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“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.

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.”

—Martin Cej, Investment Editor, The Globe and Mail

“Even readers with no interest in bonds will fi nd Andrew Allentuck’s book interesting. He goes beyond the ordinary discussion of bonds and skillfully turns a dull pudding of numbers into a wonderful souffl é of stories.”

—Caroline Nalbantoglu, Registered Financial Planner, PWL Advisors

“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.”

—Tessa Wilmott, Editor, Investment Executive

“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.”

—Derek Moran, Registered Financial Planner, Macdonald Shymko & Co.

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BONDSFOR CANADIANS

BONDSFOR CANADIANS

Andrew Allentuck

HOW TO BUILD WEALTH

AND LOWER RISK

IN YOUR PORTFOLIO

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 means—graphic, 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 www.accesscopyright.ca or call toll free 1-800-893-5777.

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.

Library and Archives Canada Cataloguing in Publication Data

Allentuck, Andrew, 1943- Bonds for Canadians : how to build wealth and lower risk in your portfolio / Andrew Allentuck.

ISBN-13 978-0-470-83691-0ISBN-10 0-470-83691-1

1. Bonds—Canada. 2. Bond market—Canada. I. Title.

HG5154.A43 2006 332.63’230971 C2006-901432-9

Production Credits: Cover design: Ian KooInterior text design: Adrian SoPrinter: Tri-Graphic Printing Limited

John Wiley & Sons Canada, Ltd.6045 Freemont Blvd.Mississauga, Ontario L5R 4J3

Printed in Canada1 2 3 4 5 TRI 10 09 08 07 06

www.accesscopyright.ca

Contents

Preface xi

Chapter 1: Bonds—A Matter of Defi nition 1Chapter 2: The Seduction of Risk 31Chapter 3: Taking a Measure of Credit 57Chapter 4: Alternative Bonds 81Chapter 5: Global Bonds—A Tale of Promises and Defaults 103Chapter 6: What’s a Bond Worth? 125Chapter 7: Bond Funds 155Chapter 8: Bond Trading Tactics 183Chapter 9: The Future Environment for Bonds 211Chapter 10: Bond Strategies—A Summary and a Conclusion 231

Glossary 251Bibliography 267Index 273

For my children, Adam and Sarah

Preface

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.

It is an arguable proposition that Canada’s 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

xii P r e f a c e

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.

Knowing one’s 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-single–digit post-World War II averages, interest rates have farther to rise than to fall. Prudence is required to navi-gate in this market.

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 Canada’s 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.

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

xiiiP r e f a c e

not be able to calculate average weighted bond returns to several decimals—indeed, 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.

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.

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 loans—the return of principal to the lender with compensation for risk and foregoing consumption—are 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.

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

xiv P r e f a c e

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.

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.

Chapter 4 moves on to riskier bonds, including pay in kind bonds—really 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.

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 country’s 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.

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

xvP r e f a c e

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.

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.

Chapter 8 is about the nuts and bolts of bond trading—how to improve one’s 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 told—how 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.

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.

xvi P r e f a c e

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 one’s 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.

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 Wright’s Getting Started in Bonds, published by John Wiley & 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 somewhat experienced bond investor who wants to broaden his or her bond skills will, I hope, fi nd this book useful and a good investment in itself.

GIVING CREDITIt is incumbent on an author to give thanks to those who helped build his book. In my case, they include professional bond man-agers Chris Kresic of Mackenzie Financial Corporation, Tom Czitron of Sceptre Investment Counsel Ltd., and Randy LeClair of AIC Limited, each of whom provided a wealth of wisdom and

xviiP r e f a c e

experience to what would otherwise have been an academic task. Sal Pellettieri, a quantitative analyst with IGM Financial, was gen-erous in the time he gave to reviewing my work. Alan Brownridge, a masterful manager of government bond portfolios, made valu-able comments on the manuscript. Brad Bondy, a shrewd bond analyst and portfolio manager with Genus Capital Management, Derek Moran, a fi nancial advisor with Macdonald Shymko & Co., and Caroline Nalbantoglu, a fi nancial advisor with PWL Advisors, gave me perspectives for assessing fi xed income returns. Patrick McKeough, a pundit and portfolio manager, offered coun-sel. Richard Gluck, a very perceptive bond analyst with Trilogy Advisors LLC in New York, offered much wisdom, as did Bank of Nova Scotia economist Aron Gampel and mutual fund expert Dan Hallett. My friends Anne Hardy and Michael Macklem listened with patience and grace to my thoughts. Investment Executive Editor Tessa Wilmott, former Managing Editor James Walker, cur-rent Managing Editor Tracy LeMay, Senior Editor Pablo Fuchs, and their gracious and expert colleagues gave me time, space, and guidance for my monthly bond column. My friend Don Hendry provided years of support. Daryl Kuhl, a diligent scholar, produced the index for the book. My editors at the Globe and Mail, including Dave Pyette, Marty Cej, Doug MacKay and Haris Anwar, heard out my thoughts on fi nance and encouraged me to write about the fi eld. My friends Jim Cristall, Rachel Siemens, Tanis Bridges, Sheila Balasko, Jerry Tutunjian and Mel Rempel were more help-ful than they knew.

I must add the names of advisors whose counsel was spiritual as well as factual. First and foremost, my partner Heather Winters added the counterbalance of insurance concepts to bond risk as-sessment. My friends Brock Cordes, Adrian Long, Bryan Dunlop, Gary Thompson, Jack Reid, and Michael Bentley gently suggested at our weekly seminars that I avoid obscurity. My friends Ric Bel

xviii P r e f a c e

and Ida Albo kept up my spirits. Tony and Felicia De Luca fed those spirits, literally.

It is customary and just plain honest to admit that in spite of the wisdom of my friends and counsellors, blunders in the text are my own. That said, I must add that the book would not have been pos-sible without the help of Karen Milner, Executive Editor at John Wiley & Sons in Toronto; the kindness of Wiley’s Lucas Wilk, Lindsay Humphreys, Pamela Vokey, and Elizabeth McCurdy; and the faith and friendship of my endlessly patient literary agent, Bev Slopen.

Chapter 1

BONDS

A Matter of Defi nition

In a world in which stocks behave like they are in a crack-driven frenzy, soaring and swooping on gusts of rumours, bonds’ prom-

ise of payments of specifi c sums at fi xed dates is precious. If the money isn’t on the table when it’s due, bondholders can use their considerable powers to seize money and even take over the compa-ny. No common stock, no income fund, no currency speculation, and no commodity deal conveys similar powers. When companies go bust, it’s often the bondholders who wind up owning the stock of the reorganized business. The power to seize the business and its assets makes bonds lifejackets in periods when stock investors are drowning.

The stability of bonds has to be seen in relative terms, howev-er. In periods when interest rates soar, as they did in the late 1970s and early 1980s, bond markets can go into tailspins worthy of the great stock market crashes of 1929, 1987, and, more recently, of the implosion of the tech craze in 2000. What’s more, the rela-tive stability of bonds is a rather static concept. Over long periods,

2 C H A P T E R 1

common stocks that tend to pay rising dividends and to gener-ate rising earnings do a better job of pacing infl ation than bonds, which never can do more than return their principal.

Why, then, should one bother with bonds? Because of their power to pay. A government bond is backed by the full faith and credit of the nation and, especially, by its printing presses. A cor-porate bond is the fl ag of its issuer. It is normal for stocks of even fi ne, secure companies like the Royal Bank of Canada to fl ourish and founder. Such behaviour is unacceptable for a bond, the credit rating for which is like an electrocardiogram of the business. For a company to suffer a credit rating loss is a huge indignity that often brings forth screams of protest from affl icted corporate executives whose fi nancial shirts have been ripped to pieces by a drop, for example, from AA to A or A to BBB+. For a major government to default on a bond is nearly unthinkable. Even talk of a bond default has led some politicians to fl ee from rooms where it is taking place. To be associated with an act that would turn a major government into a fi nancial outcast is anathema.

In the end, bonds have a pedigree that puts them above almost every other obligation a company can have except for the duty to pay income taxes. The obligation of a bond issuer to pay can be as immediate as a day or as distant as 30 years. In rare cases, it can be infi nite, as it is for perpetual bonds. This quality of certainty puts bonds in the most senior of all classes of corporate and govern-mental liability. Indeed, in a world in which chance and mayhem fi ll the news every day, a portfolio of bonds is the sensible thing to have. How much to have, of course, remains a different and quite sophisticated issue.

WHAT’S A BOND? In a legal sense, a bond is just a promise to pay made by a govern-ment or corporation that seeks to borrow from many people. It is

3Bonds—A Matter of Defi nition

a loan intended to be widely subscribed. The promise is binding within the terms of the bond agreement, usually called an inden-ture. Some bonds are issued by governments with the power to print money. These bonds, when issued in their own currencies, are regarded as riskless, at least with regard to default. Other bonds are issued by corporations that are in varying degrees of fi nancial health. When the health of the company is in question, the bonds acquire some of the characteristics of stock that rises and falls with the outlook for the business. The more wobbly the business, the more the bond resembles a stock.

Clearly, “bondness” is a fl exible idea, but all bonds earn the bond-holder a return on a loan while all stocks generate a return for the stockholder—that is, it is return for ownership. It is the difference between being a person to whom money is owed (the bondholder) and being a person owning the business that owes money (the stock-holder).

The powers given to lenders make bonds vehicles for pro-ducing relatively safe returns. The nature of those returns allows the bondholder to calibrate his returns. Stock returns, which are residues after all costs, including borrowing costs charged by bond-holders are paid, are unpredictable residues.

In this book, a bond that is pure, that is, without credit risk, is the gold standard of the asset class. There are many classes of bonds and many categories of risk. But keep in mind that secu-rity begins with bonds that have no risk of default. Beyond riskless government issues, bonds take on many of the chances of the busi-ness cycle and of other infl uences. When investors move into junk bonds, they are in a casino of bonanzas and hazards.

WHERE BONDS BEGANLending is as old as civilization itself. With the rise of money as tokens of value, the borrowing of tokens began. As loans within

4 C H A P T E R 1

tribes turned into deals among strangers, credit became formalized in bonds. Bond fi nance was the work of drudges for most of history, but the business got to be glamorous in the 1980s. Bond traders became celebrities. They bought lavish homes and yachts and at-tracted entourages of beautiful people eager to get in on the game.

Novelist Tom Wolfe wrote The Bonfi re of the Vanities about the immorality of the life of a bond trader in the money-soused atmo-sphere of New York. The bond biz lost some of its glitter when New York-based investment bank Drexel Burnham Lambert, which had become the largest dealer in the racy fi eld of junk bonds, fi led for bankruptcy protection in February 1990. Michael Milken, Drexel’s impresario of junk, led a coven of fi xed income wizards in the fi rm’s Los Angeles offi ces and brought a measure of respect to fi nancial instruments that legendary fi nancier Warren Buffett later called “weeds priced like fl owers.” Milken misrepresented the quality of junk bonds and went to jail the following year for a variety of crimes, the highest of which appears to have been fi ddling the press about his innocence while his investors burned. Defaulting bonds ate up those who thought so-called junk debt was a good deal, and the market moved on to the next mania—bond derivatives like multicurrency interest rate swaps so complex that it took hordes of mathemati-cians fl eeing the wreck of the Soviet Union to understand them. Few did.

There is a lesson here and it is this: Bonds have the poten-tial to make investors rich and, as well, the capacity to destroy those who do not understand the risks they take. Building on the founda-tion of simple, no-frills bonds issued by national governments that are sure to pay their interest and to repay their principal on time, fi nancial engineers have contrived ways to leverage small amounts of money into huge amounts of risk. Prophetically, some of the best minds on Wall Street went broke playing bonds as though they were virtuoso pianists playing riffs of Mozart. The bottom


line on turning safe or even edgy bonds into investments that can make a fortune or, just as likely, wipe out an investor in minutes is that modesty pays. Used as a sensible anchor for a nest egg or a fortune, bonds work. Manipulated with borrowed money and risk distilled into weapons of destruction of the investor’s fortune, they are best left to speculators with a tolerance for pain.

A single story makes the point: Among the many who thought they knew more than the market did about fancy bonds, Nobel Prize-winning economists and mathematicians put their life savings into Long-Term Capital Management (LTCM). That company, based in Connecticut, had owned over US$1 trillion of exposure to some of the most rarifi ed and qualifi ed bond bets ever conceived. To no avail, for they saw their formulas fi zzle and their money vanish in a few months in 1998. Professors watched the collapse of towers of formulas based on concepts of randomness that Einstein had worked into his ideas on cosmology.1 Afraid that the world banking system could collapse, the U.S. Federal Reserve, function-ing as a lender/impresario of last resort, assembled a consortium of banks to take over LTCM, and the world banking system was saved. What the episode shows is that mathematical economics is no match for the uncertainties of the market.

Bonds have made great fortunes and crushed others. The knack for achieving the former and avoiding the latter is to know that bonds, when properly viewed, are a precise barometer of economic and even of social trends. No matter how arcane the bond, no mat-ter how artful its design, the profi t of an investment or the value of a forecast depends on knowing what the bond is about and what the future holds for it and, at a higher level, measuring how fi nancial markets see the bond. Much the same could be said for stocks, but the critical difference between a bond, which is a solemn promise to pay interest and usually to repay principal, and a stock, which is ownership in a business, is the reliability of that promise.2 The

6 C H A P T E R 1

returns of bonds, when separated from the risk of bankruptcy of the issuer, can be calibrated to several decimal points. In contrast, stocks, which contain a high level of risk of such events as earnings shortfalls and insolvency, are a thumbs-up, thumbs-down exercise in taking the auguries of the market. Predictable outcomes at de-fi ned times, while characteristic of investment-grade bonds, can never be known for stocks in ten minutes or ten years.

Stocks live until their companies die or buy them back. Yet for bonds, the notion of lifespan has proven to be fl exible. Most bonds are issued for defi nite terms and are paid at maturity or when called by their issuers. Yet other bonds, such as perpetual British consols, were issued with no maturity dates. Perpetuals long ago went out of fashion and were largely redeemed by issuers, mainly governments. But the extension of life expectancy as the result of medical care and public health measures, better nutrition, and so forth, has pushed the horizons of repayment. In 2005, Britain and France began to issue 50-year bonds. Japan, which is struggling to generate a market for 30-year bonds, has been reported to be considering issuing 50s. But the king of the mountain of maturity has to be Denmark. An energy company owned by the Kingdom of Denmark issued a bond to mature in 3005, 999 years from now. The bonds, which overcome a Danish law that disallows deduction of interest on perpetual debt, are scheduled to be called in 2015, said Michael Steen-Knudsen, head of investor relations for Dansk Olie og Naturgas A/S.3 The bonds, if held to maturity in the fi fth year of the third millennium, would make their owner incredibly rich. If the bond were held to maturity, then, assuming every coupon (the periodic payments of in-terest that are sometimes printed as small slips to be detached from the bond and deposited to the owner’s account) is reinvested at 3% per year, that no taxes are charged, and that infl ation does not ex-ist—heroic assumptions indeed—the total return and fi nal value of the bond would be Kronor 6.87 × 1012. The immortal owner would


be a trillionaire nearly seven times over. Albert Einstein, asked what was man’s greatest invention, is said to have replied, “Compound interest.” Perhaps he was not kidding.

THE IDEA OF A BONDCredit is the commercial expression of the promise to repay and what a potential lender thinks of the reliability or “credibility” of the person who makes it. The concept is really how much one person may trust another who makes a promise to repay a given sum. In a remarkable book, A History of Interest Rates, investment banker Sidney Homer and economist Richard Sylla traced the idea of credit back to Neolithic times when a farmer made a loan of seed to a relative and then expected to be paid more when the crop was harvested.4 The concept is basic—the lender gives up current consumption to someone else and expects a repayment based on the risk of default, the risk of a bad harvest or loss to insects or other forces, and the amount of grain that a similar investment would have produced if the lender planted it himself.

Around 1800 b.c., Babylonian king Hammurabi created what may have been history’s fi rst uniform commercial code. His laws set maximum interest at 33½% per year for loans of grain repay-able in more grain and 20% for loans of silver. Loan agreements had to be written or chiselled, if you like, and witnessed by offi -cials. If a lender extracted a promise for higher interest or took it by trickery, the loan was offi cially cancelled. In Greece, the great Athenian ruler Solon (638 b.c. to 559 b.c.) faced what we would today call a liquidity crisis. The economy was in tatters and loans were not being repaid. That led to chain bankruptcies in which A, who had no funds, could not pay B, who then could not pay C, and so on. Solon removed limits on interest rates, allowing more wealth to fl ow into the market, and he did away with personal slav-ery for non-payment of debts.5 The concept of marketable debt at variable interest rates was growing.

8 C H A P T E R 1

Solon’s elimination of slavery as a means of guaranteeing re-payment or compensating for default raises the moral issue that tormented Christian Europe: Is interest moral and, if it is, above what rate is it immoral? In the Bible, Leviticus addresses issues of capital and property management, conditions of lending and credit. “Thou shalt not give him thy money upon usury” appears to set an upper limit on interest rates, though the measure is not specifi ed.6

What is usury to a borrower may be sound business judgment to a lender. Take the case of Philip the Fair of France (1285–1314) who borrowed heavily and then, rather than pay his bankers, ban-ished them, cancelled his own debts, and then ruled that all debts to the bankers now had to be repaid to him. His main creditor, the Order of Knights Templar, which by then had become a bank, was destroyed. Edward III of England (1312–1377) also repudiated his debts and destroyed his Florentine lenders.7

Finance in the late Middle Ages had to deal with the risks that princes would not pay their loans and that merchants even of most honest intentions were at risk of loss to vermin, plagues, pirates, and those greedy princes. The Hundred Years War between England and France waxed and waned from 1337 to 1453. In that period of 116 years, Europe suffered the plague that drove Geoffrey Chaucer to Canterbury Cathedral and to the writing of the Canterbury Tales. The plague, also called the Black Death for the colour of the pus-tules that appeared on the bodies of the infected, was a very hard time for bankers who could not collect interest or principal from the dead. In Renaissance Italy, great banking houses teetered at the edge of insolvency when their loans to princes went bad. Bankers like the Medici had to advance increasing sums of money to spend-thrift nobles and then, when the bankers had run out of money to lend, their borrowers would destroy their lenders. One scholar of the period compared the treatment of the lenders to that of “an orange…whose juice has been squeezed out.”8


The practice of Renaissance bankers was to discount loans and bills of exchange (similar to modern-day cheques) for the length of time of a loan, risk, and diffi culty of collection.9 A discount is inter-est inverted. Thus 10% interest on $100 due in one year is the same as a loan for $90.91 payable at $100 in one year: The growth in value of the discounted instrument was easily treated as a capital gain and avoided the appearance of usury, which was often confused with the charging of any interest at all. Regardless of how loans were struc-tured, collection was a problem when war or politics interfered. A lender that lost its capital in bad loans would clearly have to go out of business.

To deal with the problem of deposit instability, authorities in Venice ruled in 1374 that banks could not deal in speculative com-modities. In 1403, they were required to hold at least 40% of their assets in government bonds and loans. The Venetian Republic then appointed bank examiners to ensure that the rules were followed.10

The issues that underlie every bond were sensed and identifi ed in the ancient world. Today, we would say that a transfer of money, or of one asset that is taken as an equivalent for another, is either a loan, a pawn, a payment, or a theft. If the asset exchanged remains with the borrower, it is a loan. If the asset and title to it moves perma-nently to the payee, it is a sale with payment. If the asset is taken as a security by the payer, it is a pawn. And if the asset is taken without payment or if the payment turns out to be fraudulent or defective, as in the case of counterfeit money, it is a theft.

