Gov’t of Canada 5.75% June 1, 2029 $150.09 $150.39 2.20%

Source: CBID; Quotes as of May 25, 2012

Bond quotations provide the following basic information for investors:

Issuer: Investors who purchase these bonds are loaning money to the Government of Canada

Coupon Rate: Investors who own Bond (1) will receive annual interest payments equal to 2.75% of the
face value of the bond. Since Government of Canada bonds pay interest semi-annually, investors will
receive two interest payments per year equal to 2.75%/2 of the face value of the bond, or $1.375 per
$100 face value. The 2.75% coupon rate reflects the yield to maturity that existed in the market when
this bond was first issued.

Maturity Date: Bond (1) will mature on June 1, 2022. Investors will receive interest payments on June 1
and December 1 of each year, and repayment of principal on June 1, 2022.

Bid Price: Dealers are willing to pay $108.67 per $100 face value to investors who want to sell Bond (1).

Ask Price: Dealers are willing to sell Bond (1) for $108.87 per $100 face value.

Bid Yield: The bid price of $108.67 per $100 face value for Bond (1) implies that this bond is trading at
“yield to maturity” of 1.80%. This rate reflects current market conditions and reflects the yield that
investors required as of May, 2012 on 10 year bonds issued by the Government of Canada. Since today’s
yield to maturity is lower than the coupon rate, this bond trades at a “premium” to its face value.

Note that the yield to maturity for bond (2), which matures in 17 years, is 2.20%. Investors usually
require a higher yield to maturity to invest in longer term bonds.
8
CHART 4

Source: The Daily Roll

Coupon interest on a bond accrues daily, but is paid only once or twice a year, depending on the
frequency of coupon payments (annual in Europe and semi-annual in North America). If a bond is
purchased or sold between coupon payment dates, the price must be adjusted for interest that has
accrued since the last coupon payment. Consequently, when bonds are traded, buyer must pay the
seller the amount of interest that has accumulated since the last interest payment. This amount, called
“accrued interest”, must be added to the purchase price of the bond.

Calculating Accrued Interest:

Accrued interest for Government of Canada bonds are calculated as follows:

C/2  actual number of days from the last coupon payment to settlement date
actual number of days in coupon period

Example: A Government of Canada bond with a 4% coupon rate is quoted at $114 - $115. This bond
made a coupon payment 100 days ago. You want to buy $1 million face value.
How much accrued interest must you pay the seller?
What is the total amount you must pay for this bond?

Canadian bonds pay coupons semi-annually, so:

 Time between coupon payment dates is 365/2=183 days.
 Amount of each coupon payment is 4%/2 or $2 per $100 face value
 Amount of accrued interest to be paid is (100 days/183 days)*$2 or $1.0929 per $100 face
 The total accrued interest to be paid on $1million face value of bonds is $1.0929*10,000 or
$10,928.96
 The total amount you must pay the seller = Price + Accrued Interest = (10,000*$115) +
$10,928.96
or $1,160,928.96

9
Source: Bank of Canada

Buying and Selling Bonds

Most bonds are marketable securities, traded in the OTC (over the counter) market by investment
dealers who transact business by phone or computer systems. Dealers’ trading desks transact large
volumes, but electronic bond trading systems have become very important in recent years, especially
among large institutional investors who buy and sell large amounts of securities. In Canada, the largest
electronic bond trading system is managed by CanDeal.

Liquidity in the bond market varies with the type of issuer. Bonds issued by the Government of Canada
have excellent liquidity while some corporate bonds are relatively illiquid and trade infrequently.

Bond trading is overseen by IIROC (Investment Industry Regulatory Organization of Canada), a national
self-regulatory organization to which all investment dealers belong.

Electronic Bond Trading Systems in Canada – CanDeal

CanDeal is the leading online marketplace for Canadian dollar debt securities (www.candeal.ca ).
It provides online access to the largest pool of liquidity for Canadian government bonds and
money market instruments. The network delivers the market making power of Canada’s 12
Primary Dealers. CanDeal’s marketplace is available to institutional investors in Canada, the
United States and Europe.

