In Your Best Interest. W. H. (Hank) Cunningham
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this loan. Today, most of these physical pieces of paper have disappeared, replaced by the “book-based” system, whereby the Central Depository for Securities (CDS) maintains the records of who owns what. Your evidence of ownership is the contract you receive from your financial institution and your monthly statements.
Most bonds are issued with a coupon rate, which is the rate of interest investors will be paid. How is this rate determined? It is a product of the length of time to the maturity date, the general level of interest rates, and the creditworthiness of the borrower. Unlike a mortgage, which is a specific relationship between an individual and a lender, there may be hundreds of holders of the same bond, as individual bond issues may range from $15 million to $20 billion.
What Is the Fixed-Income Market, and How Does It Operate?
The fixed-income market, or bond market, operates in what we call an “over-the-counter” manner. To understand what this means, let us first examine how the equity market functions. When investors purchase, say, one hundred shares of TransCanada PipeLines, they purchase them from other investors who are selling the shares at the same price. These trades take place on a public stock exchange, where prices are clearly visible. Both the buyers and the sellers pay a fee (or commission) to their respective IAs. The financial institutions (for example, investment dealers or brokers), hereafter called FIs, merely facilitate this transfer from the buyer to the seller; they do not assume any principal position and thus do not risk their principal or capital. Therefore, retail equity transactions are called agency transactions, since the FIs merely act as agents.
The bond market functions in an entirely different fashion. There is no visible public market, and almost every trade is done on a principal basis and is quote-driven. That is, the FI’s bond traders are using the firms’ capital to maintain inventories and make markets in the broad spectrum of fixed-income securities.
Consider TransCanada PipeLines for a moment. It has one class of common shares with 699 million shares outstanding as of March 14, 2011, with a market capitalization of $27 billion. At the same time, it had 62 bond issues outstanding, of all different sizes, maturities, and characteristics, ranging in maturity from 2011 to 2067 and in coupon from 3.40 to 12.20 percent, having a combined face value of $16.9 billion. Many of them are held in large percentages by the investing institutions, rendering them illiquid. Very few of these issues trade every day, so if you are interested in investing in one of them, your IA will ask the retail bond-trading desk, which will likely not have them and will turn to the wholesale bond-trading group, which will then attempt to make a market for that particular bond.
It is somewhat like a grocery store or convenience store. To help individual investors, retail fixed-income departments stock their shelves with inventories of the various bond and money market products. There are special sales at times, and of course the investment dealers will showcase the products that they want you to buy. When inventories run out or become low, the retailers go to the institutional department to get restocked. As retailers have all kinds of costs — communications, technology, salaries, rent, and financing the inventories, to name a few — prices are marked up from the institutional price. I can tell you that the price markups are very small at most investment dealers. As with grocery stores, you can comparison shop by opening accounts at different investment dealers or discount brokers. Recently, I conducted a survey of online bond trading at the five major dealers to further assist you in your do-it-yourself dealings. You will find the details on page 58.
Quotations for bonds often confuse investors. The base denomination for bonds (other than stripped bonds) is $1,000. This is called the “face,” “book,” or “par” value. It is the principal amount that you invest and will receive back at maturity. We quote bonds on a percentage of face value. When you see a bond quotation, it may be, for example, $98. This means that the bond is trading at 98 percent of the face value. In other words, the $1,000 bond is worth $980.
As well, bonds (except for stripped bonds) trade with accrued interest attached. The value of that accrued interest is not included in the price. The seller of the bond that you are buying expects, and deserves, to receive the interest accruing from the last interest payment. The buyer pays that accrued interest in addition to the purchase price. This is because the new owner of the bond will receive the full interest payment when it is eventually paid, even though he or she is entitled to only the interest accruing from the date of purchase to the settlement date of the sale.
Assume, for example, that you sold a bond, there were three months before the next payment, and you did not receive the accrued interest. The next owner of the bond would then receive the full six months’ interest payment when it came due. Therefore, the next owner’s money earned double for that period and yours earned nothing! Since it is impractical and inconvenient to wait until the payment is received before selling the bond, the interest owing to the seller is calculated and paid by the new owner on the settlement date.
Let us re-examine the above example: a bond paying 4 percent semi-annually with a face value of $10,000 is sold at 98 percent of face value with 90 days of accrued interest owing to the vendor. The seller of the bond receives $9,800 of the original principal plus the accrued interest owed from the last payment date. If this bond had been held for a full year, the investor would have received $400 in interest (4 percent of $10,000). We divide $400 by the number of days in a year to calculate how much interest accrues daily: $1.09589 accrued per day. Now we take this number and multiply by 90 to arrive at how much accrued interest is owed to the seller: $98.63 of accrued interest. Therefore the seller receives the $9,800 plus the $98.63 of accrued interest for a total of $9,898.63.
BID, ASK, OFFER
The terms bid, ask, and offer create some confusion. When you are selling a bond, the investment dealer provides you with a bid. If you are buying, you need to know what the dealer is asking for the bonds or where he offers it. It becomes confusing when you say that you want an offer for these bonds. That could mean that you want a bid. Stick to bid and ask.
So, what happens to the buyer? Assuming the buyer pays the same percentage of face value, he or she pays exactly the same as the vendor receives. In the real world, the two prices will not be the same as a result of commissions being charged. The accrued interest will be the same. As we recall, the bond market functions as a principal market where the investment dealers make markets in bonds using their firm’s capital. Thus, there will be a difference in the “bid,” what a trader is willing to pay for a bond, and the “ask,” which is the price at which a trader is willing to sell. As well, the IA needs to make a living, so he or she takes the bid or ask price from the trader (depending on whether the client is selling or buying), subtracts or adds the commission, and then gives the client a net price. Note that no commission is added or deducted in a fee-based account.
Getting back to the buyer: when the next interest payment is due, the buyer will receive the full six-month payment ($200). Subtracting the $98.63 interest previously paid, the buyer has netted $101.37 of accrued interest for the period that he or she has owned the bond. Should this new owner keep the bond through successive payment dates, he or she would receive the full $200 each six months until the bond is sold or it matures.
Also, you will notice that prices for bonds range from discounts, say $90 (or 90 percent of face value), to premiums, such as $110 (or 110 percent of face value). Why is this? Interest rates move up and down, and bond prices move inversely to yields. (Not a week goes by without someone asking me which way bond prices go when yields go up. They go down. Bond prices and yields move in opposite directions, and you will understand why when you read the chapter Basic Math.)
This is to put them in line with currently issued bonds. If the price on our Canada 3.5 percent bond due June 1, 2020, was exactly $100, then its yield to maturity would be 3.5 percent. If market yields moved to 6 percent, no one would buy this bond at 3.5 percent, so we adjust its market price to $83, which equates to a yield to maturity of 6 percent. Conversely, if yields fell to 2 percent for this maturity, this bond would be re-priced to $112.13. We will examine in detail how these prices are actually calculated in the chapter Basic Math. Don’t worry.
Individual quotations on bonds