What Does the Bond Market Look Like?

      The bond market is largely invisible, being decentralized, over-the-counter, and with no post-trade disclosure in Canada yet. The United States has its Trade Reporting and Compliance Engine (TRACE) system and we are studying this approach now. I discuss this in more detail in the section on transparency beginning on page 51. It resembles an onion with a series of layers. At the heart of the Canadian bond market is the Bank of Canada, which is in charge of monetary policy and open-market operations in the foreign exchange, money market, and bond markets.

      Next come the money market “jobbers,” whose role is to ensure the orderly maintenance of the money market, including the issuance of Government of Canada treasury bills. The money market is defined as securities issued with a term to maturity of one year or less. Treasury bills are obligations issued by the various governments. They are issued at a discount from their face value and mature at their face value so all the yield is in the amortization from that discounted amount.

      Primary Dealers for Bonds

      BMO Nesbitt Burns, Inc.

      Casgrain and Co., Ltd.

      CIBC World Markets Inc.

      Desjardins Securities

      Deutsche Bank Securities Ltd.

      HSBC Securities (Canada)

      Merrill Lynch Canada Inc.

      Laurentian Bank Securities Inc.

      National Bank Financial Inc.

      RBC Dominion Securities Inc.

      Scotia Capital Inc.

      The Toronto Dominion Bank

      Then we have the primary dealers, many of whom are also jobbers. Among other things, they are required to bid for the auction of the Government of Canada’s primary bond issues. They do the bulk of the underwriting of new provincial and corporate debt, make markets in the complete array of fixed-income products, and service the fixed-income needs of the various institutional and retail investors by maintaining extensive inven-tories and bidding and offering on all sizes of blocks of bonds. Individual trades can be in the hundreds of millions or as little as $5,000. The lion’s share of the daily $38.42 billion trading volume takes place among the Big Six investment dealers (at the time of writing, they were RBC Dominion Securities, TD Securities, CIBC World Markets, BMO Nesbitt Burns, Scotia Capital, and National Bank Financial) and their institutional and global customers. The market for individual investors is approximately 2 to 3 percent of this total. The other 97 to 98 percent is in the institutional area, where the bank-owned dealers (plus a few non-bank-owned dealers, such as Merrill Lynch Canada, Desjardins Securities, Casgrain and Co., Laurentian Securities, Penson, and HSBC) make wholesale markets in all the various fixed-income products to serve the investment needs of their institutional customers. These customers include life insurance companies, chartered banks, pension funds, mutual funds, investment counsellors, governments, and foreign investors.

      It is worth pausing to note that the money that these institutions have for investment represents the aggregate savings of individuals like you! Your money is mixed in with everyone else’s, thus giving the institutions very large sums of money to invest and trade. A large percentage of this money is invested in fixed-income securities to satisfy actuarial requirements, match liabilities, and guarantee fixed returns. With large blocks of money to invest, these institutions command and receive the best prices. The investment dealers vie for this business: competitive tendering for bids and offerings is the norm, and individual trades exceeding $100 million are commonplace.

      Naturally, all of the bank-owned dealers serve individual investors, since they all have national sales forces of IAs. There are another 210 members of the self-regulatory body which goes by the unwieldy title of Investment Industry Regulatory Organization of Canada (IIROC), who transact fixed-income securities. There are large, independent firms such as Blackmont Capital (now MacQuarie Private Wealth), Canaccord, and GMP Capital, as well as a host of small- and medium-sized investment dealers such as Odlum Brown, Haywood Securities, and Dundee Securities.

      Each of these firms has to find fixed-income products somewhere in order to satisfy their customers’ needs. The bank-owned dealers help to meet these needs. They offer, via electronic delivery, retail quantities and prices of the various fixed-income products. TD Securities, Merrill Lynch, and RBC Dominion Securities are prominent in this area. In addition, Penson, Laurentian Securities, and HSBC also contribute to market making in this space. As well, a company called Perimeter CBID aggregates prices and offerings from a number of contributors and makes them available to all these same small dealers and entities. Several of the larger independents, such as MacQuarie, Dundee, Canaccord, and Odlum Brown, have their own specific fixed-income trading departments staffed by experienced personnel. They have sufficient capital and technology resources to assemble, maintain, and offer a wide range of fixed-income securities to meet the needs of their IAs’ customers.

      My former firm, Blackmont Capital, for example, has a department of four professionals who have enough capital to maintain inventories of sufficient size to adequately serve the needs of their entire sales force. They manage these aggregates on a fully hedged basis to eliminate market risk for the firm and to offer competitive prices at all times. With an online, real-time trading system at their disposal, they can offer their own inventory plus fixed-income securities that they do not own. This is possible owing to the presence of actively traded, large bond issues for which there exists a known market.

      Knowing what spread they trade at in relation to one of the benchmark issues makes it easy to offer a security without owning it. In fact, the benchmark prices are fed electronically into this system as they change, ensuring that the IAs’ customers are always seeing live prices. Also, in a typical sales force, some clients are selling securities that others will be buying. Knowing this, the trading department will keep and hedge the sold securities for later resale to its own sales force rather than to “the street,” the large market-making investment dealers mentioned earlier. This is an efficient way to do business, and customers benefit through better prices. Running to and from the wholesale market for every small transaction is very expensive. Yet, that is what the smaller dealers must do, as they do not have the personnel, capital, or the inclination to keep an inventory themselves.

      It is also worthwhile pointing out the different philosophies of the various investment dealers with respect to how they treat individual fixed-income investors. Most of the bank-owned dealers treat their retail customer base as a captive audience and therefore charge more for individual bonds than the smaller, more focused firms. What you need to know is whether the FI you are dealing with treats the retail fixed-income market as a profit centre or not. The best ones work at growing the business through value-added service and competitive prices. Make a point of ascertaining what approach your FI uses.

      Also, there are interdealer brokers (IDBs) whose role is to act as middlemen, facilitating anonymous trades among the jobbers, primary dealers, and investment dealers. The most prominent ones in Canada are Shorcan (owned by the TMX) and Freedom (owned by Cantor Fitzgerald and the Canadian banks). The trades are done anonymously so