In the movie Wall Street, arch capitalist Gordon Gecko (played by Michael Douglas) said, “Greed is good.” The statement reveals much about the man and what capitalism had become in the 1980s. But it is useful to consider what makes such a statement possible, for the measure of avarice goes to the essence of what is fair gain and what is unreasonable gain. Hand in hand with that issue is the essence of the bond—return for measured risk. “Know thyself,”

10 C H A P T E R 1

reads an inscription at the Oracle of Delphi. It is the fi rst lesson and perhaps the fi nal lesson as well in the assessment of risk.

WHAT INTEREST MEANSInterest rates are the monetized measure of risk. Over history, rates have varied from 10,000% per year charged in Germany in the peak hyperinfl ation year of 1923, during which the mark fell to one six-billionth of its pre-World War I value in 1914, to a low, real rate of zero on short-term interbank loans in Japan in the years following the bursting of that country’s economic bubble in 1991. Real rates of interest have actually become negative during many periods of defl ation, such as the Great Depression of the 1930s when the price level declined. The German infl ation, which was engineered by a government on a suicide mission to show that reparations imposed by the Treaty of Versailles were unsupport-able and unpayable, was expressed by the interest rate as a warning that money was quickly becoming worthless. The Japanese zero interest rate warned that any fi nancial investment in that nation’s shrinking economy was unproductive.

What is usurious and what is reasonable thus have to be judged against the permanent, underlying risk of so-called riskless bonds issued by governments. That risk is infl ation and, as the principal systemic risk of all bonds, it passes down the ladder of quality from the best bonds of the best governments to the shoddiest, most du-bious issues of companies nearing insolvency.

All bonds have transaction risk, the chance that an instrument is forged, that a payment system won’t work, or that money paid in redemption of a bond will be counterfeit. This category of risk obviously breaks down into many others, but each was anticipated thousands of years ago by the fi rst bond managers.

In Babylon in the time of Hammurabi, there were bond-like bills of exchange that might pass from one person to another as


means of payment, much like cheques that turn into third- or fourth-party instruments that today might be handled by commer-cial factors that make it their business to trade in such things. Each adjusts the prices of bills for the risk of nonpayment by a prior party in the chain of payees. The discount is interest in reverse, a statement that a fi nancial instrument of questionable character should be worth a good deal less than face value. The discounting business, really a way of quantifying risk and making it resalable, grew until Babylonian merchant bankers around 600 b.c. were handling international transfers, moving credits among their de-posit accounts for customers, and fi nancing other businesses. All this was done in a nation ruled as a benign despotism by a head of state regarded as having divine powers, noted Homer and Sylla.11 Think of Alan Greenspan, chairman emeritus of the U.S. Federal Reserve Board, and you get the idea.

THE GROWTH OF THE BOND MARKETThe growth of Mediterranean trade during and after the 5th cen-tury b.c. appears to have provoked people who thought about money to create ever more forms of transferable wealth. Personal and commercial loans were already in wide use as wealth became more portable. Event-sensitive loans were made in the shipping trade. Lenders made loans and carried the risk. Thus a loan might be set to require payment of the loan and interest if a voyage were successful. If the boat were lost, the loan might not have to be re-paid.12 This is insurance blended with a loan. Commercial banks make such loans today, much to the worry of insurance companies that would like to keep this business to themselves.13

Bonds emerged from the concept of loans along with clari-fi cation of the notion of security. If a loan is subscribed by many individuals or companies, it is likely to be made with documents that include a description of the business or other borrower. Some

12 C H A P T E R 1

bond issues are bought by a single lender, but the concept of the bond remains, at its core, a loan fi nanced by many people and re-payable on known conditions.

A bond is a solemn obligation. In the late 13th century, the Republic of Venice invented prestiti, perpetual bonds with no matu-rity date that initially paid 5% per year. Purchased by the Venetian nobility as dowries for their daughters and for contributions to charities, they came to trade at 75% of face value. The discount no doubt refl ected the issues of the day, including piracy on sea routes and problems facing the Byzantine empire, a major trading partner. The prestiti were forced loans, for nobles were really being hit with a refundable tax. The bond was a receipt for the loan and the coupon payments were the refunds. The amounts the nobles were forced to buy depended on the value of their real estate. Like bonds and bills that are now issued by major governments such as those of Canada and the United States, the prestiti were recorded in ledgers but not issued in paper certifi cates. Trades were recorded in a central offi ce and subsequent purchasers had the rights of the original purchasers. The prestiti traded for at least two centuries and then became a model for consols, the name given to perpetual bonds crafted by Britain’s prime minister, Henry Pelham, in 1751. Consols were constructed to pay interest until such time as the is-sue would be redeemed, which in the theory of the day was likely to be never. There is no record of default on these perpetuals, though interest rates were reset from time to time by both the Venetian and British authorities.14

Investors with the wisdom to have bought or held bonds of surviving governments have been well served by these securities. One example shows how seriously senior governments have taken their obligations to service their bonds. In 1624, a Dutch woman named Elsken Jorisdochter bought 1,200 fl orins worth of 6¼% perpetual bonds issued by the Lekdyk Bovendams Company, a


business chartered in 1323, which was essentially a Crown cor-poration able to raise money by taxation. The bonds were “free of all taxes, impositions or charges whatsoever, however called or disguised, with no single exception,” making them equivalent to U.S. municipal bonds that are not subject to tax in their state of is-sue. In 1938, the heirs of Ms. Jorisdochter presented the bonds for payment on the New York Stock Exchange. The bonds continued to trade as late as 1957.15

BONDS: THE LIMITS OF RISK AND RETURNThe international bond market has grown into what is arguably the largest capital market in the world. The total value of bonds outstanding has been estimated at US$30 trillion.16 The market trades on rumours and even on rumours of rumours to come and, in tandem with global currency markets, can offer spectacular gains or dreadful losses, especially to investors who use borrowed money to leverage their bets. Yet bonds are traded over the coun-ter at prices that are not displayed on one central board, unlike the stock market, where each exchange maintains a central, defi nitive display of the price of every stock it handles at every second of the trading day. In bonds, moreover, it is rare for large issues to be traded after sale in the primary market. It is important to make the point that corporate bonds, after initial sale, usually are not much traded.

Life insurance companies and pension funds, the main buyers of government bonds, tend to be buy-and-hold investors. They use bonds to cover the risks they carry, matching maturities to life expectancies. In comparison to stocks, which are board priced and frequently traded, bonds are constantly repriced in an active secondary market. Stocks trade at bid-ask spreads that may be as small as one or two cents with dealers making most of their money on commissions. Bond spreads may be as small as one or

14 C H A P T E R 1

two thousandths of a percent of yield or a hundred times wider. It all depends on the size of the trade and the bargaining power of the traders.

The fi rst stop for any bond investor is the yield fl oor, which is set every moment by yields offered on government bonds. That basic yield is the lowest in the market and constitutes the founda-tion that supports the entire structure of corporate bonds above it. Government bonds are liquid, are frequently traded, are competi-tively priced by dealers who often sell from their own inventories, and operate as bellwethers for infl ation trends.

Bonds issued by governments and investment-grade bonds is-sued by corporations with bulletproof credit ratings are used for investing without the risk of loss of principal. Hold the bonds to maturity and repayment is certain, though the purchasing power of money years hence is not certain.17 Government bonds have the lowest interest rates because they are regarded as immune from default, at least in the currency of the issuing country. After all, if a treasury is short of funds, it can always print more.

Corporate bonds are different from government bonds, for their issuers have to work for their credit ratings. Those bonds that are rated as investment grade have credible promises to pay and are regarded as safer than a stock issued by the same company. Bondholders get paid before any residue of cash fl ow is paid out to stockholders. Safer bets require less compensation for risk, so bonds, in theory, should earn lower returns than stocks.

Evidence supports that view. For example, in the period from 1802, when U.S. data begin to be available, to 2001, American stocks generated an average annual compound return of 8.3%. In the same period, long-term government bonds earned average an-nual compound returns of 4.9%. In that period of two centuries, infl ation averaged 1.4% per year, bringing down the returns to 6.9% and 3.5% respectively.18


Case closed? Not quite, for the data that support the two cat-egories of returns are fl awed. Government bonds issued by major nations seldom default, while companies that issue stocks have a high rate of failure. The result is that the comparison of returns is really between old governments and new companies. Had the stock of companies in deep trouble been carried forward after their bankruptcies, rather like the shares of airlines that are serial bankrupts, the averages might be very different. They might show that bonds are superior not because they pay higher returns (which remains unlikely), but because they fail far less often. Adjusting for survivor bias brings long-run stock and bond returns closer together, though how close cannot be measured. What’s more, all U.S. data has a political bias, for the 1800s and 1900s were a period during which the United States rose from being a dubious emerg-ing market, as it was after its War of Independence and the War of 1812, into the world’s preeminent industrial and military power. In that period of two centuries, U.S. shareholders earned a premium for owning American assets. Indeed, the premium generated by the shelter of location in the United States exceeded the return on loaned funds. Were geopolitics to change and the United States were to become just another power on, say, a European level of might, the returns to its stocks might decline. In those circum-stances, it could be better to be owed than owing.

For a long-run view of stocks, consider someone who invested in the stock market of the United Kingdom in 1693 and stayed invested for the next three centuries. By 1696, our immortal in-vestor would have lost 70% of the initial investment and not been able to recover the nominal, initial investment until the South Sea Bubble of 1720. After that bubble burst, the investor would have had to wait until 1961 to get back the original investment on a nominal basis. The rate of return would have been 1.44% per year assuming taxation of dividends and no reinvestment. Adjusted for

16 C H A P T E R 1

268 years of infl ation, the return slumps into negative territory at minus 0.082% per year compounded annually. Had our inves-tor bought in at the market peak in 1720, then, says Swiss banker Alexander Ineichen, who calculated these numbers for his book Absolute Returns, he or she would still be carrying a loss with an asset worth just 22.3% of the original investment in 1720.19 No set of government bonds that paid interest continuously in the same period would have been likely to have done as badly as stocks. It is worth noting that a bond investor who had the wisdom to invest $1,000 or the equivalent at 8% per annum in 1606, the year Guy Fawkes was executed for plotting to blow up the Houses of Parliament, and to have received and reinvested at that rate for the next 400 years, would today have a pile of money worth over $42quadrillion.20 That sum exceeds the money supply of the UnitedStates and the European Union and perhaps of every other nation on earth. Taxes would have eroded the rate of accumulation and, one should note, 8% was an astronomical rate unavailable on investment-grade debt for much of the period. But the outcome does show the power of compound interest continuously applied.

It remains true that stocks will outperform bonds in some periods and bonds outperform stocks in others. The reasons are straightforward: When times are good, interest rates rise and exist-ing bonds with fi xed coupons become less attractive. Their market prices fall. And when times are bad and prospects dim for shares, interest rates may fall. In this environment, the prices of outstand-ing bonds rises. Summer for stocks tends to be winter for bonds.

The fi ve years ended December 31, 2005, saw some of the most violent swings in capital markets since data began to be kept on a continuous basis. The tech bubble of the late 1990s gener-ated an implied real return of more than 10% per year for 25 years compared to the 1973 oil price spike caused by concerned action by the Organization of Petroleum Exporting Countries (OPEC)


that created returns on a similar basis of just 2% and the South Sea Bubble itself, which generated an implied annualized real return of 8%.21 Relatively safe government bonds cannot compete with markets driven by such hopes, but bond returns can put stock re-turns to shame.

For the fi ve-year period ended December 31, 2005, Canada’s S&P/TSX Total Return Index produced a 6.6% average annual compound return compared to a 3.0% average annual compound loss by the Dow Jones Industrial Average total return in Canadian dollars. In the same period, the SC Universe Bond Total Return Index, which broadly measures the Canadian bond market, pro-duced an average annual compound return of 7.4%.22 The lesson here is that as risk rises in markets, it is good to fi nd safe haven in investment-grade bonds, which seldom trade with as much emo-tion as stocks and which, therefore, tend to show less volatility.

In the end, one cannot say that bonds are always to be pre-ferred. Indeed, there is not a single asset class—stocks or bonds or cash or real estate, commodities or art and sculpture—that is right for all seasons. Yet American investors in particular have seized on the evidence of their nation’s exceptional economic success in the 20th century, when U.S. industry and banks came to domi-nate the world, to assert that bond returns are inferior to those of stocks. U.S. federal bonds have been prized for their issuers’ stability and commitment to payment. Risk capital has fl owed to U.S. stocks and has been rewarded with increases in profi tability beyond expectations. But the U.S. case of bond reliability, a qual-ity investors have eagerly accepted, has not been typical of other issuers. Foreign investors in U.S. bonds have bought them for their safety and for the haven they believe that the United States provides to capital. The high prices and consequent low returns on U.S. bonds compared to those of less stable jurisdictions have refl ected not only interest rate expectations, but also an implicit

18 C H A P T E R 1

charge for insurance against default. Safety pays and sometimes the investor has to pay for safety.

WHEN SOVEREIGN BONDS DEFAULTThe tale of woe of those who hold debt of countries that fail to pay their bonds shows the value of exchanging potentially high returns in what amounts to sovereign junk for reliable debt of countries that are very unlikely to default. At the beginning of the 20th century, three emergent nations, Argentina (the name of which refers to a place of silver or to a place of money), Russia, and the United States, were candidates for exceptional growth. The outcome was, of course, that Russian business dissolved in the chaos of a revolution that did not honour Tsarist bonds. A few of the Russian prerevolutionary issues were paid by the post-Soviet government at pennies on the dollar.

Argentina became a serial defaulter and managed to rack up the world’s largest bond default ever when it declined to honour US$81 billion of bonds in December 2001. At time of writing, the Government of Argentina has proposed to knock 70% of the face value of the dishonoured bonds off a refi nancing and to make bondholders wait until 2038 for their new bonds to mature.23

In spite of 80 years of stonewalling by Russian treasury authorities and the sideshow antics of the Argentine government, most governments do honour their debts. The investor who was wise enough to buy nothing but Canadian, U.S., and British bonds would have done fairly well. The yields of British consols (perpetual bonds that never mature) and annuities in the period from 1725 to 1975 averaged 4% per year.24 In that time, an investment of £1,000 would have doubled 14 times over. The initial sum would have be-come £10,638,400. Infl ation and taxes would have gored this nominal return, but—and this is the point—the investor would have had a positive return and with less volatility and fewer sleepless nights over the centuries than had the money been in stocks exposed to more


explosive business cycles. The essence of this history of government bond defaults is not that one must avoid sovereign debt, but that one must view governments based on of their likely commitment to pay their debts. After all, if a company defaults, its bondholders may be able to seize its assets. If a nation defaults and if that nation has an army, asset seizure is out of the question.

The bonds of any government function like a heart monitor on a living body. When a national economy is strong, it is easy and pru-dent for a government to pay its debts, particularly those incurred in other currencies. When a nation is weak or its rulers have run off with the national treasury—a not uncommon occurrence in much of the world—bonds don’t get paid. A survey of the debt of 113 gov-ernments around the globe by Standard & Poor’s, a respected credit reporting and bond rating agency, found that 69 had defaulted on foreign currency debt.25 The deadbeats were a list of governments from Angola to Zimbabwe. Only eight nations on the list of default-ers failed to pay bonds in their own eroded currencies.

Bonds become newsworthy only when defaults rise and threat-en to ruin the reputations of issuers or the lives of the investors who hold them. Yet by sheer quantity of issues and of money in-volved, bonds are in much the same league as stocks.

VALUING BONDSAt the beginning of this millennium, the U.S. bond market, the largest national market in the world, held $18.5 trillion in vari-ous government and corporate bonds. It was larger in value than the U.S. stock market, which held about US$15 trillion in various shares.26 In comparison, the Canadian securities market held total bonds outstanding as of the end of 2004 worth C$1.3 trillion com-pared to C$1.6 trillion of stocks.27

Bonds don’t get the press that stocks do because they are trad-ed over the counter without visible exchanges between bargaining

20 C H A P T E R 1

parties. Stock prices are published second by second and, apart from commissions, do not vary with who is doing the bidding and the asking for shares. Bonds, on the other hand, are traded at pric-es between what dealers pay and those at which they are willing to sell. Dealers may want to unload inventories of particular bonds or may hold out on a certain issue if they think a large bid is about to arrive. The lack of transparency of bond prices is regrettable, for it tends to make small investors stay away.

Bonds may one day be priced on boards the ways stocks are. On January 31, 2005, the U.S. Bond Market Association (BMA) started to display the prices of municipal bond trades with a 15-minute delay. The BMA began posting all corporate bond prices on February 7, 2005, with a 30-minute delay and moved to 15-minute delays in July 2005. Municipal bonds, which are exempt from taxes on their interest payments for investors resident in the state of issue, amount to more than US$2 trillion. Posting prices will encourage dealers to reduce their spreads, which is important since individuals own a third of all municipals and account for 80% of all trades. There’s a total of about a million issues of munis, as they are called, on the market, many with unique bells and whis-tles. Diffi cult to compare and often hard to understand, they tend to be keepers rather than traders. So while the BMA move may improve pricing in favour of small investors, it may do little to improve their liquidity.28

The move to public pricing of munis and corporate bonds will, one hopes, carry over to federal bonds and one day be cop-ied in Canada. The argument against public pricing is that it is unnecessary for a market in which most players are institutions like pension funds and mutual funds that have the machinery and muscle to track prices. The same argument is a defence of lack of competition, for mutual fund bond managers like to brag that their funds are a good deal because they can buy bonds wholesale and


hold out for retail prices when they sell. That defence is close to claiming virtue for the extortion that comes from lack of informa-tion. For now, however, with only moderately good information in U.S. corporate and municipal bonds and rather poor moment-by-moment pricing information in Canada and other national bond markets, the individual bond investor needs horse-trading smarts as well as strategic skills.

INTEREST RATE HISTORY Government bonds have earned respect in capital markets, but be-fore they mature, they are worth only what buyers will pay. Over the years, several formulas have been developed to determine what a bond that has no risk of default is worth. At the root of the deter-mination of value is the yield curve, which is a line that connects what bonds of increasing maturity pay from one day to 30 or more years. It is not only essential for making investment decisions, but it is also a remarkable tool of economic, social, and even politi-cal analysis. As a record of the hopes and fears of societies whose bonds and other debts are traded, it is almost without equal.

Consider a graph of interest rates that might begin around 1800 b.c., when Hammurabi standardized and regulated loans in Babylon, and that continues to the present day. Interest rates de-cline as the regulations go into effect in 1800, for merchants and lenders have less risk because of standardized procedures. Indeed, Homer and Sylla indicate that interest rates fell from 20% per year before the legal changes to 10% per year after. To the west, in the period of archaic Greece, interest rates varied with perceived risks in lending. As Solon and other rulers reformed lending practices and substituted money for seized goods in settlement of unpaid loans, interest rates fell to as little as 6% per year. Similarly in Rome, from the time of the end of the Civil Wars in the years pre-ceding the invention of the empire by Augustus in 28 b.c. and until

22 C H A P T E R 1

the empire began to be too large to supply and govern in the late fi rst century, interest rates fell to 4%. Rates then began to rise to 12% as Roman cities were sacked by barbarian tribes in the third, fourth, and fi fth centuries.

With the breakdown of the central government after succes-sive attacks on Rome and the collapse of its authority, lending practices lacked standardization. Substantial trade nevertheless ex-isted in the three centuries preceding Charlemagne, who created the fi ction and title of Holy Roman Emperor in the year 800 a.d. He abolished all lending as usury, an act that did nothing to aid commerce in his German lands. But from the 12th century to the late 17th century, interest rates fell. As business practices became more familiar, risk declined. Interest rates rose in Spain and other European countries in the 16th century as gold looted from the New World produced a huge wave of infl ation.