CanDeal’s stakeholders include: BMO Nesbitt Burns Inc., CIBC World Markets, National Bank
Financial Inc., RBC Capital Markets, Scotia Capital, TD Securities and TMX Group. CanDeal has
assembled Canada’s deepest liquidity pool for Canadian debt securities. It provides
direct access to the pooled liquidity of Canada’s 12 primary dealers:

Source: Candeal

Settling Trades:

10
Two dates are important for trading bonds: the trade date (or transaction date) and the settlement date
on which cash payment is made or received. Recall that, for money market securities, the trade date and
the settlement date are the same. For bonds, the trade date and settlement date differ, and the
settlement period varies with the type of bond:

 Government of Canada bonds maturing within 3 years – Trade date + 2 business days

 Government of Canada bonds maturing more than 3 years – Trade date + 3 business days

 All other bonds – Trade date + 3 business days

 Note that stock trades also have a 3 days settlement period.

For bonds, the price is established on the trade date, but accrued interest is calculated to the settlement
date because that is when ownership is transferred from the seller to the buyer.

Historically, physical certificates provided evidence of ownership of a bond. Certificates were available in

registered form (inscribed with the name of the owner) or in bearer form, where the owner was not
named, and settlement involved an exchange of paper. Today, most bonds in Canada and around the
world, are issued in “book-based” form that uses electronic records of ownership. Settlement for most
bond trades occurs electronically, through the Canadian Depositary for Securities (CDS) and its global
counterparties which include Euroclear.

Holding Period Returns and Bond Yields are Different

Investors who buy bonds sometimes mistakenly believe that their rate of return will be the same as the
bond’s yield to maturity. That is true only if they hold the bond to maturity and can invest all coupon
payments at the yield to maturity at which they purchased the bond.

In reality, the return on a bond has three components: Coupon payments, capital gain or loss, and
income earned from reinvesting coupons. Reinvestment income is typically very small, so we will ignore
it here for simplicity.

Example:

Suppose we buy a bond with 10 years term to maturity and an 8% annual coupon rate, and hold it for 6
months. During that time, the bond’s yield to maturity falls from 9.76% to 8%, so its price increases from
$950 to $1000 per $1,000 face value.

Our holding period return has two components:

11
 Pt  Pt 1 1,000  950
 Capital gains yield due to the change in price   5.26%
Pt 1 950

C 40
 Income yield due to coupon payment received   4.21%
Pt 1 950

Total holding period return = 5.26% + 4.21% = 9.47%

Note that more than half of our total holding period return in this example is due to capital gains earned
as the yield to maturity declined.

It is important to distinguish between the holding period return, the income yield and the “current
yield” of a bond. Current yield is simply expresses the annual coupon income as a percent of the
purchase price of the bond. It ignores the holding period and the possibility of gains or losses. For the
bond in this example, current yield = $80/$950 = 8.42%

Additional Bond Features that Impact Returns

Most bonds have a fixed coupon rate and a single predetermined maturity date, so their cashflows are
easy to predict. Others, especially those issued by corporations, may have features that alter the timing
and amount of cashflows, depending on future changes in the level of interest rates.

Callable bonds – The bond issuer has the right, but not the obligation, to “call” or repay the bond before
its stated maturity date at a preset price (the call price). Issuers will call the bond if interest rates have
fallen since the bond was first issued. Because call reduces the term of the bond and the number of
coupon payments investors, it can reduce the investor’s return and cause the bond price to decline.

Extendible bonds – Investors have the right, but not the obligation, to demand that the issuer increase
the term of the bond by extending its maturity date.

Retractable bonds – Investors have the right, but not the obligation, to demand that the issuer reduce
the term of the bond and repay principal before the original maturity date.

Floating Rate Bonds and “Fixed Floaters” – Some bonds have coupon rates that change or “float” if
interest rates rise or fall. Others are “fixed – floaters” whose coupon rate is fixed only for a specified
period of time, and floats thereafter. In the Canadian bond market, most fixed-floaters are issued by the
chartered banks.

