In Your Best Interest. W. H. (Hank) Cunningham
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although there are determined attempts underway to increase the transparency of the bond market. Online or discount brokers have offerings of fixed-income securities, while in the case of FIs, the IAs can see their firms’ inventories displayed electronically from their internal systems and can relay these to their customers. In addition, there are three public sites with up-to-date bond prices on a reasonable cross-section of the bond market:
www.canadianfixedincome.ca provides free access to a broad list of bond prices. Further, individual investors may subscribe to Bondview, which offers a more complete view of the marketplace, for $19.95 per month.
www.canpxonline.ca offers hourly updates on benchmark Government of Canada bonds. Eventually, they plan to introduce Canada’s equivalent to the U.S. Trace system whereby all corporate bond trades will be displayed with a time delay.
www.canadianbondindices.com offers a plethora of information on fixed-income markets, including live updates, some trading volume statistics, as well as performance numbers.
There are daily quotations in newspapers and more extensive lists in the weekend press, but they are not all-inclusive; they typically represent institutional pricing (greater than $1 million in size), and they are just a snapshot at a certain point in time. While they are useful indicators of where bond prices were, bond prices will be different when you attempt to buy or sell, since they fluctuate far more than investors (and IAs) realize. In any event, retail investors will not be able to transact at these prices for two basic reasons: first, they are dealing in retail quantities; second, since the bond market is a principal market, as we now know, a bond trades on a net basis (that is, with no visible commission added).
Let us consider that there might be a different (i.e., higher) price for a retail fixed-income transaction by individual investors than for a wholesale purchase by a giant financial institution. Returning to our grocery shopping analogy, individuals normally find the shelves adequately stocked for their relatively small purchases. If the store did not maintain adequate inventories, the management would have to shuttle back and forth from the wholesale warehouse. The warehouse sells in bulk quantities, so the store manager must decide how much to buy, balancing the needs of the customers with the prices for different quantities of merchandise. After adding the merchandise to the shelves, the manager now raises the wholesale price to retail to account for various factors such as heat, lighting, salaries, insurance, spoilage, and taxes.
A retail fixed-income department operates in a similar fashion. I do not run to the wholesale, or institutional, market for every $10,000 worth of bonds that I sell. Instead, I will sell them “short” (that is, sell now and buy later), or I might suggest another bond that I do have in inventory. In practice, I buy in bulk various fixed-income products from the wholesale market and add them to my “shelves,” which I call my inventory. Once I do that, I incur market risk, which I offset by hedging. Hedging involves neutralizing market risk so that I do not incur capital gains or losses as the market prices change. I also incur yield-curve risk and credit risk. I also maintain state-of-the-art computer and communication equipment. As well, there are the other basic costs, such as remuneration! Also, since most bonds do not trade every day, I resort to “matrix” pricing to at least provide a quotation. How do I do that? I do that by comparing one of those bonds to an actively traded benchmark issue, such as a Government of Canada bond of similar maturity, and adding a yield spread to that bond based on where I know or believe that they have been trading recently. I then compute a price. It is as if I know there are some TransCanada PipeLines (TRP) bonds down in the factory, but rather than keep you waiting, I price them and sell them to you now and go buy them later because I know what my relative cost will be. If I know that the “factory” contains none of what I am asked to sell, I will search everywhere for them or, more likely, suggest a similar bond.
Even given all this, the markups from the wholesale fixed-income market to the retail market are amazingly small, meaning that individual investors can be well served by the fixed-income market.
TRANSFER PRICE
The transfer price is the price at which the fixed-income trading department transfers it to the IAs. To get paid, they must add a commission to this price in the case of an investor purchase, unless the transaction is in a fee-based account.
This type of pricing is necessary since, and returning to the TRP example, there may be just one class of common shares outstanding, but there could be sixty or so different bond issues of different maturities, sizes, and features. There is just not enough liquidity to display a bid and an ask all the time in the same fashion as the equity market. The FI “makes a market” in the various instruments, willing to be long or short to accommodate investor interest. In addition, governments of all types borrow money in the bond market, and, of course, they do not have any common shares to trade!
The bottom line is that the bond market functions as a clearing house between borrowers and lenders. For IAs to earn a living, in the case of client purchases, they raise the ask price received from the bond department and get paid the differential as a commission. Again, this does not occur in the case of fee-based accounts. This is not visible to the investor, although this may soon change. I will talk about initiatives in this area in the transparency discussion. The opposite occurs when clients sell, with IAs deducting from the bond desk’s bid to create a commission. This is referred to as a “haircut” in the business, as you’ve just had a trimming!
Furthermore, the less-liquid bonds, such as corporates and zero coupons, are most frequently quoted on a matrix basis. Since many of these instruments do not trade every day, they are priced in reference to an instrument that does. For the most part, Government of Canada bonds of different key maturities constitute the benchmarks by which other securities are priced. While I have included more on benchmarks later, I think it is important to mention them now, as the majority of fixed-income securities offered to investors are priced in relation to them.
The Bank of Canada is committed to building up very large and therefore liquid benchmark issues at the key maturities: two, three, five, ten, and thirty years. They are vital not only in pricing bids and offerings, but also in pricing new provincial and corporate issues when they come to market. The benchmarks form a valuable base level from which other bonds may be valued. For example, let us take a provincial bond: the Province of British Columbia 3.70 percent due December 18, 2020. It is valued by the market at 74 basis points above the relevant benchmark, the Canada 3.5 percent due June 1, 2020. (1 percent is divided into 100 pieces, each of which is called a basis point. In this case, the B.C. bonds at 74 basis points higher in yield than the Canadas are 74/100 of 1 percent higher. You will encounter the term “basis points” frequently throughout the book.) To trade these, a trader will observe where the Canadas are trading, add the 74 basis points to the benchmark yield, and then calculate the price for the B.C. bond. Let us say that the Canada 3.5 percent June 1, 2020, is trading at $102.49 to yield 3.1 percent. Now we add the 74 basis point spread and arrive at a yield of 3.84 percent for the B.C.s, which produces a price of $98.87.
Thus, as the liquid, actively traded benchmark issues change in price and yield, so do all the matrixed bonds. The yield spread between the benchmarks and these bonds fluctuates in reaction to supply and demand factors, changes in the yield curve, and changing credit risk perceptions.
The role of investment dealers, then, is to make markets in a wide-ranging list of bonds, bidding for bonds for which there are no apparent buyers or short-selling bonds where they are not sure there are sellers. FIs sell bonds short all the time, either to accommodate demand when they know there will be a seller of the same bond soon, or to hedge long positions (quantities of bonds that they already own). They may also short-sell bonds if they think they have become expensive compared with some other bond. Thus, they are a buffer between the differing needs of a cross-section of bond market participants. These longs and shorts are all held in the dealers’ inventories, which are typically segregated by type (money market, short-term Canadas, mid-term Canadas, long-term Canadas, provincials, strips, and corporates). The dealers hedge these inventories with offsetting transactions in the benchmark issues (or in the futures market) to eliminate or reduce market risk. Bond trading volumes are enormous, averaging approximately five times the daily amount of equity trading (approximately $38.4 billion). Why is this? First of all,