By the 18th century, banking had spread throughout Europe, re-sulting again in lower risk, easier settlement of fi nancial instruments, and the rise of the merchant class, whose members were more likely to pay their loans than princes who could and often did abscond with money they had borrowed. Rates rose during the Napoleonic wars, fell in the 19th century as peace and business replaced wars and princes, and were stable until World War I drove up interest rates. In Germany, a hyperinfl ation from 1919 to 1923 devastated the country’s currency and wrecked several banks, even as annualized interest rates rose to fi ve fi gures. Rates fell in the Great Depression, rose somewhat in World War II, declined in the postwar period, then soared into double digits during the Viet Nam war and until Paul Volcker of the U.S. Federal Reserve and other central bank governors, including Gerald Bouey of the Bank of Canada, broke the back of infl ation in 1982. Falling interest rates for the next 20 years produced what may be the modern world’s greatest expansion of bond values. Today, the G-7 nations have brought their interest


rates down to single-digit levels, and bond returns have reverted to what can be regarded as their long-term averages.29 Today, bonds provide a moderate return for moderate risk.

What is clear from this brief history of interest rates is that peace and certainty reduce the cost of money, while war and infl a-tion increase risk and raise rates. To the extent that a long-term investor can sense the quality of the years to come, he can predict large movements of interest rates. Falling rates over the long run drive up the prices of existing bonds and make it cheaper for busi-ness to borrow. Wealth grows. As the cost of loans declines, more operating income is left to be paid to owners of businesses or to be reinvested in the business. On the other hand, times of very high interest rates tend to be those where repayment is uncertain, where fi nancial networks break down, where conquest or disease make re-payment unsure, or where wars destroy capital and debtors. Rising interest rates drive down prices of existing bonds, destroy wealth, and make it harder for business owners to generate earnings after paying their bills—including interest on loans and bonds.

INTEREST RATE FORECASTINGAt any moment, the outlook for interest rates is expressed by the yield curve—as mentioned earlier, a line that connects the yield to maturity on bonds with terms of one day to 30 or more years. Some yield curve graphs show stacks of curves for bonds of in-creasing risk. All yield curves have immense predictive value.

If a yield curve slopes upward and to the right, it shows that investors expect to be paid increasing amounts of interest as they defer consumption and bear risk. This is the normal curve. The curve refl ects the present view and future expectations. If short-term rates are rising, then investors infer that future conditions will be good for business. They will demand to be paid in advance for what they see as ever-improving conditions. If rates for one

24 C H A P T E R 1

year are 4% and two years are 5%, then the three-year rate will have to be at least an arithmetic average of the two prior rates, or 4.5%. The four-year rate must at least average the three prior rates. The investors will also want to be compensated for postpon-ing consumption or alternative uses of their money.

Investors can drill down to forces within the bond market. Banks tend to borrow from their depositors for relatively short periods at relatively low interest rates and to lend for longer peri-ods at relatively higher rates. All this is implicit in the normal yield curve that ascends over time to higher rates of return on money. Life insurance companies invest long to cover their mortality risks. Banks tend to be most infl uential on the short end of the yield curve while life insurers are active on the long end of the curve. In fact, both kinds of borrowers are just players in the market and are infl uential but not decisive in pricing the demand for loan-able funds. Economic expansion increases the demand for loanable funds and so increases the price of money expressed as interest rates. Economic contraction decreases the demand for loanable funds and so pushes down interest rates.

When the yield curve is fl at, investors are signalling that a pe-riod of no growth lies ahead. It is a bad sign for the months and years to come. They can lock in returns on the long end of the yield curve as a form of insurance of yet lower rates to come.

If the curve declines and becomes inverted, it implies a period of economic decline. This is an omen of recession, for it implies that the central bank will be raising short-term interest rates, after which infl ationary expectations and hopes for returns will decline. In January 2000, the yield curve did invert as the U.S. Federal Reserve and the Bank of Canada raised interest rates. Interest rates rose, investors read their fi nancial fortunes, and major market in-dices began to collapse with the recognition that the tech bubble was about to burst. And, duly, it did.


There are few economic models or forecasting tools as accurate as the yield curve. While the stock market tends to forecast eco-nomic conditions six to nine months ahead, the yield curve does the task for 12 months in advance. It refl ects central bank policy, shows what long-term assets should earn in comparison to short-term assets, and sets the basis for the increased returns expected on stocks.30

Investment managers and bond strategists use what, for many, are baffl ing constructions in mathematics to squeeze meaning out of the yield curve. But even without math, you can read it and ob-tain a great deal of information.

A very fl at curve implies that the market is paying a bond buyer very little premium for holding long bonds rather than short bonds. A fl attish curve may offer a 4.0% annual return for 90-day treasury bills and a 4.2% return for 10-year bonds. The 10-year premium is really rather modest if one expects even a nominally positive return from dividend-paying stocks.

A steeply upward sloping yield curve may offer 2% for 90-day treasury bills and then 4.5% for 10-year bonds. That’s a relatively handsome premium for going to a standard mid-term bond.

Years to Maturity

Interest %

Normal

Inverted3

4

5

1 month 3 months 6 months 2 3 5 7 10 30

Normal and Inverted Yield Curves

26 C H A P T E R 1

The incremental premium for 30 years over 10 years usually tends to be less than the premium for going from 90 days to 10 years. One can view the additional return for tying up money for what could be three decades as being an implicit insurance charge for a guaranteed return. Along with that charge, there is the op-portunity cost of not putting money into even better paying bonds should infl ation return to double-digit levels. Capital markets don’t expect a return to the infl ation levels of the early 1980s, but the wise investor does not ignore any possibility.

The present outlook for infl ation is that it will average be-tween 2% and 3% per year for the next two to three decades. The forecasting tool is the infl ation premium built into bonds that tie interest payments to infl ation rather than to interest rates. Such long-term infl ation rates imply good conditions for business and tell the investor that the additional return to be had from holding stocks (really a diversifi ed basket of stocks such as the S&P 500) is only going to be the bond return plus an equity premium of 4% or 5% to cover the added risks of stocks. Thus the question of risk and return comes back to the investor.

The basic yield curve shows the interest rate on bonds issued by the Government of Canada. These bonds are called Canada bonds, or Canadas, for short. Other yield curves exist for returns on bonds issued by the provinces and by corporations in Canada. Bonds in this latter category, which include Canadas, are called Canadian bonds. The nomenclature can be confusing, but it’s important to keep the terms separate.

All investors should learn to read the yield curve, which can be found in the Report on Business in the Toronto Globe and Mail on Mondays or constructed by connecting the dots of interest rates over successive time periods from tables of rates that are published


daily in many newspapers and at many fi nancial websites. When the curve gets steeper, it tends to refl ect higher expectations for growth and competition from other markets for funds. Think of the yield curve as a souffl é and you won’t be wrong. When it rises, it’s a good omen, and when it falls, things are bad and likely to get worse.

Government bonds are not the best way to get rich, for they have no premium for risky events like bankruptcy. They are, how-ever, a good way to avoid going broke. As one moves away from government debt into investment-grade corporate bonds and then on to junk bonds and even further into bond derivatives that may be based on foreign currency moves, risks rise. The risk-seeking investor can fi nd bonds with more potential profi t than stocks, but the risk-avoiding investor need only adjust his bond holdings to the other risks he carries.

An investor seeking safety would be likely to seek the haven of bonds. Yet how much of his fortune should he invest? Derek Moran, a Registered Financial Planner in Kelowna, British Columbia, is a partner in Vancouver-based fi nancial planning fi rm Macdonald Shymko & Co. In his view, the usual rule that the investor should buy bonds as a percentage of a portfolio equal to his or her age is too blunt. “What matters is how sophisticated you are and what your needs are,” he explains. “If an investor has enough money to withstand stock market declines without loss of living standard or sleep, then there is no need to take refuge in bonds.

“It’s really about your stomach for risk and your capacity to watch your portfolio decline in tough times,” Moran explains. “If an investor has a collection of volatile growth stocks, he may need more bonds than the investor who has relatively safe bank and in-surance stocks and a well-diversifi ed portfolio. There is no general rule apart from comfort. It’s not the bliss of blind ignorance of what may happen, but the satisfaction of knowledge of how a portfolio will behave when stressed by stock market declines and adverse

28 C H A P T E R 1

shifts in interest rates. That’s how you decide what level of bonds to have in a portfolio. What’s more, in a portfolio weighted heavily with low-grade bonds, there is a corresponding need for achieving some stability with relatively riskless government bonds.”

In the end, what matters in any portfolio is risk management. Bonds tend to offset the risks of stocks, but managing the vulner-ability of a portfolio takes not only a decision on what fraction of wealth to invest in bonds, but a knowledge of what kinds of bonds are appropriate to the task.

1. See Mark P. Kritzman, Puzzles of Finance (New York: John Wiley & Sons, 2004), pp. 104–114.

2. Almost all bonds have a fi xed maturity date, though some perpetual bonds live in the market until their issuers, including governments and banks, choose to redeem them.

3. Financial Post, June 17, 2005, pp. FP8, FP12.

4. Sidney Homer and Richard Sylla, A History of Interest Rates (3rd ed.; New Brunswick, N.J.: Rutgers University Press, 1996), p. 3.

5. Homer and Sylla, A History of Interest Rates, p. 3.

6. Leviticus 25:37. Likewise, loans of real property may be redeemed within a year, suggesting that real estate transfers were conditional on clarifi cation of whether a price was payment or loan. Leviticus 25:29.


8. Raymond de Roover, The Rise and Decline of the Medici Bank, 1397–1494 (Washington, D.C.: Beard Books, 1999), p. 141.

9. See, for example, de Roover, p. 126.



12. Homer and Sylla, A History of Interest Rates, pp. 35–36.

13. Loans and insurance meet in a grey zone, for loans may have returns conditional on events and insurance agreements may be set to make payments when a fi nancial event takes place. Option markets trade conditional loans and potential events, merging the two businesses into one.

14. Homer and Sylla, A History of Interest Rates, pp. 95–97; “Percents and sensibility,” The Economist, December 24, 2005, pp. 104–105.

15. New York Times, September 21, 1957, cited in Homer and Sylla, p. 128.

16. Geoffrey A. Hirt and Stanley B. Block, Managing Investments (New York: McGraw-Hill, 2005), p. 264.

Endnotes


17. Conventional bonds leave infl ation risk with the holder. Infl ation-protected bonds such as Canadian Real Return Bonds and U.S. Treasury Infl ation Protected Securities shift that risk to the issuer.

18. Jeremy J. Siegel, Stocks for the Long Run: The Defi nitive Guide to Financial Market Returns and Long-Term Investment Strategies (3d ed.; New York: McGraw-Hill, 2002), pp. 13, 15.

19. Alexander M. Ineichen, Absolute Returns: The Risk and Opportunities of Hedge Fund Investing (New York: John Wiley & Sons, 2003), pp.465–66.

20. Sidney Homer and Martin L. Liebowitz, Inside the Yield Curve (Princeton, N.J.: Bloomberg Press, 2004), p. 32.

21. Ineichen. Absolute Returns, p. 466.

22. Globe and Mail. Globefund data for periods ended December 31, 2005.

23. The Economist, January 15, 2005, p. 35.

24. Sidney Homer and Richard I. Johannesen, The Price of Money, 1946 to 1969: An Analytical Study of United States and Foreign Interest Rates (New Brunswick, N.J.; Rutgers University Press, 1969), p. 8.

25. Annette Thau, The Bond Book (New York: McGraw-Hill, 2001), p. 226.

26. Anthony Crescenzi, The Strategic Bond Investor (New York: McGraw-Hill, 2002), pp. 20, 24.

27. Investment Dealers Association of Canada.

28. The Economist, February 5, 2005, p.70; Crescenzi, The Strategic Bond Investor, p. 88, 90.

29. Homer and Sylla, A History of Interest Rates, pp. 64, 84, and 140; Homer and Johannesen, The Price of Money, 1946 to 1969, pp. 7, 8.

30. Crescenzi, The Strategic Bond Investor, p. 151.

Chapter 2

THE SEDUCTION OF RISK

A TASTE FOR RISK

We are afl oat on a sea of uncertainty. The chance of misfortune ranges from the devastation a large meteor striking the earth might generate to the chances of getting a cold or fl u or being overcharged by error at a grocery checkout. The fi rst event is im-probable but of infi nite value while the second is probable but of little value. Random outcomes pervade the future, but risk, as a term in fi nance, is the deviation of markets or returns from ex-pectation. Uncertainty, the measurement of potential occurrence of unpredictable events, is beyond risk and calculation. In sum, we can calibrate risk as the difference between what we expect as investors and what we are likely to get. But we cannot measure, much less calibrate, uncertainty, which is the probability of things that are beyond our imagination. We know that a stock or a bond may rise or fall in price and we can make estimates of how much each asset may vary. But we cannot know or put odds or a price on things that are beyond our experience and capacity to measure.

32 C H A P T E R 2

Most investors seek to avoid risk that is not compensated by return. Some investors, generally regarded as aggressive, believe in the big payoff and seek risk. Indeed, most investors, given a good story and some stroking by a credible investment advisor, a pundit, or even an astrologer, will willingly dip into the abyss of risk, hoping for luck and abandoning their own good sense. It is curious behaviour, but it is known and used by casino operators in Las Vegas who offer a stay in apartments of exceptional luxury as part of the reward for hitting a jackpot. The message is “Abandon reality, all who enter, and believe in our fairy tale.” It works and encourages people to make large bets or even to persist in loss-producing behaviour, such as blowing a paycheque at blackjack, because the fancy hotel suite, the free bar, the butler that comes with the apartment, etc., cannot be accurately priced in the midst of the haze of excitement at the tables and the Niagara of free booze that goes with the game. Thus the non-monetary rewards glitter and the player, who probably could estimate their value at X dollars per night, fails to do so, preferring to think of the cham-pagne and other sybaritic pleasures rather than to do the math. His trip to the poorhouse is all the more assured.

Chandeliers, a chorus line, and the chance to have a guy in a tux prepare your bath have overcome the most basic lesson of eco-nomics: Your fi rst buck or your fi rst million dollars is worth more than your second. The marginal utility of equal units of money declines as one’s pile of money increases, declares the fi rst chapter of most fi rst-year university economics textbooks. Risk aversion is not just a taste—it is the fundament of fi nancial life. In capital markets, the equation shows that investment in a bond that has a 90% chance of producing a $100 return has the same value as a stock that has a 45% chance of producing a $200 return. The com-parison ignores the question of market price and tax consequences, but it makes the point. The bond seems dull and the stock may be

33The Seduction of Risk

on an upward roll. Acting on enthusiasm rather than calculation, the investor in this example ponies up for the stock, is then ter-rifi ed by its volatility, and manages to sell it at a loss. The bond investor never bats an eyelash and, when asked by the paranoid and now impoverished stock investor how he fi nances his ocean-going yacht, rouses himself from his slumber and humbly says it’s just good math. The contrast, mob think versus calculation, is the seduction of risk. It is, one may argue, distinctly if not uniquely human and fundamentally wrong.

Zoologists have found that lions will not waste energy on the chance of catching a mouse. To a 500-pound beast, a 1-ounce snack is not worth the chase, for the calories expended on catching the little critter exceed the calories gained. The lion senses this and turns out to be a good risk manager. For people, any investment proposition can be reduced to asking the gambler’s question—what is that risk worth? The simplest answer is that a risk is worth the odds of occurrence, say one in ten, times the value of the outcome. The insurance premium for fi nancial compensation for a 1-in-10 chance of a $1,000 loss by fi re or fl ood is the same as the value of a 1-in-10 chance of winning $1,000. Either way, it’s $100. One buys insurance for large sums because the marginal value of a specifi ed loss exceeds the marginal value of the sum of the premiums that cover the loss.

Recent research on the loss aversion and trading behaviour of primates indicates that our early ancestors understood loss aversion. In a study of the trading and risk management behav-iour of capuchin monkeys, researchers have found that avoidance of bad bets is innate and not learned.1 The implied conclusion is that Homo sapiens, acting rationally, overvalue unlikely outcomes. Survivor bias, discussed in Chapter 1, makes returns of stocks over time appear larger than those of government bonds over the same periods. That bias feeds the risk-taking behaviour of human beings

34 C H A P T E R 2

who invest in capital markets. Bonds lend themselves to accurate risk measurement while stocks tend not to do so. Thus while stock investors may delude themselves that the popularity of a stock as expressed by a high ratio of price to earnings has the validation of popular opinion, bond investors can measure the average weighted return of their bonds over relevant time periods and make accu-rate rather than enthusiastic investments. Bond investing turns out to be cerebral in comparison to stock investing, which evidences bandwagon effects as the mob of bettors jumps into a hot issue and fl ees one that appears to be destined for disdain.

RISK HAS MANY FACESStocks and bonds, often paired together as a synonym for capi-tal markets, are really very different in their risk characteristics. Companies that issue stock are managed by people motivated to make more money from year to year and, usually, they do. Shareholders benefi t in the process. One can therefore guess with a reasonable chance of being right that shares of General Electric or the Royal Bank will have higher prices in 10 or 20 or 40 or 50 years than they do today. Excluding the chance of bankruptcy, which is unimaginable for both businesses at the time of writing, a hundred shares of either will probably generate a capital gain if sold a few decades from now.

One cannot say the same thing for bonds. It is diffi cult to pre-dict where interest rates will be a year from today. A forecast of rates fi ve years from today would be a wild guess and twenty or thirty years is beyond what any economist could foresee.

Yet the opposite is true for the short run. Stock prices vary wildly and without much direction in periods of minutes, hours, days, and even months. While shares of companies with huge stock market valuations such as Exxon Mobil and the Royal Bank tend to be more stable than shares of unknown companies whose shares


amount to little on the stock market (“small caps” in stock market speak), it remains true that for periods of less than a year or two, one cannot make a sure bet on the direction of companies’ share prices. Just ask an insolvent day trader. The game of playing on short-term volatility is much harder than it seems.

Investment-grade bonds, on the other hand, have predictable short-term values. The short end of the yield curve is manipulated by each nation’s central bank. The odds are that bonds due in a few weeks or even a few months won’t vary much from their face value. Even at fi ve years before maturity, some pencil work on the slope of the yield curve can help to set upper and lower limits on what a bond will be worth. More bond math can help to measure the rate of return on bonds—a valuation technique called duration. It allows the bond investor to know the odds of profi t (or loss) at any time prior to maturity of the bond in question. The bond’s profi t if it is held to maturity will be knowable with certainty at the time of purchase. Prices must converge to the face value of each bond at the time of maturity.

Stocks, however, have no maturity dates. Their prices therefore can vary without any dampening effect from any clock running out. Not surprisingly, in the daily prices in stock markets, there is almost no pattern at all.2 Over long periods, it is possible to see trends, but the character and visibility of those trends depends on where one begins and ends.