A full description of a bond’s attributes is provided in the trust indenture.

Composition of the Canadian Bond Market

12
Bonds are usually classified by the type of issuer. Governments, both federal and provincial, are active
borrowers as they must issue bonds frequently to finance their growing deficits. Corporations are also
issue bonds, but access to the Canadian bond market is generally limited to issuers that have good
financial strength.

Bonds are also classified by their remaining term to maturity, according to the following guidelines:

 Short term – 1 to 5 years

 Mid Term – 5 to 10 years term

 Long Term – 10+ years

Bond Market Indices

Bond indices have existed in the Canadian market only since the late 1970’s when they were developed
by Scotia Capital. Like stock market indices, they reflect the composition of the market and provide a
daily measure of bond market performance. Today, the DEX bond market indices, owned by TSX, are
widely followed by investors.

The overall investment grade Canadian bond market is represented by an index called the DEX Bond
Universe. Other DEX indices represent the performance of different components of the Canadian bond
market, including DEX All Governments Index and DEX All Corporates Index, as well as DEX Short Term,
Mid Term and Long Term indices.

The composition of the bond market changes over time, reflecting the amount of new bonds issued by
governments and corporations, net of maturing securities. Periods of high government deficits lead to
increased issuance of government bonds, as occurred during the 1990’s when Canadian government
deficits spiked as a percentage of GDP.

CHART 5 – Percent of Canadian Bonds by Issuer Type

13
Source: iShares, DEX Bond Universe

There are also indices represent the global bond market, and the bond markets of different countries.
The largest provider of fixed income market indices is Barclays Capital, which acquired them from
Lehman when that firm failed during the US financial crisis.

https://ecommerce.barcap.com/indices/index.dxml

Canada has a well developed domestic bond market but it is much smaller than the bond markets of the
United States and Japan.

CHART 6

14
Source: BIS; December, 2011

Types of Bonds

Government of Canada Bonds

The Government of Canada is the largest single issuer of bonds in the Canadian market, representing
41% of the total dollar value of bonds outstanding. Similar to Treasury Bills, Government of Canada
bonds are sold in an auction, which is managed by the Bank of Canada and announced in advance. Only
authorized investment dealers may submit bids (Press announcements of a recent Government of
Canada bond auction, auction results and a list of authorized investment dealers is provided in the
Appendix.) All bonds are marketable and very liquid. Bonds issued by the Government of Canada are
deemed to have no default risk, so their yields to maturity are the lowest for any given term to maturity.

The government of Canada also guarantees bonds issued by its agencies, which include Export
Development Corporation (EDC), Business Development Bank of Canada, Central Mortgage and Housing
Corporation (CMHC), and Canada Housing Trust (CHT). These bonds have slightly less liquidity so they
trade at slightly higher yields that Government of Canada bonds of comparable terms to maturity.

Provincial Government Bonds

Provincial governments also issue bonds to finance their deficits. The largest issuers are the largest
provinces: Ontario and Quebec. In aggregate, provincial bonds now represent 27% of the Canadian bond
market and the amount is growing with the recent increase in provincial government deficits. Provincial
bonds have low default risk and less liquidity, relative to bonds issued by the Government of Canada, so
their yields to maturity are 70 to 100 basis points higher for comparable terms to maturity.

15
Municipal Bonds

Bonds issued by municipal governments are a large component of the US bonds market, but they are
insignificant in Canada where they account for less than 1.3% of the market. The small size of the
Canadian municipal bond market is attributed to the fact that provincial governments often issue and
guarantee bonds of behalf of municipalities, so municipal borrowings are counted as provincial bonds.
Other differences include the fact that US investors do not pay income tax on interest earned on their
investment in US municipal bonds, while Canadian municipal bonds offer no tax advantage for Canadian
investors.

Corporate Bonds

Corporations issue bonds and debentures with terms to maturity ranging from 2 or 3 years, to 30 years
or more. Most have coupon rates that are fixed for the life of the bond. Corporate bonds account for
approximately 30% of the total dollar value of bonds outstanding in the Canadian market. The largest
non-government issuers are financial corporations, primarily the chartered banks.

