Bonds for Canadians: How to Build Wealth and Lower Risk in Your Portfolio

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<ul><li><p>MORE PRAISE FOR BONDS FOR CANADIANS</p><p>In the midst of the most important secular shift in investing in several generations, a majority of Canadian retail investors are still stumbling blindly, unable to identify, analyze or manage what should be the cornerstone of every successful portfolio: bonds. Whether a failure of the mainstream fi nancial press, or an unwillingness on the part of bond-market professionals to throw back the curtains on their own machina-tions, retail investors remain largely in the dark on how bonds work or how to incorporate them into their investment strategy.</p><p>That is, until now. Deconstructing what is often considered the most cerebral of fi nancial markets, Mr. Allentuck provides an engaging, enter-taining and anecdote-laden account of what bonds are, how they work and why they matter more now than ever. This is the sort of book that every serious retail investor should carry around, dog-eared and rolled, in his back pocket.</p><p>Martin Cej, Investment Editor, The Globe and Mail </p><p>Even readers with no interest in bonds will fi nd Andrew Allentucks book interesting. He goes beyond the ordinary discussion of bonds and skillfully turns a dull pudding of numbers into a wonderful souffl of stories.</p><p>Caroline Nalbantoglu, Registered Financial Planner, PWL Advisors</p><p>In a lively and engaging style, Andrew Allentuck explains not only how bonds work, but also when and why you should invest in bonds. He cov-ers all the bases.</p><p>Tessa Wilmott, Editor, Investment Executive</p><p>Bonds are essential in portfolio building, yet to many retail investors they still lack the sex appeal of stocks. Bonds for Canadians may just change that notion forever.</p><p>Derek Moran, Registered Financial Planner, Macdonald Shymko &amp; Co.</p></li><li><p>ffirs.indd viffirs.indd vi 2/2/08 6:10:50 PM2/2/08 6:10:50 PM</p><p>This page intentionally left blank </p></li><li><p>BONDSFOR CANADIANS</p></li><li><p>ffirs.indd viffirs.indd vi 2/2/08 6:10:50 PM2/2/08 6:10:50 PM</p><p>This page intentionally left blank </p></li><li><p>BONDSFOR CANADIANS</p><p>Andrew Allentuck</p><p>HOW TO BUILD WEALTH</p><p>AND LOWER RISK</p><p>IN YOUR PORTFOLIO</p></li><li><p>Copyright 2006 by Andrew AllentuckAll rights reserved. No part of this work covered by the copyright herein may be reproduced or used in any form or by any meansgraphic, elec-tronic, or mechanical without the prior written permission of the publisher. Any request for photocopying, recording, taping, or information storage and retrieval systems of any part of this book shall be directed in writing to The Canadian Copyright Licensing Agency (Access Copyright). For an Access Copyright license, visit or call toll free 1-800-893-5777.</p><p>Care has been taken to trace ownership of copyright material contained in this book. The publisher will gladly receive any information that will en-able them to rectify any reference or credit line in subsequent editions.</p><p>Library and Archives Canada Cataloguing in Publication Data</p><p>Allentuck, Andrew, 1943- Bonds for Canadians : how to build wealth and lower risk in your portfolio / Andrew Allentuck. </p><p>ISBN-13 978-0-470-83691-0ISBN-10 0-470-83691-1</p><p> 1. BondsCanada. 2. Bond marketCanada. I. Title. </p><p>HG5154.A43 2006 332.63230971 C2006-901432-9 </p><p>Production Credits: Cover design: Ian KooInterior text design: Adrian SoPrinter: Tri-Graphic Printing Limited</p><p>John Wiley &amp; Sons Canada, Ltd.6045 Freemont Blvd.Mississauga, Ontario L5R 4J3</p><p>Printed in Canada1 2 3 4 5 TRI 10 09 08 07 06</p><p></p></li><li><p>Contents</p><p>Preface xi</p><p>Chapter 1: BondsA Matter of Defi nition 1Chapter 2: The Seduction of Risk 31Chapter 3: Taking a Measure of Credit 57Chapter 4: Alternative Bonds 81Chapter 5: Global BondsA Tale of Promises and Defaults 103Chapter 6: Whats a Bond Worth? 125Chapter 7: Bond Funds 155Chapter 8: Bond Trading Tactics 183Chapter 9: The Future Environment for Bonds 211Chapter 10: Bond StrategiesA Summary and a Conclusion 231</p><p>Glossary 251Bibliography 267Index 273</p></li><li><p>ffirs.indd viffirs.indd vi 2/2/08 6:10:50 PM2/2/08 6:10:50 PM</p><p>This page intentionally left blank </p></li><li><p>For my children, Adam and Sarah</p></li><li><p>ffirs.indd viffirs.indd vi 2/2/08 6:10:50 PM2/2/08 6:10:50 PM</p><p>This page intentionally left blank </p></li><li><p>Preface</p><p>Bonds are regarded by those who do not know them as a snooze, rocking chair investments for folks who can stand no losses. The image of grannies clutching savings bonds has no relevance to the sophisticated but careful world of global debt fi nance. This book, which is a broad view of bonds as well as a discussion of investing in Canadian debt markets, examines bond and related markets to show how one can make handsome amounts of money, usually with less risk than by investing in common stocks.