Getting into the MarketAn investor who wants to take advantage of the distinct advantages of the relative safety of bonds can work up through a scale of money he wants to put at risk. The lowest level of bond in return to the investor is Canada Savings Bonds, which are sold through payroll savings and by banks and credit unions, caisses populaires, and stockbrokers. However, serious bond investments are sold by conventional investment dealers

36 C H A P T E R 2

such as CIBC Wood Gundy or RBC Dominion Securities. Discount brokers can do bond deals as well. Bond mutual funds may be sold by these investment dealers or by investment dealers with licences limited to selling mutual funds or related insurance products. Some of these limited licence dealers are fi nancial planners. With limited licences, they cannot directly sell anything but bond or other mutual funds and certain deposit instruments such as guaranteed investment certifi cates sold by some mutual fund companies. For $500, one can get into many bond mutual funds. Fees are high, but active management will be of help to the fi rst-time investor and provide diversifi cation into many bond issues, professional selection, and tracking of investment gains or losses. Next in line for the investor seeking bond exposure is purchase of bond exchange-traded funds, often abbreviated as ETFs. There are no minimum purchases, though it is customary to buy so-called “round lots” of 100 shares or more. At the time of writing, units of an ETF that replicates the most widely used bond portfolio measure in Canada, the SC Universe Bond Total Return Index, is priced at $29.26. A 100-share round lot of this bond ETF would therefore cost $2,926 plus a brokerage commission. Sold like stocks on stock exchanges and purchasable through discount brokers for fees that can be as low as $30 straight commission, ETFs have very low operating charges that can be a tenth or less of those charged by most bond mutual funds. The investor must, nevertheless, know which bond ETFs to buy. Chapter 7, which is about bond funds, deals with this in more detail. Finally, the investor who wants to develop his own bond strategies and to buy bonds that, unlike shares in mutual funds and ETFs, eventually revert to cash at maturity, can buy single issues of government or corporate bonds. Bond dealers at major brokerages that handle these trades charge no commission but add a percentage “spread” over what they pay at wholesale. The spreads vary greatly,


and the bond buyer must shop the market to fi nd a good deal. At this tier of the market, though bonds are sold in $1,000 units or “pieces,”as brokers call them, the good deals start to kick in when the investor has $25,000 or $100,000 or more to spend on single issues. The bond investor will need to know (a) current prices of bonds, (b) the face value at which bonds mature, (c) the yield of bonds (coupon interest divided by current price), and (d) the sensitivity of bonds to changing interest rates. Items a, b, and c are printed in national newspaper and many local newspapers daily. Item d, which is of interest to experienced bond investors, can be found at many fi nancial websites such as http://gold.globeinvestor.com (a service of the Toronto Globe and Mail). Each item of information, including credit ratings of bonds—available at such websites as www.moodys.com and www.fi tch.com—is important in making decisions about purchase of individual bonds. We will delve further into bond value issues in Chapter 6.

IMAGING RISKWhat makes the prices of bonds and stocks and other assets vary has intrigued traders and mathematicians for centuries. Measuring the length and repeatability of fi nancial cycles has been the preoccupa-tion of theorists who have linked market moves to causes as varied as sun spots and numerology. Some theories, such as the number sequences observed by Italian mathematician Leonardo of Pisa, are remarkably durable. In 1202, Leonardo published his observation that special numbers can be found from the sum of the preceding two numbers in a sequence. The series 1, 1, 2, 3, 5, 8, 13, 21 appears to have some predictive value in estimating populations of rabbits. Known by Leonardo’s nickname, Fibonacci, the numbers appeal to cultists in stock price forecasting who have based notions of price

38 C H A P T E R 2

waves on these sequences. The problem with using rabbit breeding cycles or other bits of numerology is that people interfere with the abstractions. Fear makes people run from assets, driving down their prices. Greed eventually drives up asset prices. Mathematical purity hasn’t a chance when market psychology is at work.

The intrusion of mob psychology into capital markets makes them disorderly, at least according to “normal” statistical models. Capital markets are not Gaussian in math-speak, that is, they don’t move along a normal bell curve. For example, the huge drop of the Dow Jones Industrial Average on October 19, 1987, should, ac-cording to normal probability theory, never have happened. To be more precise, it should have happened once in 520 million years.3 What is wrong with the prediction is that it is based on the idea of normality. The frequency of huge stock market crashes in 1929 and 1987 and the collapse of the Russian debt market in 1997 and of Long-Term Capital Management in 1998 all attest to the abnor-mality of fi nancial events, at least according to conventional ideas of what is normal.

The question of the true risk of the market is vital for bond analysts and investors. Over the life of a 30-year bond, a perpetual preferred stock—which Canadian chartered banks issue—or rare but still-issued 99-year debt instruments, there is a pretty good chance of extraordinary price variation caused either by the intrin-sic mechanics of fi nancial markets and their embedded instability or by external events. Every century of post-medieval European history and its extension into the Americas has had events that have put investment at grave risk.

The plague of 1349–1351, which is the driving force of the pil-grimage in Geoffrey Chaucer’s Canterbury Tales, wiped out a third to a half of the population of Europe and wrecked the landhold-ing system and its accompanying system of serfdom. Dynastic and religious wars occupied the next 200 years, shattering the Catholic


envelope of Europe. The Protestant reformation succeeded in producing vast shifts of control of real estate and the rise of taxing power under a system of margraves, dukes, princes, electors, and so on at the conclusion of the struggles in Germany. In the 16th century, the destruction of Spain as a naval power by the defeat of its armada in 1588 put Spanish landholdings in the New World at risk of loss, which English naval forces duly achieved. Plundering Spanish ships was a growth industry for the next 150 years. The Thirty Years War from 1618 to 1648 destroyed agricultural surplus-es as soldiers pillaged food from villages and farms. The struggle wrecked European populations, spread disease (culminating in the plague of 1650), and moved capital from agriculture to trade. Wars of the mid-18th century rearranged Poland and Canada, in-validating titles to property along the way. The French Revolution redistributed power and property, as did Napoleon a few years later, and the Congress of Vienna at the end of the Napoleonic Wars sought to reset the clock to 1789—a move that led to revolu-tions in Europe in 1832, 1848, and 1870. The Russian Revolution that brought forth Lenin and his successors—no friends of capital markets—and World War II have made it certain that uncertainty is the permanent condition of asset management. The astute inves-tor needs to understand that peace and asset price “normality” are the exception to the condition of instability. A short-term investor may operate with some safety on the principle that peace may last another few days or few months. The long-term bond investor who takes a risk that, for the next 30 years, the yield to maturity he buys will be satisfactory and that there will be someone to re-pay principal in a sound currency three decades from the time of purchase is an optimist. So far, capital markets have rewarded opti-mism when invested in governments and corporations that will be around to pay their debts. It may not always be so. The implication is that buying government bonds is a bet on political survival and

40 C H A P T E R 2

on the wisdom of those governments in managing the infl ationary forces that can trash the value of their bonds.

French geophysicist Didier Sornette suggests in his provocative analysis of fi nancial catastrophes, Why Stock Markets Crash: Critical Events in Complex Financial Systems, that singular events can bring down entire societies. He notes that a period of atmospheric cool-ing from 2300 b.c. to 2200 b.c. terminated the Akkadian empire in Mesopotamia, the Old Kingdom of Egypt, the Indus Valley civili-zation in India, and early societies in the eastern Mediterranean.4 Exponential growth of world population could be self-limiting and, indeed, a scientist at the University of Colorado has argued that The End is coming in the form of demographic cancer. The proof of this odd pudding is explained by Sornette. “The sum of human activities viewed over the past tens of thousands of years exhibits all four major characteristics of a malignant process: rapid, uncontrolled growth, invasion and destruction of adjacent tissues (ecosystems), metastasis (colonization and urbanization), and de-differentiation (loss of distinctiveness in individual components as well as communities throughout the planet).”5 The end of the world caused by this demographic malignancy would, of course, be a one-time event. It is also improbable, for such a global catastro-phe would be many years in the making. Governments would be likely to respond by appropriate measures to limit incursions into remaining forests, reduce overfi shing, and so on.

Statisticians use the term kurtosis to describe the power of the improbable to appear more often than it should in a normal dis-tribution. In a diagram of the bell curve, it means that the tails are very long and that, by implication, odd events will occur more fre-quently than they would in a more orderly map of the distribution of outcomes. Negative outcomes, which in the case of fi nancial assets are losses, are more likely in capital markets than in well-ordered systems that have no psychological feedback mechanisms.


Feedback can turn a small market decline into a panic and a ru-mour of a bank’s problems into a run on deposits. It turns a hint of gold in a distant place into a supposedly credible story of a new version of Midas’s treasure. Feedback converts occurrences that are normal within the conventional distribution into extraordinary events of abnormal scale or frequency. And that is what separates fi nancial prediction from predictions in botany or chemistry, where the things studied cannot fool the analyst by changing the game. If you think this is not so, then compare fi nancial assets to tomatoes. If the price of tomatoes falls, shoppers rush to buy the bargain. If the price of a fi nancial asset falls, investors may abandon it for fear that others may also fl ee. If tomatoes rise in price to some absurd level, few will be sold. If a fi nancial asset soars in price, many in-vestors will pursue it. Vanity is a part of this process. No shopper would brag of having paid, say, $10 for one tomato; he would be thought an idiot. But many investors brag of buying into a stock or bond frenzy, assuming that fi nancial gravity does not work and that what has gone up will continue to do so. The tomato shopper is wise, the investment gambler is a fool and soon to be parted from his money. The issue, of course, is this: Under what conditions can a fi nancial asset in the midst of a price rise maintain its momen-tum? The diligent investor changes the issue to a question of risk, assuming, quite correctly, that if risk is well shepherded, profi t and wealth will grow.

In an effort to fi nd new ways of managing risks in capital mar-kets, economists, mathematicians, and physicists dragooned to Wall Street have suggested alternative maps of market behaviour. Knowing risk is important, for if bond investors are willing to sac-rifi ce what may be the higher returns of stocks for the safety of bonds, they should know what sort of protection they are buying. Risk aversion is worthwhile, but the price has to be right. After all, it makes no sense to overpay for insurance and bonds, though

42 C H A P T E R 2

they do outperform stocks in many periods and tend to have lower long-run returns than stocks.

The standard bell curve that describes the frequency of oc-currence of events derives from a proposition in statistics called the Central Limit Theorem. The normal bell curve is fi ne for mapping variance from the size of an average pea in a collection of pods, but it does not deal well with characteristics of fi nancial markets. The central tenet of the theorem is that no one variable in a distribution should be dominant. In stock trading, when the market value of a single company like Nortel Networks swells up to become a third of the total capitalization of the Toronto Stock Exchange, as it did before the bursting of the tech bubble in 2000, the theorem is invalidated. Realize this and a world in which huge gains and huge losses can happen becomes more understandable. However, if statistics perfectly described outcomes, events could be priced perfectly and trading on differences of opinion of the value of outcomes would cease.

MANAGING RISKThe diffi culty of constructing a predictive model does not mean that fundamental investments in stocks and bonds are a crap shoot whose outcomes cannot be mapped. Because stock market events and bond market events tend to be driven by different forces, one can still make reasonable if not perfectly error-free bets and expect profi table—though very different—outcomes in either. Put bonds and stocks in a portfolio and, quite predictably, the portfolio’s vola-tility declines while the long-term expectation of gain will rise. The process that builds returns and lowers risk when dissimilar assets are put into a portfolio is a conclusion of modern portfolio theory. In a sense, smoothing of returns adds the process of compounding to what would otherwise be jumpy and oddly spaced intervals of gain interrupted by other jumpy periods of loss.6


In a theoretical way, we can say that if we live in normal times, we can expect normal outcomes. If we live in periods of collapse, as in the crumbling of pre-Columbian societies after the arrival of the armies of Europeans and their weapons and diseases, then we can hardly expect anything but collapse of their tokens of exchange and stores of value.

In a representational sense, it’s possible to put collapse and stability into order. Using fractal geometry, the concept that un-evenness is constant even as one scales from grains of sand to the usually choppy lines where the sea meets the shore, we can say that we can be masters of small changes and cannot help but be victims of very large changes. It is the difference between analyzing mar-kets with a pencil and a calculator and preparing for Armageddon. In the end, if you want to reduce the volatility of a portfolio of jumpy stocks, you buy some bonds. If you want to buffer the con-sequences of off-the-map catastrophes, you’ll need more than a clutch of fi nancial assets. The wise investor will sensibly avoid the sins of greed and ignore what he cannot possibly control. In the fractal sense, we are in the mid-range of unevenness.

In this range of what can be estimated and controlled, it is possible to manage even the risks of considerable mayhem. The tragedy of September 11, 2001, had a swift refl ection in the U.S. and Canadian stock markets and on other bourses around the world. For most investors, the events of 9/11 would be called a case of un-certainty. Even if some terrorist events could have been anticipated, the targeting of the World Trade Center was not known to the in-vesting public. The unanticipated catastrophe caused stocks to fall at various rates, largely depending on how close markets were to New York. Money rushed to bonds, but the bond market’s reac-tion was mild in comparison. This is the wisdom of bonds. While stocks march to current events—many of which are unpredictable—bonds, particularly investment-grade bonds, vary in price and return

44 C H A P T E R 2

according to their predictable characteristics. And when all else is chaos, government and investment-grade corporate bonds will be islands of relative safety. Of course, bonds can crumble in value dur-ing periods of high infl ation. That was the situation of the 1970s and early 1980s. But over extended periods of 30 years or more, bonds, though they produce returns not adjusted for risk inferior to those of stocks, actually tend to provide risk-adjusted returns competitive with those generated by more volatile equities.

For a risk-averse bond investor, the question arises: What sort of issues to buy? There are scores of fl avours of bonds, ranked by seniority of government issuer, status of corporate issuer, avail-ability of stock conversion, payment determinants, collateral or security backing the bond, currency of payments, and much more. At the top of the bond kingdom are bonds of senior governments able to print money, if need be, to pay interest and to repay princi-pal. Since government bonds issued in the currency of the national issuer have no credit risks, interest rates determine value. Even if investment dealers vary prices at which they sell bonds to refl ect their inventories of particular issues or the prices at which they buy them in order to satisfy their customers, prices tend to cluster around their mathematically determinable values.

CALIBRATING BOND RISKGovernment bond prices and prices of the upper echelons of bonds of corporate issuers that are thought to be very secure are set by coupon, which is the periodic payment every bond promises to make, and term, which is the time left before the bond is expected to revert to cash and pay back those who have held the bond.

The concept of coupon payment needs a bit of explanation. A $100 bond with a $5 annual coupon is said to have a “running yield” or “cash yield” of 5%. All things being equal, for any given cash fl ow or coupon payment, current yield will rise if the bond


price falls and current yield will fall if the bond price rises. Thus $5 is 10% of a bond priced at $50 and 5% of a bond priced at $100.

The farther away the maturity of the bond (the longer the term), the greater are the amounts by which interest rates and resulting bond prices may change. Thus 30-year bonds are much more vola-tile in price than 90-day treasury bills. Clearly, over three decades interest rates may fl uctuate more than they can in three months. And a very short-term, government or investment-grade bond is al-most as good as cash and thus deviates little from the face value it pays at maturity.

Let’s look further into how time infl uences bond prices. More time to change means more opportunity for price change in refl ec-tion or anticipation of those changes. There are two components to future value. One is the value of reinvested coupons, which rises as time lengthens. If a $100 bond pays $10 a year or $5 every six months, the total value of the coupons will be greater for a 30-year bond, whose coupons have a simple arithmetic value of $300 than for a 5-year bond, the sum of whose coupons is $50. The other is the present discounted value of the return of principal, that is, the value today of the promised return of the bond’s face value months or years in the future. It turns out that the maximum volatility of a bond with a 3% annual coupon is at 34 years maturity in a yield range of 7.11% to 9.41%.7 The calculation of the relationship of bond value to interest rates is today done with the duration equa-tion, a topic that’s treated in greater depth in Chapter 6.

As the coupon rate declines, prices become more volatile. That’s because there is less fi xed income to compensate for any bond price decline driven by rising interest rates. The periodic pay-ments of the coupons are compensation for holding the bond. As the coupon goes down—in other words, as the periodic payments that are made decline—there is less ongoing pay for not having the face value of the bond in one’s bank account. Conversely, the

46 C H A P T E R 2

bond’s value depends less on the repayment of principal as inter-est rates rise. Thus a $1,000 bond with a 10% annual interest rate paid in a $50 coupon every six months pays the holder more even if the bond falls in price than a $1,000 bond with a $25 coupon ev-ery six months. The holder of the $50 semiannual coupon bond is under less pressure to sell than the holder of the bond with the $25 semiannual coupons. In the market, the $50 bond refl ects reduced selling pressure and holds its price much better than the lower in-terest bond. The careful bond investor will watch for changes in interest rates, for bond price volatility rises as coupon interest rates fall and vice versa.8

Two kinds of bonds have conditions that eliminate either the principal repayment or the coupon stream.

Perpetual bonds pay coupons but have no repayment of prin-cipal, so their market value is proportionate to the percentage changes in yield. Thus a 33 1/3% increase in yield always produces a 25% price decline for perpetuals.9

Strips, or zero coupon bonds as they are called in the United States, have no coupons. They rise in value at a fi xed and true rate. Their price volatility varies with the present discounted value of that principal at any time.

The baseline of risk in any bond investment is the bond with no credit risk and a brief time to maturity. Such bonds present no risk of default and almost no price risk. As credit risk rises, bonds go from top investment grades to medium investment grade to be-low investment grade, then to bonds almost in default and, fi nally, in default. The potential return is always expressed as a discount from face value, so if a U.S. Treasury or Canada issue offers 5% if held to maturity, a high-yield bond will pay perhaps 700 basis points more, 12% to maturity.

The risk of holding bonds of questionable worth in a portfolio is compensated by higher interest rates. Volatility tends to be highest at


the mid-range of the yield curve. Short bonds have very little room to move in price before maturity. The long end of the yield curve tends to be set by investors’ infl ation expectations, which tend to be stable. The mid-range of the curve around 10 years to maturity tends to have high volatility in relation to other bonds. Risk avoidance is best achieved with a so-called barbell of maturities—heavy at the short end of the curve and heavy as well at the long end with the middle relatively barren.10

Risk increases with exposure. In government bonds, the only exposure is to interest rates and expectations. In corporate bonds, the exposure is to the varying fortunes of corporations. As bonds take on more of the risk of corporate performance, going from the AAA rating that is given to companies that are thought to be beyond any reasonable chance of default, to medium levels of risk, often denoted as an A bond, and down to sub investment grades, risk and return rise.

There is a philosophical question in this transition from bonds with no credit risk to those with credit risk and even credit peril. If you want a bond, a pure bond, that is, then should you not choose the government bond?

There are two views. Purists prefer the government bond for obvious reasons, for it provides the best protection for a portfolio exposed to stock market risk and can insure a portfolio against the risk of prolonged defl ation. Government bonds march to the drum-mer of monetary policy and infl ation expectations. Gold in coin or bullion form does that too, but pays no interest. Other commodities dance to their own drummers. Government bonds have the same provenance as currency. Their low interest rate can be viewed as an opportunity cost equivalent to an insurance premium.

There are less pure but potentially more profi table ways to hedge equity risk in a portfolio. Institutional bond managers often like to point out that there is still a good risk-return tradeoff in

48 C H A P T E R 2

investment-grade bonds. A corporation must pay bondholders before stockholders. If they are not paid, bondholders can seize a company and sell its assets. If bonds are collateralized against defi ned assets, restitution is even easier. Over periods of fi ve or fewer years, a diver-sifi ed portfolio of high-quality corporate bonds should work as well as government bonds for risk reduction, though for periods of ten or more years, corporate mortality comes into play. There are no guarantees that Ford or General Motors or Air Canada or even the Royal Bank will be around three decades from now.

THE FLAVOURS OF RISKBefore 1960, bonds were simple promises to repay principal at a specifi ed date and interest on fi xed dates. Bonds and their attached pages of coupons (called coupon tails) were elaborately engraved to add dignity and to forestall forgery. They traded on the credit standing of the issuer and the prospect of future interest rates.