New issues of corporate bonds are sold to investors by investment dealers. The new issue process is
highly regulated and requires that the issuer prepare a “prospectus”, which is a legal document that
discloses all relevant information about the issuer and the securities being sold to the public. Although
corporate bonds are negotiable and marketable, most have poor liquidity and trade infrequently in the
secondary market.

Some new corporate bonds are issued as “private placements” which are sold only to a few large
institutional investors and not to the general public. Private placements are less regulated, and are sold
with a brief “offering memorandum”, not a full prospectus.

In Canada, the corporate bond market is dominated by “investment grade” issuers that have good
financial strength. Canadian issuers of lower quality “high yield” bonds usually issue in the US where the
junk bond market is well developed and investors are more receptive to accepting high yields to
maturity in return for assuming default risk.

The yield to maturity on corporate bonds is composed of the yield on risk free securities plus a credit
spread that compensates investors for default risk. Credit spreads rise with increasing term to maturity
because loaning money for a long time period has more uncertainty and greater risk. Credit spreads are
also impacted by investors’ perceptions of risk levels in the financial market, and increase during periods
of economic recession or financial crisis.

CHART 7

16
 Corporate Spreads

350

300

250

200

150

100

50

0
5/17/1996
11/17/1996

5/17/1998
11/17/1998
5/17/1999

5/17/2001

11/17/2003

5/17/2006
11/17/2006
5/17/1997
11/17/1997

11/17/1999
5/17/2000
11/17/2000

11/17/2001
5/17/2002
11/17/2002
5/17/2003

5/17/2004
11/17/2004
5/17/2005
11/17/2005

5/17/2007
11/17/2007
AA A BBB

Credit Ratings and Default Risk

Investors demand that all bonds issued in the public market have a credit rating assigned by at least one
of the large credit rating agencies: DBRS, Moodys and S&P. Credit ratings reflect the risk that an issuer
will fail to satisfy its financial obligations to investors. Credit ratings are assigned to a specific security
and not to the issuer, with unsecured debentures ranking below bonds that are secured by a mortgage
or other claim to specific real assets. Most investors purchase only securities rated BBB or higher
because they are considered to be “investment grade”, with minimal default risk.

CHART 8 - Bond Credit Ratings

17
Source: Bodie, Investments

DBRS BOND RATING DEFINITIONS

18
Long-Term Obligations
The DBRS® long-term rating scale provides an opinion on the risk of default. That is, the risk that
an issuer will fail to satisfy its financial obligations in accordance with the terms under which an
obligations has been issued. Ratings are based on quantitative and qualitative considerations
relevant to the issuer, and the relative ranking of claims. All rating categories other than AAA and
D also contain subcategories “(high)” and “(low)”. The absence of either a “(high)” or “(low)”
designation indicates the rating is in the middle of the category.
AAA
Highest credit quality. The capacity for the payment of financial obligations is exceptionally high
and unlikely to be adversely affected by future events.
AA
Superior credit quality. The capacity for the payment of financial obligations is considered high.
Credit quality differs from AAA only to a small degree. Unlikely to be significantly vulnerable to
future events.
A
Good credit quality. The capacity for the payment of financial obligations is substantial, but of
lesser credit quality than AA. May be vulnerable to future events, but qualifying negative factors
are considered manageable.
BBB
Adequate credit quality. The capacity for the payment of financial obligations is considered
acceptable. May be vulnerable to future events.
BB
Speculative, non investment-grade credit quality. The capacity for the payment of financial
obligations is uncertain. Vulnerable to future events.
B
Highly speculative credit quality. There is a high level of uncertainty as to the capacity to meet
financial obligations.
CCC / CC / C
Very highly speculative credit quality. In danger of defaulting on financial obligations. There is
little difference between these three categories, although CC and C ratings are normally applied to
obligations that are seen as highly likely to default, or subordinated to obligations rated in the CCC
to B range. Obligations in respect of which default has not technically taken place but is considered
inevitable may be rated in the C category.
D
A financial obligation has not been met or it is clear that a financial obligation will not be met in the
near future or a debt instrument has been subject to a distressed exchange. A downgrade to D may
not immediately follow an insolvency or restructuring filing as grace periods or extenuating
circumstances may exist