</p><p>It is an arguable proposition that Canadas bond market will be the envy of the senior markets that make up the G-7 (the U.S., the U.K., France, Germany, Italy, Japan, and Canada), for only Canada has been able to generate a fi scal surplus in recent years. In 2005, Canada retired $34 billion of bonds while issuing only $23 billion of fresh debt. The implication is, of course, that Canadian inter-est rates need not soar to induce investors to buy bonds. Relative interest rate stability translates to relatively strong bond prices. Canada may, if things go on as they have, become the Switzerland of North America. The loonie, which has soared as the prices of its resources have risen, now shares the monetary limelight as a pet-rocurrency whose value is linked to the price of oil. The loonie has </p></li><li><p>xii P r e f a c e</p><p>become the only oil-linked currency in the G-7. One can hazard a guess that even as stock markets and currency values gyrate over energy and political issues, Canadian bonds will do relatively well. </p><p>Knowing ones way around the bond market is vital for inves-tors. We are at the tail end of a very long party that has gone on since 1982 when the Bank of Canada governor, Gerald Bouey, and the chairman of the U.S. Federal Reserve Board, Paul Volcker, broke the back of infl ation and started the downward course of interest rates. That two-decade-long slide produced extraordinary returns for bond investors. It was possible in that period to make money in almost any sort of investment-grade bond and quite a few junk bonds too. Today, with interest rates still hovering at the low end of mid-singledigit post-World War II averages, interest rates have farther to rise than to fall. Prudence is required to navi-gate in this market. </p><p>Canadian public fi nance is in relatively good shape as 2006 begins and this book heads for the printer. The fi scal surplus that Ottawa continues to generate puts Canadas bond market on sound ground. Bond investors are betting that interest rates over the long run will remain fairly low. Many of the questions about investing in Canadian government bonds involve where to fi nd the right level of comfort and opportunity. The issues of selecting corporate bonds will remain, as always, the ability of corporate borrowers to pay their debts. </p><p>Bonds for Canadians has been written for investors of moderate experience who want to gain fl uency in debt fi nance without the pain of taking a bath in instruments they have neither experienced nor understood. The book is intended to be something to be read from cover to cover as well as a reference on the pricing and trading mechanisms of various types of bonds. Anyone numerate enough to do long division can handle the math. But math is what sepa-rates the serious investor from the dilettante. A private investor need </p></li><li><p>xiiiP r e f a c e</p><p>not be able to calculate average weighted bond returns to several decimalsindeed, that information is already available at websites that assist bond investors. A seat-of-the-pants understanding of bond math is enough to give the private bond investor a working understanding of the pricing of investment-grade bonds. But that understanding is essential.</p><p>I have tried to alleviate boredom with real stories of the mayhem that some bond dealers like the ex-convict Mike Milken, formerly a prince of junk fi nance, have infl icted on investors. I have avoided building the book on confected stories of eager investors, a style that has gained currency in recent years. The reader will also fi nd that this book is free of the inspirational content that fi lls many personal fi nance books. A reader who wants to make money in the relative safety of bonds has inspiration enough. </p><p>Chapter 1 is an examination of how bonds came to be. The con-cept of debt fi nance is almost as old as civilization itself. Before there was defi cit fi nance and government debt, there was regime debt ar-ranged by medieval bankers for their princes. Modern debt fi nance is a development of the 17th century global exploration and of the need of states to pay for their conquests. Even as debt markets grew, banking dynasties continued to pay for the wars of friendly govern-ments. Bankers loaned money to clients whose titles were variously Royal, Serene, and Imperial. Government fi nance is no longer a series of deals between great banking dynasties and great princes, but the basics of loansthe return of principal to the lender with compensation for risk and foregoing consumptionare still the principles of public fi nance. We end the chapter with an introduc-tion to the yield curve, a tool that connects time and interest rates and that is a superb predictor of the economy.</p><p>Chapter 2 is an examination of the risks that drive bonds and other fi xed income products. We examine the complex relation of risk to return, of the risks of bonds or other interest-paying </p></li><li><p>xiv P r e f a c e</p><p>vehicles over time, and of credit risks inherent in all corporate bonds. Bond risk, unlike stock risk, can be precisely calibrated and, in government bonds, that calibration can be expressed to several decimal points. We show how bonds respond to changes in inter-est rates. Finally, we show how expectations change over time and illustrate how an investor can manage his expectations with simple bond strategies.