Today, as a result of corporate takeover wars that began in the 1970s, bonds come in a bewildering variety of fl avours. New bonds in major nations tend to be issued in book-based form and exist in certifi cate form only in special circumstances or for the clientele of some institutions that like the anonymity of bearer bonds, which are inscribed with no owner’s name at all. He who bears or carries the bond is regarded as the benefi cial owner entitled to payment of interest and principal. Regardless of the style of issue, every bond requires assessment of the following:

• Interest rate risk• Credit risk—the risk of default• Call risk—the risk that the issuer will call in the bond, often

exercised if interest rates fall below the bond’s rate of interest• Liquidity risk—the chance that spreads will widen if a bond

ceases to be actively traded


• Foreign currency risk—foreign currency bonds rise and fall in price with the exchange value of their currency of issue

• Sovereign immunity risk—foreign nations and their govern-ment corporations are diffi cult to sue and even tougher to compel to settle

Whether taking additional risk is worth the additional return is a question without a simple answer. Bonds are often quoted as yields over federal debt, the Canadian term, or over U.S. Treasury debt. Spreads over national government debt vary. Institutional man-agers of high-yield debt note that the time to buy their product, which they usually decline to call “junk,” is when pessimism is at its greatest. Spreads may expand to as much as 800 basis points or more, so that if a 10-year Canada bond pays 5%, high yields may pay 13%. The time to sell is when business conditions improve and the outlook for junk improves. Then spreads shrink, refl ecting a rise in high-yield bond prices. This is contrarian investing and a risky form of it at that. A critic of this style of investing would ask why, if a person has a taste for risk, he does not just buy stocks and ride what may be a long-term upward path to far higher returns than the junk bond may provide if it continues to pay interest and eventually pays its principal. The answer is that a company’s bond has a higher probability of being paid than its dividend or its stock during an insolvency proceeding.

This is not to say that government bonds are riskless, for they are not. They refl ect ever-changing monetary policy and fl uctu-ating expectations of infl ation and thus have persistent volatility. The bedrock question for bondholders is whether the embedded and expected volatility of bond prices can be used to reduce portfo-lio risk. Because bond prices move opposite to stock prices, bonds will reduce portfolio risk. One could say that risk embodies vola-tility, but risk is more than volatility. After all, as Peter Bernstein

50 C H A P T E R 2

pointed out in his 1996 bestseller, Against the Gods, “We can say that volatility sets in when the unexpected happens. But that is of no help, because, by defi nition, nobody knows how to predict the unexpected.”11 This is not mere verbiage. We have noted that risk is measurable while uncertainty is not. But in times of great peril, government bond prices may rise as investors fl ee perils they fear but do not understand. Thus we come to the essential question—do bonds really pay investors for the total risks, including some un-knowable hazards, that they face?

Risk as a concept is a fragile thing. If risk is defi ned as fl uctuation in the abstract, it becomes a truism, for negotiable assets vary in price almost by defi nition. After all, they are negotiable. By adjusting the measuring period, one can predetermine the amount of fl uctuation measured. This approach to risk is valid in an abstract sense but not helpful in the measurement of risk as an investment tool.

An alternative approach is to defi ne risk as variation above or below some benchmark. Stock market analysts refer to Beta, which is volatility of a stock in comparison to its index. It’s a good con-cept, but if an index is very volatile, a jumpy stock may emerge with relatively low Beta. Standard deviation is the more general measure of risk and can be defi ned as variation above or below a benchmark such as the mean return of a market or of a sector.

That leaves open the problem of what is a good benchmark for a bond? Indices abound for short-term bonds, medium terms, long terms, infl ation-adjusted bonds, etc. Costs of investment are implicit in net returns and are thus a challenge to any portfolio for which the management fees are deducted from the assets’ gross returns.

In 1995, Morningstar analyst Don Phillips demonstrated that as fees rise, bond returns fall. Higher fees imply lower returns and thus a greater gap between what may be expected and what the investor gets. Phillips proved the case for mutual fund promotional charges called 12b-1 fees in the United States. His demonstration


is valid for all fees and all bond returns. If you raise the fees and lower returns, the odds of a bond performing well against a fee-less benchmark are reduced.12

Higher costs imply higher risk in comparison with a bench-mark. Thus the question remains: What is the measure of performance of something that ought to be as uncontroversial as an investment-grade bond? The choice of benchmark is critical in this measurement.

THE MEANING OF EXPECTATIONThe question of whether one can predict the unexpected or, for that matter, the expected, is an issue of semantics. The answer, in other words, depends on how the question is put. We all will die. That is certain. The timing of death can be predicted with a high degree of confi dence within a range of years. Life insurance compa-nies make a nice living doing just that. But how one will die—what illness or what event—can only be predicted with reduced confi -dence. Existing diseases from major killers such as heart disease and cancer have been seen in various populations. So have obscure diseases. But the potential for a major death wave from infl uenza is speculative. The related problem for the bond investor is to realize that the greatest events are unpredictable. A person investing in a 30-year Tsarist railway bond in 1890, when many Russian railroads were being built, might have anticipated that Nicholas II would not last forever. That he would be succeeded by Lenin’s regime dedicated to the overthrow of property rights after a devastating war that ruined the Russian economy and transferred much of European Russia to German control was surely unforeseeable. The most general law of history is that things change. But change begins with the particular and expands to the general. In bonds, the corol-lary is that the market price of a long bond or perpetual stock 30 years from now is uncertain. Any investment in such an asset must

52 C H A P T E R 2

bear a discount for risk or a premium return to pay for carrying that risk. The value of an asset class can be known a bit better, for bank-ruptcy is not likely to wipe out all corporate bonds or all perpetual preferred shares issued by banks. Therefore the value of all bonds and their return can be estimated within a band, albeit a wide one, of historical experience. Risk inevitably increases over time.

Government bonds provide a baseline for returns, but they have interest rate risk. In the most recent long-term cycle of bond returns, bond prices tumbled in the period from 1973 to 1982 as the infl ation rate soared. In late 1981, as the prime rate on loans rose to 22.75%, the Government of Canada 20-year bonds bore a yield of 17.85%. Bond prices were deeply depressed in the period and what was left of a $1,000 bond priced at a third of its face value was eaten away by the double-digit infl ation of the period. Bond prices then began to rise in a kind of debt festival that lasted for two decades. Investors who bought deeply troubled bonds in 1982 have been able to realize a tenfold increase in their asset values. Clearly, bonds have the capacity to pace stock returns for substan-tial periods of time. It is all a question of managing risk.

In a well-managed portfolio, bond returns can be hand-some indeed. For the 20 years ended December 31, 2005, the ScotiaCapital Universe Bond Total Return Index returned 9.5% per year compounded annually compared to the 7.0% average an-nual compound return of the S&P/TSX Composite Index in the same period.13 Other periods would produce comparisons both more and less favourable for bonds. In the right time and space, bonds hold their own with stocks in markets exposed to many of the same risks.

TIMING BOND RETURNSWhen are bonds appropriate for investment? The simple an-swer is when interest rates are declining, driving up the prices of


outstanding bonds. But that answer is too pat. Rates tend to de-cline as central banks ease up on lending and drive down interest rates, often in periods of economic contraction. Predicting mac-roeconomic trends is diffi cult for economists, some of whom are famous for excessive bearishness. For the individual investor, macro predictions are even harder to make. Thus the frequent counsel to the individual investor is to select a benchmark bond and to stick with it.

Appraisal of bond risk turns out to be a delicate thing, abstract if you do not plan to live on the returns and very real if you do. For those who expect to retire on their coupons, return is what the coupons yield as a fraction of the bond’s cost. Risk expresses what the bonds will be worth prior to maturity. In the case of bonds priced and paid in foreign currencies, return and risk gain the ex-tra component of exchange fl uctuation. Both streams of meaning converge in a single test of what an income-producing asset will buy over time.

Professional bond managers struggle to eke out an extra 10 or 20 basis points of performance above what their benchmark returns. The individual investor interested in yield rather than trading profi ts can use a few strategies to provide liquidity and to minimize risk.

Assembling a ladder of bonds with terms matched to when funds are needed circumvents the problem of bond market value prior to maturity. The investor at age 50 who plans to retire at 65 can buy bonds maturing in 15, 16, 17, and so on years. He will have fairly relatively high sensitivity to interest rate changes, but in ex-change he will have relatively high yields. He can reduce time risk by using a ladder of bonds maturing in 1, 2, 3, 5, 10 years, and so on, switching to terms matched to his retirement years later on.

Alternatively, the investor can buy some short bonds and some long bonds to assemble a barbell of maturities. He gains liquidity

54 C H A P T E R 2

in short bonds and some yield advantage in long bonds. Holding to maturity eliminates market risk no matter how it is defi ned. Our investor has avoided the temptation of risk with a prudent handful of bonds that will thrive either by exposure to the long end of the yield curve or by the ability to climb the curve as rates go higher. If rates appear to be declining, he can shift some shorts to longs as the shorts mature, boosting yield.

A FEW FINAL WORDS ON RISKRisk, defi ned as asset price volatility, is inherently diffi cult to quan-tify. But risk exposure is manageable by controlling the amounts of money in play, its concentration or diversifi cation, the time over which money is exposed to market forces, etc. The truly risk-averse investor can spread his asset base over bonds and stocks, commodi-ties, and such exotica as weather-related options. He can limit bond exposure by holding just short treasury bills. He can buy insurance for many exposures, paying premiums to others to take risks off his hands. Such a strategy, if done to protect all asset exposure, would leave the investor with a zero return on assets and a large insurance bill, probably driving his total returns into negative territory. In the end, the investor must take some risks. The prudent investor will accept risks with knowable outcomes within the space of what can be anticipated. In short, forget assets that behave as meteors, burn-ing brightly and then burning out. Just plan to pay for your kids’ university educations, your retirement, and your other needs. If you match bond maturities to when you need the money, you become the benchmark and risk becomes a mere abstraction.

1. M. Keith Chen et al., “The Evolution of Our Preferences: Evidence from Capuchin-Monkey Trading Behaviour,” Yale School of Management, available at www.som.yale.edu/Faculty/keith.chen.

Endnotes


2. Edgar E. Peters, Chaos and Order in Capital Markets (New York: John Wiley & Sons, 1996); Didier Sornette, Why Stock Markets Crash: Critical Events in Complex Financial Systems (Princeton, N.J.; Princeton University Press, 2003), p. 31. One may note that the chill that has settled on day trading, once the great hope and now the great despair of investors who have a taste for industrial gambling, shows how great the gulf is between recognizing volatility and being able to anticipate it profi tably.

3. Sornette, Why Stock Markets Crash, p. 51.



6. Modern portfolio theory segments asset classes into such conventional units as domestic stocks, foreign stocks, domestic bonds, etc. The segmentation can be far more granular and thus recognize industrial sectors as distinct asset classes. It can also more broadly recognize non-fi nancial assets such as antiques as asset classes. Promoters of art as an investment do this in hope of attracting investment. The answer to proposals of segmenting sectors down to one or another metal is that such fi nancial microscopy adds little to return or to the effi cient frontier that displays what various asset mixes can produce as portfolio returns. As for art and collectibles, the diligent asset allocator can only protest that they are not effi ciently and frequently priced and that their inclusion in any process to move toward the effi cient frontier is therefore ineffective.

7. Sidney Homer and Martin L. Liebowitz, Inside the Yield Curve (Princeton, N.J.: Bloomberg Press, 2004), p. 46.

8. Homer and Liebowitz, Inside the Yield Curve, p. 45.



11. Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (John Wiley & Sons, 1996), p. 260.

12. Don Phillips, “A Deal with the Devil,” Morningstar Mutual Funds, May 26, 1995, cited in Bernstein, p. 260.

13. Data from Globefund, an index produced by the Globe and Mail, for periods ended December 31, 2005.

Chapter 3

TAKING A MEASURE OF CREDIT

There is an old saying in the securities business that if you don’t know who the sucker is, it’s you. In the bond world, the

buyer who thinks that it’s possible to get a deal that is as secure as a government bond or a strong investment-grade bond with a vastly higher rate of interest is probably going to wind up being cleaned out. Once one leaves the tidy world of white-shoe investment banking (named for the footwear the lords of Wall Street wore in the 1920s before their castles of dreams collapsed), the complexity of deals rises along with potential payoffs. But complexity, which makes assets hard to understand, often leads to loss. Complexity is frequently a road paved with ruin. As well, as deals become more elaborate, there are more ways for fees and charges to be hidden. Understand complex bonds or avoid them.

In moving away from the world of government bonds and in-vestment-grade corporate bonds into convertible bonds, hybrid stock/bond instruments, junk bonds, and structured products so du-bious that they are called “toxic waste,” the investor travels from low

58 C H A P T E R 3

to mid-single-digit annual returns into what may potentially be an-nual returns of as high as 20% or more. Investors in distressed debt, such as defaulted bonds of insolvent companies, may be able to make 80% or 100% per year or even more on their stakes. At this level of risk, investors are beyond anything that might be called secure returns. Here, interest rates matter less than the credit standing of the issuer, its chances for recovery, the outcomes of civil trials, and the investor’s chances of sweeping his winnings off the table before other players arrive. This is also the land of the newly poor, where fortunes are lost in minutes. And it is the land in which the traveller needs not only a map of the risks he faces, but a knack for forensic accounting.

In this tier of the market in which bonds morph into crap shoots—some sensible, some preposterous—every deal has a story. There are junk bonds that pay not in cash, but in yet more junk. There are promissory notes that investment bankers call bonds that have as much promise of fulfi lment as a lame horse winning at Woodbine. There are wonders of fi nancial engineering so complex that they defy understanding. And there are markets in the bonds of bankrupt companies in which speculators fi ght, often success-fully, for payoffs in the shares of the eventual restructurings.

We’ll examine a succession of hybrid bonds in two chapters. In this chapter, we’ll deal with familiar or relatively simple bond products that vary from step bonds that pay increasing amounts of interest over time to high-yield bonds and bond-like credit de-fault swaps that pay the investor to act as insurer of other people’s default risk. Some of these markets are only for the wealthy and the professional. The payoffs for these deals dwarf the small rates of return on government bonds with no credit risk. The problem is that, while the deals have bond characteristics, they are for risk seekers, not risk averters.

It is possible to combine bond investments that are risky on a standalone basis with conservative bonds, stocks, and other asset

59Taking a Measure of Credit

classes such as cash, commodities, and real estate to produce an ef-fi cient portfolio that has enhanced return and reduced risk. Both are properties of diversifi cation, according to modern portfolio theory. The concept of blending high- and low-risk debt instruments as a part of a diverse portfolio invites the question of weighting. And weighting can come down to the question of when money is need-ed. High-risk bond investments tend to be indefi nite in their terms. How long does it take to work out a settlement of a distressed bond? What happens to the weighted average return on a bond when an insolvent debtor restructures debt by issuing new debt with a lon-ger term and a lower coupon? (Answer: Lower coupons and longer terms tend to increase the volatility of the bond compared to its higher-coupon, shorter-term predecessor.) In the end, the individ-ual investor is probably best to do what is easy, safe, and natural. Managerial acrobatics are best left to professionals.

STEP BONDSThe bond investor who wants the benefi t of higher rates has a dilemma. Should he wait, staying short on the yield curve and sac-rifi cing current income? Or go out on the yield curve to capture some of the rate rises to come and adding risk?

There’s a compromise solution in step bonds, a.k.a. “steppers,” which are issued by government and corporate borrowers. Step bonds get their name because each year, or at defi ned intervals, the amount of interest promised, the coupon rate if you like, rises a predetermined amount. For example, the 2005 Ontario Savings Bonds (often called Osbies) have rates that rise from 2.25% for the fi rst year ending June 20, 2006, to 2.75% in the second year, 3.00% in the third year, 3.50% in the fourth year, and 4.00% in the fi nal year. The 2003s, ’02s, and ’01s were more generous, and the 1996 issue, which started at 4.50% and notched up to 9.00%, was downright heavenly. The Osbies are good vehicles for pacing

60 C H A P T E R 3

rising rates. While conventional bonds drop in market price as in-terest rates rise, the Osbies don’t.

Corporations are seldom so generous. Steppers issued by cor-porate borrowers often have call features that allow the issuer to pay off holders under specifi ed conditions or dates. For example, a Royal Bank fi ve-year stepper due July 22, 2010, was sold in mid-July 2005 with a 3.10% coupon for the fi rst year, 3.30% for the second, 3.75% for the third, 4.15% for the fourth, and 4.60% for the fi nal year. The bond is callable on its anniversary date each year and comes with a year of call protection during which the Royal Bank cannot take the bonds back. The initial yield is close to the 3.25% yield to maturity on the Royal Bank 6.75% due June 3, 2007. In comparison the Royal Bank 6.3% of April 12, 2011, has recently been priced to yield 3.95%. That’s less than the nominal 4.60% on the step bond. But the average yield on the stepper is 3.75%. Thus the stepper of-fers a modestly decent return each year with an incentive to hold it to maturity.

Behind the convenient packaging of rising interest rates, the step bond turns out to be a series of bets the holder is not likely to win. If interest rates rise dramatically, the holder will suffer an opportunity loss if he keeps the bond to maturity and a cash loss if he sells it before maturity. If rates fall, then the bank can exercise an annual call on the issue’s anniversary date. After all, when inter-est rates are substantially above those it has promised to pay in a relevant period on the step bonds, the bank will exercise its rights and give back the principal. Then the bank can go back to the bond market and issue a new bond with a lower but still adequate rate of interest to attract investment funds. With just one year of call protection, the issue provides no sustained ability to participate in a bond rally generated by a rate decline.

This amounts to a deal in which if rates rise a good deal, the investor is stuck with the bond. If rates fall, he loses the bond. It’s


heads you lose, tails the issuer wins. Thus the RB stepper works only if rates stay within a band of low-ish interest rates in which the bank is content to let the bonds ride without a call. Finally, the bond is destined to fl oat in the twilight of small issues, for at $15 million offered (plus another $10 million available at the issuer’s option), it will have bid-ask spreads that discourage institutional buyers. Active managers will fi nd that spread a roadblock to trade or swap strategies, say professional bond investors.

Step bonds tend to be a retail product for the private inves-tor, explains Peter Kotsopoulos, executive vice president for fi xed income at McLean Budden Limited in Toronto. “The retail inves-tor is more inclined to accept a higher coupon down the road in exchange for a smaller one in the present,” he notes.

The longer the step bond has to run to maturity, the more elab-orate the analysis it requires. Consider the 10-year stepper sold by the Bank of America in May 2004. It started with a 4.5% coupon in the year ended May 2005. Payouts then climb incrementally to 6.5% in the fi nal year ending May 2014. If the bond were not called until 2014, it would have an average yield of 5.5%.

“With step bonds, you have sold an option to the issuer if the bond is callable,” says Richard Gluck, principal at Trilogy Advisors in New York. “If there is a call feature in the bond, you should be paid a higher rate. Thus the question is this: Are you being paid enough? You need a model for pricing the option in the bond. Retail investors don’t have that equipment. For them, it is a feel-good product.”

What’s more, the investor who wants a rising interest rate bond or a bond that paces infl ation has more choices than steppers. Variable rate bonds that adjust payouts according to a formula that accompanies the bond, real return bonds that pace infl ation, and convertible bonds that turn into common stock that can rise with infl ation if the issuer does well all can do what step bonds do—pay more money on a nominal or real basis.

62 C H A P T E R 3

This leaves the question of which sort of bond is best for the investor who wants some infl ation protection and who is willing to accept complexity and a measure of illiquidity. An alternative is to make one’s own bond combination with a short issue and a long bond. The short issue provides liquidity while the long bond takes advantage of rising interest rates when coupons are reinvested.

A stepper with no risk of call offers some compensation in high-er income as interest rates rise. It has relatively superior returns should rates fall. The longer the span of the stepper, the higher its intrinsic value will be. If the bond is negotiable, as most are (with the exception of savings bonds that are sold to retail investors, often through payroll savings plans with trivial interest rates and limitations on when they can be cashed), it should have premium value in the market. So is a stepper with no call liability the best of all possible worlds? Not necessarily. A long-term investor who thinks interest rates are headed down for decades to come may get a higher return in a long bond or a long strip. The complexity of the stepper and its lack of liquidity will likely render it a follower rather than a leader in a strong bond market driven by declining interest rates.