Credit ratings are based on quantitative and qualitative factors. Quantitative factors are financial ratios
that measure profitability, solvency and liquidity, including gross profit, the amount of leverage, interest
coverage, asset coverage and current ratio, to name a few. Credit ratings reflect level and recent trends
in these measures.
19
CHART 9 – Financial Ratios

Source: Bodie, Investments (Must obtain permission or prepare a new chart)

Qualitative factors are also important because the nature of the industry in which the issuer operates
affects the cyclicality of earnings and cash flows which are needed to pay interest and repay the
principal amount borrowed. Other factors include the quality of management, and the competitive
position of the issuer within its industry.

Protective Covenants

The terms and conditions under which a bond or debenture was issued are important because they
include measures to ensure that the financial strength of the borrower will not deteriorate during the
term to maturity. They also specify the investors’ claim to assets if default occurs. These measures are
called “protective covenants” because they are designed to protect investors. They are contained in the
trust indenture, and influence the credit rating. “Positive covenants” state what the issuer must do to
protect the interests of investors, and “negative covenants” state actions that are forbidden.

Positive Covenants may include requirements to provide quarterly financial statements, maintain a
specified level of working capital, interest coverage or asset coverage, and to keep assets that secure the
bonds insured and in good repair. They may also include a requirement that the issuer use a “sinking
fund” or “purchase fund” to buy back a certain amount of bonds prior to their maturity date.

Negative covenants may include restrictions on additional borrowing, the sale or pledging of assets, or
payment of dividends if certain financial conditions are not met.

Bond investors are now demanding covenants that protect them against “event risk”. The terms of some
recent corporate takeovers harmed bondholders because restructuring included the issuance of
additional debt, thus reducing the credit rating, and hence the market price, of bonds that had been
issued previously by the target company. Covenants that reduce event risk include a “doomsday call”
20
which requires the issuer to repurchase its bonds at an attractive, predetermined price if certain adverse
events occur. Also known as Canada calls, these provisions are typically found on corporate debt issues
made by Canadian corporations. With a doomsday call provision, issuers are required to redeem
(repurchase from investors) all outstanding bonds at either par value or at a predetermined attractive
price.

Other Types of Bonds

Real Return Bonds – Unlike regular coupon bonds which pay investors a nominal fixed rate of interest,
real return bonds pay the real interest rate plus inflation. They are also called inflation protected bonds
because they pay interest based on the real interest rate, plus compensation for changes in the price
level. Most of these bonds are issued by governments, including the Government of Canada ‘s Real
Return Bonds (RRB’s) and the US Treasury’s Inflation Protected Securities (TIPS).

Government of Canada RRBs pay semi-annual interest based on the real interest rate that existed when
the bonds were first issued, plus an adjustment for changes in inflation, as measured by the consumer
price index (CPI). The CPI, for the purposes of RRBs, is the all-items CPI for Canada, not seasonally
adjusted, as published monthly by Statistics Canada. The semi-annual nominal coupon payments are
calculated as follows:

Coupon paymenti
= real coupon rate/2 x (principal + inflation compensation i)  where inflation compensationi
= ((principal x reference CPI i/reference CPIbase) –  principal).

Inflation compensation is calculated with a time lag. The reference CPI for the first day of any calendar
month is the CPI for the third preceding calendar month. The reference CPI for any other day in a month
is calculated by linear interpolation between the reference CPI applicable to the first day of the month in
which such day falls and the reference CPI applicable to the first day of the month immediately
following. The reference CPIbase for a series of bonds is the reference CPI i applicable to the original issue
date for the series.

At maturity bondholders will receive, in addition to a coupon interest payment, a final payment equal to
the sum of the principal amount and the inflation compensation accrued from the original issue date,
i.e. final payment = principal + ((principal x reference CPI maturity/reference CPIbase) – principal). Information
on the reference CPI is posted monthly on the Bank of Canada website.