</p><p>Chapter 3 is a catalogue of bonds with risks that vary from the opportunity losses in step bonds to potential risk in convert-ible bonds that lurk in the shadow of stocks to the substantial but manageable risks in junk bonds, and fi nally to credit default swaps that convert the bond investor to a bond insurer at a measured premium that amounts to an enhanced bond return. </p><p>Chapter 4 moves on to riskier bonds, including pay in kind bondsreally junk that pays in junk, hybridized stock/bond issues called preferred securities, collateralized debt obligations with risks that vary from slight to huge, bond derivatives, dishonoured bonds, defunct bonds, and the outright frauds of prime bank notes. </p><p>Chapter 5 is an examination of global bonds and the particular problems of risk and default intrinsic in investing in distant places. The problem of the Argentinian default of 2001, recently settled by that countrys regime at immense cost to hundreds of thousands of small investors in other countries, is examined as a typical if large case of the epidemic of defaults characteristic of the devel-oping world. Business can ruin investors, as Parmalat Finanziaria SpA did when its web of frauds began to unravel in 2003. We ex-amine the problem of defaults of foreign bonds, the role of Brady bonds in facilitating investment in foreign bonds, and the use of infl ation-linked bonds in hedging infl ation. </p><p>Chapter 6 is a venture in bond pricing and analysis from the use of duration calculations in pricing government and investment grade bonds to the credit analysis required to evaluate corporate </p></li><li><p>xvP r e f a c e</p><p>bonds and the assistance of credit rating letter scores used by large bond raters. We show that default rates are closely connected to rat-ing scores and review the recent, sorry history of General Motors Corp.s slide into the purgatory of the sub-investment-grade market. We discuss liquidity and bond prices and begin a discus-sion of tailoring bond types to investors situations.</p><p>Chapter 7 discusses investing in bonds via intermediaries like bond mutual funds and exchange-traded bond funds. The chapter makes the point that while professional management is valuable, the fees customarily charged by bond mutual funds are prohibi-tively high. We review some funds that are exceptions to the rule and that provide value for their fees. We move on to a discussion of specialty closed-end bond funds that trade with price premiums or discounts. </p><p>Chapter 8 is about the nuts and bolts of bond tradinghow to improve ones information and to get the best deals invest-ment banks can offer to the private investor. We begin with one of the greatest bond stories ever toldhow Long-Term Capital Management managed to get involved in US$1.2 trillion of bonds and bond options and then lose it all in a series of what we now know were wacky bets and mathematics gone haywire. The story is instructive as a lesson to the investor to keep bond deals simple. We move on to bond custody, direct sales without the benefi t (or hindrance) of intermediaries, and the use of synthetic bonds that lure the investor with promises of improved odds of capital gains but at a hefty cost in increased volatility.</p><p>Chapter 9 examines the future of bond investing and what in-vestors can do about it today. We examine alternative asset classes, how bond allocations should shift as one grows older, and the po-tential role of China becoming manager of global infl ation and interest rates. In this environment of uncertainty, the value of the promise of absolutely sure payment by a government is precious.</p></li><li><p>xvi P r e f a c e</p><p>Chapter 10 puts the information of the preceding chapters to use by developing bond investment strategies, adjusting for bond price cycles, investor age, total portfolio risk, selection of bond terms, the use of bonds in insuring portfolios, real return bonds, and the ulti-mate question, raised in the fi rst chapter, of what a bond strategy should be with regard to fundamental risk management. As the great stock market investor, Warren Buffett, has said, safety in the market lies in what you know about what you have. In bonds, that means setting ones sights on precise targets rather than shotgunning capi-tal markets for whatever deals are being sold. And that, in sum, is the point of Bonds for Canadians. </p><p>WHO SHOULD READ THIS BOOKInvestors who have limited capital and no experience in capital markets need a broader grounding than Bonds for Canadians aims to provide. They can begin with a standard text on economics; add a review of algebra, calculus, and statistics; and then read a topical introduction to investing such as Sharon Salzgiver Wrights Getting Started in Bonds, published by John Wiley &amp; Sons. Experienced in-vestors who know their way around options and futures, foreign exchange markets, and bond covenants will fi nd this book too elementary. But the stock investor who wants to shift to a differ-ent fi eld of risk and the somew...</p></li></ul>