An investor concerned about preserving long-term purchas-ing power would do well to buy real return bonds, such as the 3.0% Canada RRB due December 1, 2036, and recently priced at $138.13 per $100 face value to yield 1.46% to maturity. That’s a paltry return, but like a property and casualty insurance policy that covers every form of mayhem that can possibly happen, a three-decade-long, infl ation-proof bond is costly.

In the end, Steppers do offer the retail investor limited protec-tion from moderate interest rate gains. They won’t make you rich, they won’t leave you poor, and if they work as expected, the holder won’t have to worry about the fi ghts and games that go on in the real world of fi nance.


CONVERTIBLESConvertible bonds, so-called because they can be turned into the issuing company’s common stock, are the most readily analyzed of risk-enhanced bonds. They fall into the class known as deben-tures, that is, bonds that have no collateral beyond the promise of the issuer to pay. Unlike asset-backed bonds and mortgage bonds, which have specifi c collateral that bondholders may seize for non-payment, debentures are backed by no more than the good faith and credit of the issuer.

Convertibles come in many fl avours, but the essence of the concept is that the bond can change character under defi ned con-ditions. The most common variety is the bond convertible into common stock of the issuer.

Some convertibles have been issued by large companies ea-ger to reduce their credit costs, but convertibles are usually issued by second-tier companies that cannot get as much respect as they would like in the bond market. The conversion privilege is really a built-in stock option.

Convertibles are usually, though not always, issued by compa-nies with sub-investment–grade credit ratings as a way of making bonds of questionable reliability appealing to the market. They are issued in $1,000 denominations and have distant maturity dates and defi ned terms of conversion to common stock. The conver-sion sweetens the deal, for the bonds usually are subordinate to other outstanding and nonconvertible debt issues of the company. As well, many convertibles are sold with interest rates inferior to what plain bonds of the same term would carry. The tradeoff is a future capital gain if the bond is converted to common shares at the cost of a lower current interest rate. After conversion, the com-mon shares produce a lower yield, refl ecting the investor’s cost of having purchased a stock warrant (time-limited option to buy) that is intrinsic in convertibility.

64 C H A P T E R 3

Other attributes of convertibles make them potentially appeal-ing to an investor who wants the comfort of a bond attached to the potential for equity growth intrinsic in common stock. Even as holders of subordinated debt that is paid in bankruptcy after holders of more senior debt have been satisfi ed, convertible bond-holders stand ahead of common shareowners in the event of the issuer’s insolvency—provided they have not converted to common shares. That comfort changes the convertible’s behaviour in the market. If the price of the common shares of the company rises, the convertible bonds will tend to rise, but not by as much. If the common shares fall, the convertible bonds will tend to decline but by a smaller percentage. The interest payment, which is more se-cure than a discretionary dividend, tends to support and stabilize the price of the stock/bond package.

Convertible bonds could therefore be considered a hedged bet, for in their role as interest-paying bonds, they put a fl oor under the stock price of the issuing company. When converted to stock, they remove the upside limit of the bonds, which is always the face value of the bond at maturity, and offer the potentially unlimited gains of any company’s shares. At fi rst sight, these qualities make convertibles look like the ideal security.

The operation of a convertible bond is simple at fi rst sight. Assume that a bond with a face value of $1,000 is issued with a conversion price of $100 per share. That makes it convertible into 10 shares of stock. The conversion price may rise over time so that it is $110 for the fi rst fi ve years, $120 for the next fi ve, and so on. Convertibles may also have what are called antidilu-tion provisions that protect the bond and the holder. Thus if the stock were to be split on a four-for-one basis, so that the $100 shares become $25, then the conversion ratio would rise from 10 to 1 before the split to 40 to 1 after it. This is just arithmetic, for the pre-conversion value of the bond is unchanged and, if the


underlying stock has not changed price, there is no alteration in the worth of the bond.

Convertible bonds often have a call feature that allows the issuer to force conversion to stock. This allows the company to reduce its outstanding debt or to eliminate the bond with fresh is-sues at lower costs to the corporation should interest rates decline. Debt reduction improves the balance sheet and should, in theory, be good for the stock. When times are tough and the issuer’s fi -nancial health suffers, the convertible will tend to trade as a bond and be priced close to what a conventional bond of the same credit quality would trade at. When times are very good and the issuer’s share price is high, the convertible will be priced as though it were converted into shares. These are all good attributes, but they com-plicate analysis of the bond.

It is useful to view convertibles as though they were children’s playground teeter-totters, for, depending on the conversion price and the stock price at any moment, the convertible may tilt toward its bond side or fl op over to its stock side and beg the holder to convert. The bond makes the stock and, in turn, the stock makes the bond. The parity or stock-equivalent price of a share in a $1,000 bond con-vertible into 20 shares is $50. If the stock were to rise to $75, then the new price of the bond would be $75 × 20 or $1,500. The dual nature of a convertible means double the homework for the investor and raises a diffi cult question: Do you buy a bond you don’t want as a way to get stock you do want? Either way, if you don’t want both the stock and the bond, it’s easier to buy plain bonds without the conver-sion feature or the common stock without an attached bond. In the past, a particular feature of a related security, convertible preferred stocks, which are much the same as convertible bonds, have produced so-called death spirals that have wrecked common share values.1

The death spiral problem arises when the issuing company tries to provide comfort to shareholders in the event of a declining

66 C H A P T E R 3

stock price. If conversion ratios increase as the price of common shares declines, then, to protect themselves, holders will convert to get shares. The process of conversion dilutes the common shares, making them worth ever less and further driving down their val-ue. Such convertibles are fodder for short sellers who recognize the potential gain of selling at the top and waiting until the bitter end to buy shares to close their positions. In the end, the fl oat-ing conversion rate in these deals is not comfort for the investor, but potential poison. The phenomenon works in young compa-nies in which a group of venture capitalists protects itself with a right to convert one class of preferred stock or convertible debt into common shares with the provision that, should the price of the common drop, they get a large hunk of shares as compensa-tion. Infamous Internet fl ops like Drkoop.com and e-toys were devastated by these engineered death traps. May the convertible investor beware. “Many of these high-risk instruments appeal to some investors, because if they work, then they win big,” says Richard Gluck, who specializes in fi xed income at Trilogy Advisors LLC in New York. “But, of course, if they fail, then people just walk away. That’s how high-risk securities work.”

Convertible securities are more complex than straight bonds or straight common stock. The investor who owns convertibles has to monitor the benefi ts of conversion. Astute investors can use convertibles in low-risk straddles, buying the convertible and shorting the underlying stock. If the price of the stock falls, the convertible, supported by the interest coupon, will tend to fall less. If the stock price rises and the investor has not closed his short position, the boost in underlying stock value can make up for some or all of the loss on the short.

There are other virtues to convertibles. Unlike dividends, which are discretionary, paying interest on bonds is mandatory.


The investor who wants income from a stock may have greater comfort with a convertible bond. But the cost is loss of interest compared to what straight bonds of the same issuer tend to pay.

Convertible bonds work best if interest rates are falling, there-by pushing up the bond price, with concurrent increases in the price of the company’s stock. In good times, these conditions pre-vail, but convertibles tend to rise to premium prices. If an investor pays too much for the convertible and it is called by the issuer at a price below the investor’s purchase price, he will lose. The general conditions for convertibles remain much the same as they are for the common stock of a company or its bonds: Buy on pessimism, sell on optimism, and watch asset prices closely. But a fundamental risk remains—should one buy a low-quality stock just because it has a bond welded to it? No, says Sceptre Investment Counsel Ltd. managing director Tom Czitron, who runs fi xed-income portfolios for the fi rm: “Don’t buy crap just because it is convertible.”

PACKAGED LINKERS Creative minds in fi nancial engineering produce doggies that may be prizewinners. Or mutts. Connor Clark & Lunn Capital Markets Inc., a unit of Connor Clark & Lunn Group, has a potential win-ner. The company has packaged a stack of infl ation-linked bonds with the name Connor, Clark & Lunn Real Return Income Fund. Most of the bonds in the fund are U.S. bonds called Treasury Infl ation Protected Securities (TIPS) that are designed to pace changes in the U.S. consumer price index. If the CPI goes up, the bonds’ coupon rate rises proportionately. The fund will seek to generate returns of 5.5% net of fees and adjusted for infl ation. The fund, to be managed by Western Asset Management of Pasadena, California (which got the Morningstar award for fi xed income management in 2004), can boost yields by borrowing up to two times the amounts that it raised from the offering.

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The CCL structure of TIPS is tax-effi cient because it converts annually taxable income from the bonds into capital gains. The downside of the offering is the fees: 120 basis points for manage-ment, 30 basis points to the broker, 50 basis points for the forward swap agreement that converts the income into capital gains that will be realized when units are sold or when the fund winds up in ten years, and 12 points for fund expenses—a total of 2.12%. The 5.5% target return is nevertheless net of these fees and is considered return of capital to unitholders for tax purposes. In operation, the fund will have to enhance the return from its infl ation-linked bonds. Leverage will help, but if short rates rise a great deal and long rates do not rise with them, the fund would be caught in a classic long-short squeeze and could see its projected returns decline, says Neil Murdoch, CCL’s CEO and president. “If short interest rates rise a lot without a comparable rise in long rates, then we will adjust the lever-age, that is, pay off the loans,” he explains. This fund is not without risk, though CCL, which has a good deal of experience in creating and managing structured products, should be able to control them. The fund’s assets have a dollar-weighted average credit rating of AA+, which refl ects the blend of U.S. Treasury TIPS and structured products like U.S. mortgage-backed securities, corporate bonds, bank loans, and emerging market debt, Murdoch adds. Finally, the fund, which mainly holds U.S. bonds, will be hedged back to the Canadian dollar. The hedge eliminates the U.S./Canada foreign ex-change risk and converts it to a Canadian-dollar asset. The fund will be able to do well if infl ation rates or even if stagfl ation breaks out, though defl ation would drive the fund’s return toward zero after fees,” Murdoch says. “But sustained defl ation, which would be a bad thing for the fund and its investors, is not likely to happen,” he adds. “The rising prices of oil and other commodities are infl ationary, as is the probable continuing decline of the U.S. dollar and its effect of pushing up U.S. consumer prices,” he notes.


COMMODITY-LINKED BONDSIn the history of bond investing, few issues have turned out as well for investors as the 1973 French Trésors with 7% nominal coupons and a redemption value indexed to the value of a one-kilogram bar of gold. The gold valuation was to go into effect if the French franc lost its parity with the metal. In 1977, France had to let the franc fl oat. The next year, the International Monetary Fund abolished the linkage of currencies to the price of gold. Those two moves pulled the trigger on the safeguard clause and reset the bond on the price of gold. Beginning in 1980, the government of France paid 393 francs annual interest for every 1,000-franc face-value bond instead of the 70 francs originally planned.

What happened with the French bonds, called the Giscards in memory of French president Valéry Giscard d’Estaing during whose term as minister of economy and fi nance from 1969 to 1974 they were marketed, can happen with other commodity-linked issues if the price of the commodity to which the bond is linked zooms up in price. Other gold linkers have been issued by Lac Minerals Ltd. (taken over by Barrick Gold Corp. in 1994), the Reserve Bank of India, the Bank of England, and the Government of Argentina. Bonds linked to the price of oil have been issued by Inco Ltd. and Cominco Ltd. (the two companies became Teck-Cominco Ltd. in 2001 in a merger).

Bonds with a commodity valuation mechanism appeal to in-vestors who want commodity exposure but value the essential bond idea that, at maturity, the instruments will not pay less than face value, notes Bank of Canada Working Paper No. 20 issued in 2004. The problem in pricing a commodity-linked bond is that it is very hard to value by either determination of duration or by conventional credit analysis. The buyer must evaluate the price of the commodity or the value of the index over the life of the bond.

70 C H A P T E R 3

Investors who buy commodity-linked bonds give up some cash interest in exchange for taking a whirl in the designated commodity or index. For their part, corporate treasurers get to pay sub-market rates. The concept is nothing new. In 1863, the Confederate States of America issued bonds payable in bales of cotton. The Confederacy was short of gold but long on the crop. The engi-neering of the bond was a natural.

Today, there are as much as US$70 billion of debt issues linked to commodity prices, says Heather Shemilt, a Goldman Sachs managing director who heads the company’s commodity index business. About US$45 billion hangs on the sector-weighted Goldman Sachs Commodity Index, she says. Most are custom-crafted for institutional clients. Some have been designed for wealthy individual investors who have easier access to the bond market than to futures trading, she adds.

The market is already primed for fi nancial assets linked to commodity plays. Royalty trusts based on oil or gas are thriving. What distinguishes a bond linked to a commodity is the relative certainty of return of principal. In contrast to the royalty trust, really an equity product that has no price fl oor, the commodity-linked bond has a predetermined value at maturity.

Commodity-linked bonds offer advantages absent from con-ventional bonds that just pay interest in cash. Commodities are an asset class separate from stocks and bonds. During periods of very high infl ation, such as the early 1980s, commodities out-performed equities, bonds, and cash. What’s more, commodities tend to do well during catastrophes while stocks wobble and in-fl ationary expectations decline. We are in such a period now with the Goldman Sachs Commodity Index (GSCI), a widely used ref-erence for the bonds, up 60% in 2005. The GSCI’s weights in the fourth quarter of 2005 were 79.2% energy, 5.6% industrial metals, 1.7% precious metals, 9.0% crops, and 4.5% livestock.


Linking to that index provides exposure to the hottest sector in today’s market.

Commodity-linked bonds and related instruments have done well in the last fi ve years, notes John Brynjolfsson, a portfolio man-ager with California-based Pacifi c Investment Management Co., usually called PIMCO. “There are hundreds of issues outstanding, but they are not actively traded,” he says. “Issuing dealers handle these structured notes as private placement.” There are ways to participate in the market, however. The U.S.-based Oppenheimer Real Asset A Fund, which holds commodity-linked bonds, and the PIMCO Commodity Real Return Strategy Fund provide com-modity-linked returns. Is it time to buy into a commodity-linked bond, especially after energy and certain materials have had a long and profi table run?

“There is reason to think that the real return on commodities will remain at the high end of the spectrum,” says Aron Gampel, deputy chief economist of the Bank of Nova Scotia. “We are at the beginning of a fairly good commodity cycle that refl ects a combi-nation of factors of increasing demand. Whether it is for mining or energy, to a great extent, the demand curve has shifted, but the supply curve has not moved. I think that these conditions would suggest that the cycle has a way to go.”

Gampel says the commodity connection will work despite the lack of the double-digit infl ation characteristic of the early 1980s. “Infl ation itself is modest by historic standards and is not at the tipping point that would force policy makers to rein in growth or to abort the cycle prematurely,” he explains. “On the other hand, no one has an accurate map as to how large or how deep this cycle will be.”

Commodity-linked bonds for direct retail sale are ready for a comeback, says Harry Koza, a bond market analyst with Thomson IFR in Toronto. “Gold-linked bonds would be hot if they came

72 C H A P T E R 3

out right now,” he says. “Retail investors love gold, and the bonds would swap yield for the gold price. From an investor’s point of view, even if the gold price did fall, you’d get your coupon and the cash value of principal at maturity.” Investment managers are al-ready creating commodity-linked, bond-like products. In October 2005, Toronto-based Sentry Select Capital Corp. launched its Sentry Select Rogers International Commodity Index Principal-Protected Notes with a fi xed return price and a return that will vary with commodity prices. The structured note will behave much like a bond with a commodity pricing option.2

HIGH-YIELD BONDSThe term “high yield” is a polite way of saying “junk.” This is the tier of the market in which bonds, to use the phrase of the late Rodney Dangerfi eld, “don’t get respect.” The reason that bonds which rat-ing agencies describe as speculative lack dignity is that, simply put, they are in a class noted for defaults. In theory, high-yield bonds can compensate investors for their risk with higher returns. The ques-tion, however, is whether the returns are suffi cient to compensate for the appreciably higher risks that junk bonds bear.

In tough times, default rates on junk rise dramatically. In 2002, for example, 12.8% of all corporate junk defaulted, setting a new record previously held by the default peak of 10.3% during the interest-rate spike of 1991. Default rates at such levels defl ate the concept of “high yield” and bring the premium rates the stuff offers, which may be 800 basis points over federal debt, back to earth.

The great majority of issuers of junk debt are small compa-nies that don’t have the muscle to get investment-grade ratings. But some issuers of junk are great companies on the way down. Following a March 16, 2005, announcement that its profi ts for 2005 would be 80% lower than the US$5 per share it had pre-viously estimated, General Motors Corp.’s US$116 billion of


outstanding bonds was soon downgraded. GM, once the best in-dustrial credit in America, wound up with a market cap (the value of stock outstanding) of US$16.4 billion, less than the market cap of motorcycle maker Harley-Davidson Inc. After the announce-ment, GM common fell by 14%, and there was talk that GM might have to cut its US$2 annual dividend. It did, in fact, cut the dividend to US$1.00 on February 7, 2006. For holders of a total of US$300 billion of GM debt, including holders of debt of General Motors Acceptance Corp., its fi nance unit, the prospect of a dunk into junk is nothing less than horrifi c. Institutions barred from holding junk must sell what they have, driving down prices and pushing up yields. Many investors are excluded from the market as buyers. GM will have to roll its debt, paying off bonds com-ing due and reborrowing the money it needs at what are likely to be higher interest rates, thus putting additional pressure on its profi ts. The impact of the default may affect all corporate credit markets, for as the third-largest issuer of corporate debt in America, GM is anything but a lightweight. Indeed, as GM’s problems became a bond market scandal, things appeared to get worse. The press added to the company’s woes, for on March 17, 2005, the National Post asked the rhetorical question, “Are [inter-est] spreads (what GM must pay over benchmark federal bond interest rates) set to widen?”3 As we go to press, GMAC Canada, the fi nance unit of the U.S. parent, is seen as troubled. GMAC Canada 5.9% bonds due October 9, 2007, yield 9.53% to matu-rity. That’s deep in junk territory.

Before descending further into the market for high-yield debt, we must explain that Canada’s junk market is different from that in the United States. In Canada, income trusts have provided a way to fi nance ventures built on high but not necessarily sustainable energy prices and single-product companies that turn out such things as peat moss, pizza, and mattresses. The resource trusts are based on

74 C H A P T E R 3

volatile energy prices, for the most part. The business trusts tend to have what investment dealer Blackmont Capital called in an April 2005 analysis “the fi nancial characteristics of equities with a single-B rating, given that 20% have become fallen angels [by suspending or cutting income distributions to unitholders] within only 2.4 years, on average, of going public.” Of course, some income trusts are shells for large companies with diversifi ed product lines, and some income trusts are truly mammoth companies with strong businesses. Not all are at risk of performing like junk bonds.

U.S. junk comes in a surprising variety of styles. Robert Campeau, Ottawa builder turned U.S. retailing wizard, drove Federated Department Stores into insolvency soon after he took it over in 1988. To fi nance that takeover, he had issued Pay in Kind bonds, PIKs in bond-speak, that would pay interest not in money, but in more junk.

Some high-yield issuers turn out something even more dubi-ous than PIKs. That’s what the street calls No Coupon At All or NCAA bonds, which means that the issuer goes bankrupt before it has made even one coupon payment.