Source: Bank of Canada

Real return bonds were developed during a period of high global inflation when rising nominal interest
rates caused bond investors to suffer significant loses. They were introduced in the UK in 1981, first
issued in Canada in 1991, and in the US in 1997.They are useful for investors, such as pension funds,
who wish to protect the value of their bond investments from rising inflation and invest to fund future
payments that are linked to the CPI.

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Stripped Coupons (also called Zero Coupon Bonds) – These fixed income securities pay only a single
cashflow on their maturity date. Stripped coupons are created by investment dealers who buy regular
coupon-paying bonds, “strip” off their coupon payments, and sell the individual cashflows separately to
investors. The repayment of principal is also sold separately as the “residual”. The price of a stripped
coupon bond is the present value of its single future cashflow, discounted by the appropriate yield to
maturity. By convention, price calculations are based on the coupon payment frequency of the bond
from which the coupon was stripped (ie semi-annual for Canadian and US bonds).
 
P = M / (1+r)n
 
where:
P = price
M = maturity value, $1,000 per bond
r = Annual Yield to Maturity / 2
n = number of years until maturity x 2
 
For example, the cost of buying a Government of Canada stripped coupon bond that has a $1,000 face
value, matures in three years, and a yield to maturity of 4% is
  $1,000 / (1+0.02)6 = $887.97

Recall that bond prices are normally quoted for $100 face value, so investment dealers would quote the
price of this stripped coupon as $88.797.

Maple bonds - Bonds that are issued in the Canadian bond market by non-Canadian borrowers,
denominated in Canadian dollars.

Yankee bonds – Bonds that are issued in the US market by non-US issuers, denominated in US dollars.
Examples of “Yankees” include US dollar bonds issued by the Government of Canada and several
Canadian provinces.

Eurobonds – Bonds that are issued in the European bond market by non-European issuers, denominated
in any currency, but usually, US or Canadian dollars, or Euros.

Samurai bonds - Bonds that are issued in the Japanese market by non- Japanese issuers, denominated in
yen.

Bulldogs - Bonds that are issued in the UK market by non-UK issuers, denominated in pounds sterling.

Convertible bonds – Investors may convert these bonds into another security, usually stock of the
issuing corporation. Convertible bonds have a stated maturity date and pay fixed coupons until the
earlier of maturity, or conversion. The conversion feature is offered to make the bond more attractive to
investors who receive interest payments, and an opportunity to profit from future appreciation in the
stock price. Convertible bonds are usually issued by corporations that have lower credit ratings and little
access to the investment grade bond market. Potential capital gains earned on the stock price cause
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 investors to accept a lower coupon rate, reducing the issuer’s cost of debt financing. Convertible bonds
are usually traded on the equity desks of major investment dealers, and not on bond trading desks.

Key Terms

Accrued Interest Eurobond

Bond Extendible Bond
Bond Price Holding Period Return
Bond Market Index Income Yield
Callable Bond Maple Bond
Capital Gains Yield Protective Covenants
Covenant Real Return Bond
Credit Spread Retractable Bond
Convertible Bond Stripped Coupon
Coupon Trust Indenture
Current Yield Yankee Bond
Debenture Yield to Maturity
Duration

APPENDIX

Primary Dealers – Government of Canada Bond Auctions

BMO Nesbitt Burns Inc.

Casgrain & Company Limited
CIBC World Markets Inc.
Desjardins Securities Inc.
Deutsche Bank Securities Limited
HSBC Securities (Canada) Inc.
Merrill Lynch Canada Inc.
Laurentian Bank Securities Inc.
National Bank Financial Inc.
RBC Dominion Securities Inc.
Scotia Capital Inc.
The Toronto-Dominion Bank

Note: The primary dealers' aggregate competitive bidding limit is 285 per cent of auction amount.