Bond analyst Harry Koza explains that NCAA bonds do happen. In April 1999, Just For Feet Inc., a U.S. chain of shoe stores, issued US$200 million in 11% senior subordinated notes at $100 with a May 1, 2009, due date. The company did not have solid fi nances, for in July, just a couple of months after the bond issue, Just For Feet told the world about a nasty bunion—lousy earnings. The company defaulted on its fi rst coupon due November 1999 and fi led for Chapter 11. The company was liquidated, the books turned out to have been as well cooked as an overdone turkey, and the U.S. Securities and Exchange Commission fi ned the auditors for having overlooked what the agency thought it should have seen. Once the second-largest shoe retailer in the United States, the company admitted that its


fi nances were fi ctitious. Needless to say, investors in the com-pany were devasated.4

In 2004, Canadian companies issued $6.3 billion worth of debt rated below BBB (the lowest investment-grade rating), according to BMO Nesbitt Burns. Compared to the US$142 billion of junk debt issued in the United States in 2004, the Canadian market is minuscule.5

Low-quality bonds are nothing new, but the idea of mar-keting them and, what’s more, of creating them specifi cally for investors hungry for yield, is a quarter of a century old. In 1977, Drexel Burnham Lambert, a U.S. investment bank, did a US$30-million loan for Texas International. Mike Milken, soon to become the Rasputin of junk, fi gured that there would be a market for the great majority of American companies that did not have the fi nan-cial muscle to issue investment-grade debt.

In the next ten years, Milken raised money for perhaps a thou-sand companies, including Warner Communications, McCaw Cellular, and MCI. He fi nanced hostile takeovers by T. Boone Pickens, Saul Steinberg, Carl Icahn, and Ronald Perelman. With a combination of skill and arrogance, Milken brought investors together with issuers, made markets in junk, and refi nanced the stuff when it was about to default, juggling mountains of debt dur-ing what were said to have been 15-hour days. In 1988, the U.S. Securities and Exchange Commission fi led complaints against Milken and Drexel. Milken was indicted on 98 counts of stock manipulation, insider trading, and racketeering. Drexel fi led for bankruptcy protection in February 1990. Milken was sentenced to ten years in prison and agreed to pay US$600 million in fi nes and restitution. He was out in two years and took up the cause of prostate cancer, appearing on television talk shows as a new man shorn of what had been his trademark hairpiece and devoid of the ego that had made him the mascot of greed in the 1980s.

76 C H A P T E R 3

The story of the rise and fall of Milken and of other junk bond Svengalis often overshadows the fundamental issue of low-grade bonds—many are colossal fl ops. While in any brief period, junk bond defaults are modest, over extended periods they are terrify-ingly common. Over fi ve years, 39% of issuers rated B minus will default. Those with the dubious CCC rating will have a 53% fail-ure rate over fi ve years. Ominously, noted the British newsweekly The Economist, in a November 2004 survey of junk bonds, 85% of new junk issues have come to market with maturities of seven years or more.6 The grim reaper may be put off by such deals, but he inevitably returns when the business cycle goes into a funk.

The high default rate on junk debt suggests that the investor must receive at least twice the interest paid on riskless govern-ment debt. If a ten-year federal bond pays 5%, then junk of the same term should pay 10%. In fact, the spread can be less since many companies that default work out their problems. Investors average a 60% recovery on junk in default, thus reducing the required spread. Yet junk at the end of 2005 was trading at some of the lowest spreads over government debt ever recorded. From spreads of 1,300 points over the benchmark ten-year U.S. Treasury bond that prevailed during the middle of the tech melt-down that began in 2000, junk traded down to 200 points over the benchmark Treasury.7 At that level, junk bonds were effi cient-ly priced, but offered nothing more, commented Doug Knight, a portfolio manager with Deans Knight Capital Management Ltd. in Vancouver. A specialist in high-yield debt, Knight has one of the best track records in the business. None of this is to say that one should not invest in junk bonds, but it is the sort of thing best left to professionals like Knight. The research re-quired to appraise companies is demanding, the cost of error is high, and the need for diversifi cation is huge. Given the need for serious research and the need to diversify into many issues, it is


essential that the investor not squander money on bonds that rating agencies have pushed into bargain bins. Most are not bar-gains at all. A substantial investment in junk is hugely risky, yet in diversifi ed junk, an investment can become sensible. Professional bond managers can exploit the inconsistencies in the risk and re-ward relationship of lower quality bonds.

CREDIT DEFAULT SWAPSAn alternative to trying to squeeze yield out of doubtful bonds is insuring investment-grade bonds against default. It is a huge inter-national market. Recently, credit default swaps (CDS) fi nance has become available to retail investors. The concept is simple: Rather than hold bonds that may default, sell insurance against default and keep the premium. The scheme works as long as defaults don’t get too high. That happens when business conditions deteriorate, infect many companies, and lead to widespread defaults.

The data behind the CDS concept make the swap concept at-tractive. Investment-grade bonds have low default rates. When they do default, 31.1% of the bonds’ par value is recovered by investors, according to a study by Standard & Poor’s. A higher re-covery rate of 49.1% was found in a study by Ed Altman, professor of fi nance at the Stern School of Business at New York University. Averaging out the two recovery rates to 40% of par value, Connor, Clark and Lunn Capital Market Inc. estimated that even with an average 1.74% cumulative fi ve-year default rate, actual losses on sample investment-grade bonds would be 1.04% and, in the worst historical case, no more than 1.57%.8

Connor, Clark produced an estimate for a September 24, 2004, prospectus on its ROC Pref II Corp. that it would take default losses in excess of seven companies in a sample portfolio of as many as 140 companies with a weighted S&P rating of A–. But a high level of defaults would work to reduce the investor’s potential in-come from the scheme. If more than 11 companies were to default,

78 C H A P T E R 3

the CDS in its plan would have no remaining value.9 Other swaps have been done by several chartered banks, including Royal Bank and National Bank. Each is complex and each contains a critical risk: Issued when defaults were at a cyclical low, defaults rose in 2005, theoretically pushing the swap structures toward their break points.10 For its part, Connor, Clark notes that active management of the bond portfolio should weed out bonds that appear to be gaining in default risk. The ROC issue, sold at $25, has recently traded at $25.30. The company did another, ROC Pref III, in the spring of 2005, riding the default curve and, perhaps in retrospect, coming a bit close for comfort. Time will tell.

A rise in default rates is likely, says Neil Murdoch, president and CEO of Connor, Clark and Lunn Capital Markets. “Default rates have been at historical lows, but rising interest rates will increasing fi nancing costs.” Even with moderate increases in interest rates, the ROC issues should remain sound, Murdoch says. Default spikes are unlikely as long as interest rates remain in the low or mid-single digits and the recovery from dot-com mania and the market collapse of 2000–2002 continues. But there is a nagging worry, for there is never a free ride, especially when fi nancial engineers invent new kinds of assets. “The CDS concept should work 99% of the time,” says Chris Kresic, Mackenzie Financial Corp. senior vice president. “But 1% of the time, the investor loses everything.”

The bond investor should realize that complexity or packaging with other bonds cannot rescue a bond that is being sold off by investors concerned that the issuing company isn’t making enough money to cover interest due. When suspicion that there may be a shortfall turns into an actual lack of cash to pay the coupons due, the bond goes into default. This is where an investor never wants to be. To that end, he must understand the risks of what he is buying and do suffi cient homework to determine how well bond


Endnotes

1. Aaron Lucchetti and Leslie Scism, “Unusual Convertible Preferred Raises Needed Cash—and Risks,” Wall Street Journal, September 28, 1998, p. C-1.

2. See http://www.sentryselect.com.

3. Jacqueline Thorpe and Ian Karleff, “Will GM News End Bond Rally?” National Post, March 17, 2005, p. FP-9; Lee Hawkins Jr., “GM’s Abrupt Profi t Warning Rocks Markets,” Globe and Mail, March 17, 2005, p. B-3.

4. Harry Koza, “Don’t Bet on This NCAA,” http://gold.globeinvestor.com, May 30, 2005. GlobeinvestorGOLD is a premium website operated by the Toronto Globe and Mail. See also U.S. Deptartment of Justice press release, February 25, 2004, “Former Executive Vice President of Just For Feet, Inc. Agrees to Plead Guilty.”

5. David Berman, “Will Junk Bonds Rival Trusts,” National Post, February 10, 2005, p. 1N1.

6. The Economist, November 6, 2004, p. 78.

7. The Economist, November 6, 2004, p. 78.

8. ROC Pref II Corp. prospectus, September 24, 2004, pp. 16–17.

9. ROC Pref II Corp. prospectus, p. 18.

10. The Economist, May 14, 2005, pp. 76–77.

interest due to holders is covered by the cash the company gener-ates from its business. Financial scholarship, examined in Chapter 6, is indeed its own reward.

Chapter 4

ALTERNATIVE BONDS

As one moves down the ranks of creditworthiness, there is a wonderland of instruments that promise to pay interest.

They vary from bonds that currently pay no money at all but promise to pay it in the future, to bonds in the clothes of preferred shares that limit their holders’ rights as creditors, to bonds made up of cash fl ows. There are other bonds backed not by bricks and mortar but by the relatively light air of intellectual property, bonds that are priced with the complexity of formulas sometimes found in higher mathematics, bonds that have defaulted or have been dishonoured or cancelled, and, at last, at the lowest level of credit worthiness, fi xed income devices that are all promise and no performance.

At a distance, one can wonder why investors would even con-sider purchase of bonds with serious doubts about repayment and even credibility. In this chapter, we’ll examine the range of bonds that represent reasonable gambles for higher returns to out-right frauds that look like bonds but that have no prospects for

82 C H A P T E R 4

returns. Over the range, there is a kind of continuous shifting of expectations in which the sensible investor should expect rising disappointments in exchange for a presumption of eventual out-performance by his entire portfolio of unconventional debt. At the bitter end of the spectrum, there are no prospects for gain. The rule of self-protection comes down to the old advice: Never sus-pend disbelief. And, of course, one cannot say too often that if a thing is too good to be true, it probably is.

Even the most naïve of investors have an inner oracle that tells them their deals can go sour. So why do sensible people sometimes fall for rackets? Perhaps because adept con artists accompany pro-posed deals with backstories about conspiracies to deprive honest folks of a chance to get what the rich get. Or tales that a thing is about to take off and turn participants into early players in a new version of Microsoft Corp. There are warnings not to tell anyone about a great deal. And there may be early repayments of money just to instill confi dence.

The following list of investments are mostly potentially rea-sonable, if increasingly risky, plays in debt fi nance. Only the last category of bond-like “investment,” prime bank notes, is a clear fraud. But what is a deception and what is a misunderstanding can be a fi ne line. In debt investment, it’s often the scholar who winds up with the spoils of those who did not read the fi ne print.

PAY IN KIND BONDSPIKs, short for pay in kind bonds, are issued by companies that are pressed for cash and would rather not have to pony up when cou-pons come due. In a February 14, 2005 story on leveraged bond deals, London’s Financial Times lumped PIKs in with other oddities like two-headed calves, relegating them to investments of last re-sort.1 They tend to be rated as junk and offer stratospheric interest rates for greedy or courageous investors.2 The theory behind PIKs

83Alternative Bonds

is that, in exchange for accepting the risk intrinsic in accepting a promise of payment each time a promise comes due, the investor will make out like a bandit—if the plan works. PIKs are nothing but IOUs payable in more IOUs—investments for the faithful or the credulous. Sometimes the PIKs bear fruit, sometimes they don’t. PIKs can be fair bets for high returns. Or they can be hopeless.

In November 2004, CanWest Global Communications Corp. told the world that it was successful in replacing pay in kind notes that had yielded 12 1/8% due in 2010 with conventional 8% senior subordinated notes due in 2012. The PIKs had been issued to pay for the purchase of newspaper assets and, at the time of the bond swap, the company was doing well. The PIK investors fi gured it was a good deal and went for it. Happy ending.

They don’t all turn out that way. Canada’s own fallen idol of high fi nance, Robert Campeau, issued PIKs in the late 1980s in the process of acquiring the icons of U.S. retailing—Jordan Marsh, Brooks Brothers, Ann Taylor, Macy’s, Allied Stores, and Federated Department stores. An Ottawa offi ce building developer who had been called “a blood sport enthusiast who is most alive when kill-ing moose,” Campeau issued US$11 billion in debt, including $250 million in PIKs. The PIK device, used in 1987 to take over retailer Allied Stores, was constructed for Campeau’s no-money-down dealing. The debt fi nancing deal allowed him to have not only great department stores, but also such lumps as the number three department store in Indianapolis and a store in Grand Rapids, Michigan, Herpolsheimer’s, which locals nicknamed “Herps.”3

The Campeau PIKs joined other obligations that the Campeau takeover did not pay. In January 1990, just two years after Campeau had gained control over much of American re-tailing, his empire was in tatters, facing 50,000 creditors in bankruptcy who had fi led 29 volumes of documents each 2,020 pages long. Total claims of US$8.2 billion had produced their own

84 C H A P T E R 4

adjudication industry with lawyers as the initial benefi ciaries of a process that saw accountants and securities companies billing al-most a million dollars a month and other charges, including such things as $52,189 for photocopying by just one law fi rm, suck-ing the blood out of creditors’ claims. With poetic justice, First Boston, the securities fi rm that had thought up the PIK concept, wrote off fees it had charged for helping Campeau and emerged with a $100-million loss.4 Campeau, having produced a comic opera bankruptcy, departed for Austria with wife Ilse where he took on the title “Doktor” (he had an honorary one) and became a local celebrity. At last report, he had received $25,000 a month in spousal support from Ilse, from whom he has been separated since 1996. Ilse, it turns out, wound up holding substantial mari-tal property, including their Austrian villa.5 The fi nancial schemes that impoverished the credulous investors in Campeau’s dreams fi nally came home to roost.

PIKs are still being created and used as a way of paying inter-est without paying real money. Like bonds that defer interest until maturity—called zero coupon bonds in the United States and strips in Canada—they postpone judgment day. Eventually, they have to be monetized through payment of real cash. Until then, however, the investor has to pay tax on the value of the bonds issued in lieu of cash. One can think of a PIK bond as a way of participating in the growth of a business, but on an after-tax basis, the holder is ef-fectively subsidizing the enterprise by foregoing current payment on his bond. He might be better off as a stockholder, for the “earn-ings yield” stays within the business, is not distributed, and does not turn into a taxable liability.

In the end, PIKs are for risk seekers, partially because the in-vestor is asked to fi nance a company so strapped for cash that it is willing to pay very high interest rates on the promise to turn PIKs into real money. On both counts, the conservative investor should exercise extra caution when evaluating a PIK bond.

85Alternative Bonds

PREFERRED SECURITIESThere are other ways that corporate borrowers can get money but avoid the requirement to pay lenders back on time. In exchange for paying interest rates typically 400 basis points over federal debt of the same term, preferred securities allow the issuer to postpone payments for as much as 20 consecutive quarters before investors can exercise their rights to seek legal relief. Maturities are long, yet there is demand for these things. Preferred securities are usually issued by marquee names but rate as deeply subordinated debt. The issuer treats the payments as interest rather than as dividends that share in profi ts. The holder, who is being paid handsomely for what could be years of postponed payments, has to pay tax on whatever is paid as income and, worse, would have to pay tax even if the payments are missed. They pay tax on the accrual of interest, for accrual of income or benefi t is the basis of Canadian tax law. If and when the investors do get post-poned interest, the tax will have been paid. COPrS, short for Canadian Originated Preferred Securities, were invented by Merrill Lynch for a November 1996 TransCanada PipeLines issue. Outstanding issues have been culled by issuers who have used call dates to pay them off and refi nance at currently lower rates. See the following table.

Preferred Securities: A Menu of ChoicesName of Issuer Coupon Term Call Date Price Current Yield Symbol

Brascan Corp. 8.35% 12 31 50 12 31 06 $26.70 7.8% BNN.Pr.S

Shaw Commun. 8.875% 9 30 46 10 15 05 $25.80 8.5% SJR.Pr.A

TransAlta 7.75% 9 30 46 12 31 06 $26.57 7.27% TA.Pr.C

Preferred securities expose the holder to a huge risk, for if in-terest rates were to rise to the double-digit levels that prevailed in 1981–1982, the market price of the issues would be cut to a small fraction of today’s prices. If interest rates were to fall drastically,

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remaining issues would be called. Yet for all their risks, the issues have done fairly well in the market. A default by Echo Bay Mines Ltd. on a $100-million preferred securities issue that was marketed in March 1997 remains a sore point in the history of this variety of hybrid stock/bond. Yet it is a reminder that an issue is only as good as the company behind it, a truism, of course, but also a fact of life in this niche of debt instruments in which mostly strong compa-nies issue debt that is, as one wag has said, “at the end of the food chain.”

COLLATERALIZED DEBT OBLIGATIONSEager to free up their balance sheets of loans and the capital re-quired to back them, banks and other lenders like major automobile fi nance subsidiaries sell collateralized debt obligations (CDOs) and collateralized mortgage obligations to investors eager for an increase in yield. CDOs are the more interesting vehicles. In 2004, $11.5 billion of CDOs were issued to back car loans and credit card debts.6

CDOs are structured in layers called tranches so that the top level gets paid before the next and so on down to what the in-dustry calls the “equity tranche.” Investors typically buy the top tranches, leaving the middle and bottom, much riskier, tranches for specialist speculators. The idea is that the top-level tranche gets paid fi rst, then the second tranche, and so on down the line. This risk shifting leaves the top level as a superior credit, usually rated AAA, while the lower levels wind up with increasing risk of default. The farther down in the stack one goes, the lower the prospects for payment in full and the higher the return promised. Thus CDOs tend to be sensitive to the business cycle and to short-term interest rates. Issuers range from very secure banks to less secure equipment lenders. Every CDO has a story, and it pays to learn it. They tend to be illiquid. Investors should therefore

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expect to hold them to maturity. Tom Czitron of Sceptre Invest-ment Council warns that the premium interest the structures pay is no gift—it is a payment for illiquidity as well as for higher risk in the lower quality tranches.

The potential return in the CDO market attracts yield-hungry investors who want a boost in yield over provincial debt that pays perhaps 10 basis points over federal debt of the same term. As the term lengthens and as conditions for repayment grow, risk and yield increase.

The temptation for the CDO investor is to go for the high-est yields offered by the lowest tranches where defaults may run to 12% or more of the value of the packaged debt. In the market, these levels have been called “toxic waste” and often are retained by the institution selling the CDOs.7 Low-quality tranches of CDOs are really long bets that belong in Las Vegas. The investor has bet-ter odds with straight common stock.

INTELLECTUAL PROPERTY BONDSBonds are about security and, not surprisingly, investors have tend-ed to prefer bonds backed with specifi c assets or debentures backed by the full faith and credit of large, well-known issuers. The se-curity preference of the market has made it diffi cult for small or non-public companies to sell their debt to the public. Moreover, bonds with backing less solid than real estate and other hard physi-cal assets have been very diffi cult to place.

Innovative bankers have leapt over the problems with a new class of bonds secured by a soft asset, intellectual property (IP). In a new niche in the debt market, fashion houses and rock stars offer holders of bonds backed by their trademarks and songs at interest rates above those for comparably rated corporate bonds. Moreover, they have the comfort of asset backing through special-purpose trusts.

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Adapting bonds to capture IP income is the essential novelty of these “glamour bonds.” The most famous bonds were issued in February 1997 with a 10-year term by David Bowie’s music com-pany, Jones/Tintoretto Entertainment LLC. The asset backing was a package of royalties from 25 albums such as The Rise and Fall of Ziggy Stardust recorded before 1990. Offered as a US$55-million issue with a 7.9% return, well above the 6.8% yield on 10-year U.S. Treasury bonds at the time, the bonds got an invest-ment grade rating of AAA from Moody’s Investor Services.