Source: Bank of Canada

Announcement of Government of Canada Bond Auction

For Release: 10:30 E.T. OTTAWA

Publication : 10 h 30 HE 2012.03.30

Quarterly Bond Schedule Calendrier trimestriel des obligations

On behalf of the Minister of Finance, the Bank of Canada announced plans for La Banque du Canada vient d'annoncer, au nom du

23
nine regular issues of Government of Canada marketable bonds and one issue
of Real Return Bonds, to be auctioned to government securities distributors of
Government of Canada bonds as set out below.
ministre des Finances, que le gouvernement du Canada prépare neuf émissions
régulières d'obligations négociables et une émission d'obligations à rendement
réel, qui seront vendues par adjudication aux distributeurs de titres d'État
d'obligations du gouvernement du Canada, selon les modalités décrites ci-
dessous.

In addition this quarter, one operation is planned under the Government of De plus, une opération est projetée dans le cadre du programme de rachat
Canada bond repurchase program. A repurchase operation will be held, in d'obligations du gouvernement du Canada. L'opération se tiendra
conjunction with the 30-year nominal bond auction. conjointement avec l'adjudication d'obligations nominales ayant une échéance
de 30 ans.

Further Details
of Issue
Détails Auction Date Amount Maturing*
Auction Type Term Type Allotment Method complémentaires Date de Delivered Montant venant
Type d'adjudication Type de terme Mode de répartition sur l'émission l'adjudication Livrée à échéance*

Bonds - Nominal 2 Year Multiple Price 2012.04.05 2012.04.11 2012.04.13 $0

Obligations nominales 2 ans Prix multiples
Bonds - Nominal 3 Year Multiple Price 2012.04.19 2012.04.25 2012.04.30 $0
Obligations nominales 3 ans Prix multiples
Bonds - Nominal 10 Year Multiple Price 2012.04.26 2012.05.02 2012.05.07 $0
Obligations nominales 10 ans Prix multiples
Bonds - Nominal 5 Year Multiple Price 2012.05.03 2012.05.09 2012.05.14 $0
Obligations nominales 5 ans Prix multiples
Bonds - Nominal 2 Year Multiple Price 2012.05.10 2012.05.16 2012.05.18 $0
Obligations nominales 2 ans Prix multiples
Bonds - Nominal 30 Year Multiple Price 2012.05.17 2012.05.23 2012.05.28 $0
Obligations nominales 30 ans Prix multiples
Bonds - Real Return 30 Year Single Price 2012.05.24 2012.05.30 2012.06.04 $0
Obligation à rendement réel 30 ans Prix unique
Bonds - Nominal 10 Year Multiple Price 2012.05.31 2012.06.06 2012.06.11 $0
Obligations nominales 10 ans Prix multiples
Bonds - Nominal 3 Year Multiple Price 2012.06.07 2012.06.13 2012.06.18 $0
Obligations nominales 3 ans Prix multiples
Bonds - Nominal 2 Year Multiple Price 2012.06.14 2012.06.20 2012.06.22 $0
Obligations nominales 2 ans Prix multiples

*Maturity of $16,295 million on 1 June 2012. *Échéance de 16 295 $ million le 1er juin 2012.

For further information: Pour de plus amples renseignements :

Marc Larson, Bank of Canada Marie-Josée Lambert, Ministère des Finances
(613) 782-7836 (mlarson@bank-banque-canada.ca) (613) 992-6116 (marie-josee.lambert@fin.gc.ca)

Results of Government of Canada Bond Auction

OTTAWA
 
2012.05.23

Bonds - Nominal Obligations nominales

Auction Results Résultats de l'adjudication

On behalf of the Minister of Finance, it was announced today that tenders for On vient d'annoncer aujourd'hui, au nom du ministre des
Government of Canada bonds Finances, que les soumissions suivantes ont été

24
have been accepted as follows: acceptées pour les obligations négociables du gouvernement du Canada :

Auction Date 2012.05.23 Date d'adjudication

Bidding Deadline 12:00:00 Heure limite de soumission
Total Amount $1,400,000,000 Montant total
Multiple Price / Prix multiples
(%)
Coupon Outstanding (%) Allotment
Rate After Auction Yield and Equivalent Price Ratio
Amount Issue Maturity Taux du Encours après Taux de Ratio de
Montant Émission Échéance coupon l'adjudication rendement et prix correspondant répartition

$1,400,000,000 2012.05.28 2045.12.01 3.500 $6,100,000,000 Avg / Moy.: 2.413 124.883

Low / Bas: 2.409 124.989
ISIN: CA135087ZS68 High / Haut: 2.416 124.803 23.41667

Bank of Canada Purchase     $280,000,000    Achat de la Banque du Canada

Value of bids submitted by distributors / Valeur totale des offres déposées par des distributeurs
Coupon
Rate
Maturity Taux du Total Non-competitive
   
Échéance coupon Total Non concurrentielles

  2045.12.01 3.500 $3,628,100,000 $54,100,000  

SUPPLEMENTARY MATERIAL

Composition of the Canadian Bond Market

Federal Provie/Muni Corporate

1993 57.7 32.7 9.6
1998 60.4 22.9 16.7
2003 46.6 25.9 27.5
2008 45.9 26.1 28.1
2012 39.7 28.8 31.5
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 Source: TDAM and iShares

September 14, 2009 - All primary dealers participate in

CanDeal as Deutsche Bank becomes 12th liquidity provider
MONTREAL, Quebec & TORONTO, Ontario (September 14, 2009) – CanDeal, the leader in
online Canadian debt securities trading, is pleased to announce that Deutsche Bank Securities
Limited has agreed to a multi-year commitment to join its marketplace.
The addition of Deutsche Bank represents full participation on CanDeal by all of Canada’s
primary dealers.
David Fry, Head of Global Markets, Deutsche Bank Canada said, "As a primary dealer in Canada
and strong global participant, we are committed to providing our customers with ease of access
to our liquidity. CanDeal provides a proven and effective solution for our customers and joining
CanDeal’s marketplace demonstrates a further commitment to the fixed income business.”
Jayson Horner, Co-Founder, President and CEO of CanDeal, added, "We are very pleased to
welcome another first class financial services organization to CanDeal’s marketplace.
Completing our goal of including all of Canada’s Primary Dealers is a milestone achievement for
our firm and it represents our ongoing commitment to create the deepest pool of liquidity that
institutional investors can access for Canadian dollar debt globally.”
About CanDeal
CanDeal is the leading online marketplace for Canadian dollar debt securities ( www.candeal.ca ).
CanDeal provides online access to the largest pool of liquidity for Canadian government bonds
and money market instruments. The network delivers the market making power of all twelve of
Canada’s Primary Dealers. CanDeal’s marketplace is available to institutional investors in
Canada, the United States and Europe. In addition to straight-through-processing, online trade
allocations, real time trade blotters and confirmations, the network also provides its users with
superior compliance and audit functionality.
Press Release Courtesy of Candeal

CanDeal bond market overtakes TSX in value traded

BOYD ERMAN

The Globe and Mail

Published Tuesday, Mar. 27 2012, 7:41 AM EDT

Quiz: On which Canadian securities market is the most business done?

Answer: Until a few months ago, the Toronto Stock Exchange. But of late, the bond marketplace
CanDeal has overtaken the TSX in value traded.
26
It's a big milestone for CanDeal, which has steadily been working for years to build a busy
electronic trading system for Canadian bonds. CanDeal booked 35 per cent growth last year in
value traded, at the same time as equity trading activity hit a slump.

Prior to last fall, the TSX was by far the bigger market by value. Then equity activity went into a
tailspin as investors started avoiding stock markets.

Beginning in October, monthly traded values on CanDeal outstripped those on TSX. For
example, in February, CanDeal handled almost $122-billion of bond trades, while the TSX
recorded about $114-billion of equity trading.

The CanDeal market enables participants to talk electronically and match trades, in much the
same manner as a stock market handles shares. On CanDeal, more than 600 participants can
trade electronically in bonds, including those issued by the Government of Canada and the
provinces.

To be sure, the TSX still does vastly more trades in a given month. But the much larger size of
individual bond trades evens things out on a value basis.

27