Although the Bowie bonds were later downgraded to Baa3, the lowest investment grade, over worries that Internet downloading of music would cut into the royalty stream that repays the bonds, holders have received their payments in full and on time. But angst over the ability of Bowie’s publisher, EMI Group Plc, to meet its obligations in the face of Internet music downloading caused its own ratings of asset-backed bonds to drop to junk status. The lesson—asset-backed bonds are only as good as their packaged collateral.

The asset-backing concept, once used mainly to fi nance railroad freight cars and offi ce buildings and such prosaic fi nancial instru-ments as credit card receivables, is growing as a means of fi nancing the growth of small to medium-sized fi rms, says Robert D’Loren, president and CEO of UCC Capital in New York. He has packaged and sold intellectual property bonds for fashion houses Bill Blass and Gloria Vanderbilt and shoe vendors Converse and Athlete’s Foot. His fi rm has done most of the deals of IP-backed bonds since 1999, he says. In each case, the assets backing the bonds are royal-ties from licensing a brand name. Once the bonds are paid off, the royalties revert to the issuer, he notes. It’s a distinctive structure crafted to the U.S. bond market. Somewhat similar underwritings based on intellectual property have been done in Canada through income trusts funded by franchise food royalties from chains with well-known names.

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Most of the U.S. IP asset-backed bonds are bought by institu-tions and held to maturity, says a senior analyst with UCC Capital. Usually issued in tranches under US$100 million, the issues are relatively small and not very liquid. But a modest secondary mar-ket for the bonds exists. The potential buyers in the resale market could be individuals whose interest is piqued by the potential as-sociation with a famous name.

Not all IP bonds are boutique-sized. In 1997 Morgan Stanley and JP Morgan sold an issue for Dreamworks (the studio backed by Steven Spielberg, David Geffen, and Jeffery Katzenberg). There have been several fl oating rate IP bonds in average offerings of US$500 million based variously on the U.S. prime rate and com-mercial paper. Ultimately, movie ticket sales pay off the studio that pays back the investors.

We can expect IP bonds to grow in the market. According to James Malackowski, president and CEO of Duff & Phelps Capital Partners in New York, over US$100 billion is collected annually in licensing income around the world.

Bonds with investment-grade IP backing are usually priced at 500 to 600 basis points over comparable U.S. Treasury bonds for the average seven-year life of the deal, D’Loren says. Using the 4.5% rate on the benchmark 10-year U.S. Treasury bonds, the rate on IP-backed debt works out to 9.5% to 10.5%. “That’s much bet-ter for the issuer than paying 12% on junk, or as much as 22% per year on a hybrid stock and debt fi nancing deal in which the bor-rower pays out of revenues or through paying out large chunks of stock to lenders,” D’Loren says. It’s also better for the investor to hold bonds with a cashable asset behind them than to stand in line for payment if the issuer defaults, he notes.

Structuring IP bond deals is critical to getting the market to accept them, D’Loren explains. Each deal has a special-purpose corporation that is protected from bankruptcy of the underlying

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business, he says. Thus, if a fashion house were to become insol-vent, the special-purpose corporation receiving the royalty stream would not be affected. The process separates the valuable intellec-tual property from the operating company and, in D’Loren’s view, makes it more secure.

The IP debt market is likely going to remain selective. It’s not for the run-of-the-mill rock star, notes UCC Capital. The music royalties that are packaged must have dependability. The performer who is thinking of having IP-backed bonds issued against royalties has to be able to generate at least US$42.5 million in royalties to pay holders of a US$50-million issue, D’Loren explains.

Fame aside, the investor has to be concerned with the charac-teristics of the assets and the history of the issuer. “The more stable the cash fl ow, the better off you are,” says bond manager Chris Kresic, senior vice president for Mackenzie Financial Corporation in Toronto.

FIXED INCOME DERIVATIVESThe riskiest of all plays in the formerly humdrum world of fi xed income investing is the derivatives market. A derivative, simply put, is a security that derives its value from another, underlying security. An option, which is a right but not an obligation to buy or to sell another security, is a derivative.

The development of the fi xed income derivatives market is relatively recent. In the mid-1980s, as takeover artists were po-sitioning themselves to capture companies like Revlon and RJR Nabisco, investment banks began to market a lexicon of fi xed in-come products that included Dollarized Yield Curve Notes and Prime-LIBOR Floating Rate Notes. Some involved renting com-panies’ balance sheets in order to satisfy regulators. There were payoffs based on sports bets and complex deals involving foreign currency trends. Most were built on an underlying fi xed income

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product like a bond and all created risks that it would take, literally, rocket science to evaluate.8

Some debt derivative deals that were sold to insurance com-panies put retirees’ pensions at risk if the Philippine state power company or the Mexican peso had a tough year.9 Hedge funds loaded up on some of these deals, putting what were at times as much as 20 times their capital on the trades.10 One speculator, Nick Leeson—an employee of Barings Bank in Singapore—created his own cross-asset derivative plays. He bet that Japanese stocks would go up and then bet that Japanese bond prices would go down. He was wrong on both and, within a few weeks of trad-ing in early 1995 in which he wagered US$30 billion, he wiped out the capital of Barings, the bank that handled the Queen’s personal accounts. The Bank of England was asked to save the venerable institution but could not, partially because of the size of Leeson’s bets, partially because the bets could not be prop-erly quantifi ed. In the space of the period between January 26 and February 24, 1995, Leeson blew US$1 billion or so. Leeson, age 28, was sentenced to six years in the slammer. Defenders of derivatives argue that Leeson’s problem was not in the nature of his bets, but the lack of internal controls at Barings. The failure was purely idiosyncratic, goes this line of reasoning, and Leeson could have avoided wrecking Barings by diversifying his bets.11 Today, while Barings is history, Leeson is not. Out of jail, he has a new job as the fi nancial manager of Galway United, an Irish football club, has written a book about his adventures, and lec-tures on his life.12

The diversifi cation argument that defends derivatives works out to something like this: No matter how poorly your bets work out, not all will be catastrophes. Spread out your money and you will survive. That’s true, but it negates the essence of a bond as a secure investment. A conventional investment-grade bond’s return

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can be estimated with accuracy if the bond is held to maturity, at least if the issuer remains healthy. Even if you don’t hold it to maturity, its volatility can be estimated at any time by checking its duration, as will be explained in Chapter 6. With domestic bonds, there is no credit risk to worry about. How markets will react to complex derivatives involves a good deal of elaborate mathematics and often comes up against the problem that fi nancial history does not always predict the fi nancial future.

The bottom line on derivatives is this: With borrowed money and fancy derivatives, you can blow your brains out. With con-ventional bonds and stocks purchased for cash and not borrowed money, the most you can lose is whatever the things cost. If you want to invest in bonds for their intrinsic security, stay with the game. If you want to play bonds to produce the returns expected of stocks, diversify your portfolio and keep your bets no bigger than the losses you can afford. Finally, if you really want to play casino odds, head to Vegas.

DISHONOURED BONDSThe shabbiest of all bonds are those that are in default; paradoxically, they are also among the most profi table. Investors can buy defaulted bonds at pennies on the dollar and then wait for payoffs as receiv-ers and liquidators sell off company assets or as bankers and lawyers restructure the companies’ debt. Between 1974 and 2003, recovery rates on publicly traded corporate bonds ranged from 29.0% on subordinated bonds to 52.8% on senior secured bonds.13 Another study found recovery rates as high as 87.3% on senior bank debt.14 Direct investment in these recovery plays are available through spe-cialized hedge funds.

Credit Suisse First Boston made US$130 million by buying the distressed bonds of paging companies in the late 1990s. When the IPO market in dot-coms and other dubious ventures revived

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in the spring of 2000, the distressed bonds of these paging compa-nies soared in price and rewarded vulture investors who had picked them up at deep discounts.15

Sovereign loans—that is, loans made to a sovereign nation—are another matter. While a lender may be able to seize a factory or a fl eet of trucks, it is not possible to seize a nation that defaults, especially if, as usual, it has an army. Nevertheless, international pressure tends to force most debt nations to settle on some terms with lenders. As a result, tough-minded investors have been able to get three to twenty times their investments in sovereign defaults net of legal fees. Litigation can take three to ten years, but inves-tors who bought into the bad loans at an average of 10% of face value have done very well.16

The concept of digging value out of defaulted bonds is really just a variation of buying deep-value stocks, the market prices of which have been crushed by undue pessimism. Indeed, since bondholders have a claim on assets in the case of debentures or specifi ed assets in the case of collateralized bonds, it should be relatively easy to fi nd value in excess of the market price of distressed debt. Extracting value in these bonds is a form of arbitrage. It can be done when prices are depressed to less than true value after institutions holding the bonds sell in order to comply with law and regulations forbidding them to own anything but investment-grade bonds. But getting value out of defaulted bonds may put the bondholders in confl ict with other creditors. Wars, even when won by bondholders, can wind up as pyr-rhic victories. The idea, after all, is to make money, not just to win.

As well, not all workouts of distressed debt are profi table. The 2005 workout of the debts of the Republic of Argentina, which paid just 30 cents on each dollar of debt on which the nation defaulted, left many investors insolvent. Before the payments were fi nalized, bondholders sold their debt and other investors bought the defaulted bonds at rates as low as 10 to 15 cents on the dollar. Those who

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bought at the bottom made out well, doubling or tripling their mon-ey. It goes without saying that this is high-risk investing. The investor who wants to dabble in distressed debt should either be very well heeled and well advised or work through a hedge fund able to price and manage these deals. Investors in this tier of debt need lawyers to work through international courts and to collect from such debtors as Yemen, Uganda, Ethiopia, Guyana, Nicaragua, Cameroon, Ivory Coast, Congo, and Zambia. It is good to remember there are no-torious cases of distressed sovereign bonds that are never resolved. Pre-revolutionary Russian debt, for example, has never been paid, in spite of numerous promises from Soviet and Russian authorities to do so. The lesson appears to be that when a regime that has issued bonds is defeated in a civil war, prospects for payment are reduced.

OLD AND DEFUNCT BONDSOld bonds have remarkable powers to return to life and profi t. Unlike common and preferred shares, which sink to zero value when a company goes bankrupt or just folds up and disappears, bonds retain claims on the residual assets of the business. The problem is to fi nd those assets. The process can involve nothing more than a phone call to the investor relations department of a company or it can be as tough as diving for buried treasure.

Researching old bonds and stocks is potentially profi table. Cheryl Anderson, president of America West Archives Inc. of Cedar City, Utah ([email protected]), says she fi nds value in half the securities she researches. Her fee is US$45 per bond.

Researching old bonds and stocks is a cottage industry run by people with a passion for archival research and an affi nity for old documents. Bob Kerstein, president of Old Company Research (www.oldcompany.com), one of the leading fi rms in the fi eld, was chief information offi cer in the mid-1990s for Orca Bay Sports and Entertainment, owner of the Vancouver Canucks. His company,

95Alternative Bonds

based in Fairfax, Virginia, gets 15% of its business from Canadian investors, he says. After he provides the history of the bond and its links to what money remains, he leaves it to the holder to work out the sale in the market or to cash it in via the issuer.

“Time is the enemy,” Kerstein explains. He does securities searches for US$39.95 per issue. He notes that if a bond-issuing company goes out of business with assets intact, then any value at-tributable to the issue in question reverts to the government of the jurisdiction in which the company is registered. The funds tend to be held for fi ve to seven years by each registrar. If the registered owner or claimant does not communicate with the holder of the funds, the money will move to the general account of the state or province, he adds.

Canada also has specialists in tracing old bonds and stocks. In Ottawa, Don G. Levy does securities tracing for $35 per security or company, starting with provincial and federal company registrars. He can be reached at [email protected]. It’s a sideline to his main work as a forensic accountant, he says. For do-it-yourselfers, a place to begin is the manuals published by FP Bond Books in Toronto, an affi liate of the National Post.

A company called Stock Search International Inc. in Tucson, Arizona, handles old fi nancial instruments. The fi rm, which was started in Montreal in 1969 by Micheline Massé, moved south of the border in 1988. “Our main business is to research cor-porate histories and to fi nd residual values in old instruments,” says Pierre Bonneau, Stock Search CEO. “There is no statute of limitations on fi nding value. If there is someone responsible for payment, the bond can be redeemed.” The company main-tains a database of 40,000 companies that are defunct or that have dropped out of sight or that have been privatized. “Our regu-lar research work takes six to eight weeks per company and we charge a fl at fee of US$85; however, if the research has already

96 C H A P T E R 4

been done, it is online for US$40,” Bonneau adds. Check www.stocksearchintl.com.

In New York, R.M. Smythe & Co., an auction house specializ-ing in numismatics and old stock and bond certifi cates, researches old bonds and stocks. “We do a few thousand issues a year and fi nd value in a small fraction of those that turn up, says Caleb Esterline, director of research. His company specializes in U.S. and Canadian issues. See www.smytheonline.com. “If the company is still in business, we go to the horse’s mouth and get the informa-tion directly,” he notes. “Each bond is case-specifi c and often there has been a settlement.” Even the most dubious securities can have value. Esterline notes that German bonds issued in World War II were covered by the London Debt Agreement of 1954, which set up parameters for payment of pre-1945 German bonds.

Those who want to do their own research can consult the bibliography of such resources as The Directory of Obsolete Securities published annually by Financial Information Inc. of South Plainfi eld, New Jersey (www.fi inet.com).

A list of resources for fi nding the value of old securities is listed at www.goldsheetlinks.com. Contacts for registrars of all provinces and territories and the 50 states are provided. A link to specialists in tracing British securities can be found at http://money.indepen-dent.co.uk/personal_fi nance/invest_save/article309865.ece.

The fact that a bond has been turned in and cancelled by the issuer or issued by a company that went bankrupt does not au-tomatically mean it has no value. A U.S. Steel Corp. 5% bond issued in 1901 for $100,000 and signed by Andrew Carnegie, who founded the company with the help of fi nancier J.P. Morgan, went on the auction block with an asking price of $70,000. Payable in gold at market price or in U.S. Treasury greenbacks, the bond had been paid and cancelled by the issuer. But negotiability is not the test of value in the market for antique or unusual bonds and stocks, collectively called scripophily.

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The fi eld is fi lled with bonds that are traded at the custom-arily wide spreads characteristic of the antiques trade. Yet retail prices asked for old bonds indicate their intrinsic value as curios. At www.scripophily.net, one can fi nd a 7% 1863 Confederate States of America issue with four annual coupons still attached priced at US$249.95. The Confederacy did not survive to make payment, but there is an active market for such bonds among U.S. Civil War buffs.

A £1,000 Province of Nova Scotia callable perpetual bond is-sued as “Government Redeemable Stock” in 1904 with a 3½% annual coupon and later paid and cancelled is available at time of writing from Scripophily.com for US$49.95.

A 10,000 Lei 4.5% Government of Romania World War II Loan issued in 1941 can be yours for US$59.95, also at Scripophily.com. Engraved in the Balkan realist style with images of a rickety bridge, naked maidens, a tank, a hay wagon, fi sh, and eagles, it is better as wallpaper than as a fi xed income instrument. The re-gime of the kleptocratic Romanian dictator, Nicolae Ceausescu, cancelled its obligation to pay bondholders. In 1989, Romania cancelled him, executing the man who called himself “the genius of the Carpathians” on Christmas Day.

Researching old bonds is a dying skill, for the rise of book-based securities means that there will be fewer instruments in future with printed pathways to transfer agents and issuers. Book-based regis-tration systems include that data, of course, but the option to sell an elaborately engraved bond or stock certifi cate in the scripophily market will decline. As that happens, the dwindling supply of old pa-per bonds will presumably become more valuable. Therein lies the best chance old securities have for regaining some of their worth. No security certifi cate is ever too old or too dubious to have value, if not as a security, then as a collectible.

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PRIME BANK NOTESIn the fi les of bond deals that have featured promises of staggering returns and, later, stories of crushed investors are so-called prime bank notes (PBNs). Marketed to people who are credulous enough to believe that they can get 40% to 60% and even higher rates of interest per month, they are frauds and nothing more. PBNs and similar scams are not much different than the infamous Nigerian bank letter that asks for money to participate in schemes to redeem money from nefarious deals. The PBN scam involves no system-atic bond risk. It is a ripoff.

PBNs have been around for about a decade. Peddled under aliases that include “seasoned bank debentures,” “fresh cut bank debentures,” “de-facto Treasury securities,” and “blocking of as-signed Treasury securities,” they all have offi cial-sounding names and purported links to the International Monetary Fund and the International Chamber of Commerce. IMF, for the record, does not issue such obligations, and the ICC, based in Paris, is a public relations and lobbying entity, not a fi nancial institution.

The Ontario Securities Commission has warned that come-ons such as purported secrecy and the need to keep offers hush-hush and referral fees to bring in fresh suckers are typical of the plans.17 The U.S. Securities and Exchange Commission issued an alert in 1993 as an interagency advisory to regulated fi nancial institutions, warning that fraudsters were using the names of major, well-known banks, the World Bank, and various central banks to promote PBNs. At best, warned the SEC, the deals were Ponzi schemes that would pay off early participants with money contributed by later participants.

One of the most ambitious schemes involving PBNs was based on bonds issued by bankrupt U.S. railroads in the 19th century. Investors were told that they could put $2,000 each into a plan to

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buy a share in the Galveston, Houston and Henderson Railroad’s 10% bonds issue in 1855 and then receive back $1.2 million over the next 12 months. The bonds did exist as collectors’ items. The money put up for the plan was to be wired to a bank in Tennessee.18 Needless to say, the railroad gambit and other proposals that so-licit money for what amount to impossibly high returns are not registered securities.

The common thread of the PBN plans is that they have bonds or other debt instruments as a foundation and a cloak of secrecy that, according to promoters, must be used to keep out the masses. The schemes use complex structures to explain how they can turn a single-digit bond return into a double- or triple-digit annualized return.

For some reason, perhaps lack of bond education by investors, perhaps because of sheer greed, even institutions have been suck-ered. In the United States, the National Council of Churches of Christ, a charitable organization, paid $7.98 million to buy $13.2 million face value of “prime bank guarantees” supposedly issued by a Czech entity called Banka Bohemia. The Chicago Housing Authority Benefi t Plan invested $12.5 million in a PBN scam.19

Prime bank notes continue to exist because people think they can get in on the huge profi ts that fi xed income derivatives play-ers were seen to make in Hollywood movies. Some traders have indeed made fortunes selling complex derivatives, though it is not clear that buyers have done as well. In a market as effi cient as the world bond market, debt issues worth over US$1 trillion a day are traded among thousands of commercial banks and central banks. In this market, bonds can be priced to three or four decimals by shrewd traders. Given this effi ciency, it is not possible for any investment-grade bond to pay four times the base rate for sover-eign bonds. If those deals exist, they involve dubious bonds that

100 C H A P T E R 4

may bankrupt the investor as readily as enrich him. If you are of-fered a bond deal or any scheme that provides impossibly high returns on fi xed income investing with no risk, do the shrewd thing: Walk away.

1. John Dizard, “The Yield-hungry Jostle for a PIK,” Financial Times, February 14, 2005, p. 24.

2. Carolyn Sargent, “Picking PIKs in Desperation Buyers Line Up for ‘Investment of Last Resort,’” Investment Dealers Digest, February 14, 2005. Rates for recent issues of PIKs were 700 to 800 basis points over the internationally used Libor (London Interbank Offered Rate). PIKs may be called by issuers at huge premiums over face value, which is a bonus for holders, but most of the time, they trade down and generate paper losses until—and if—they get monetized with real cash.

3. John Rothschild, Going for Broke: How Robert Campeau Bankrupted the Retail Industry, Jolted the Junk Bond Market, and Brought the Booming Eighties to a Crashing Halt (New York: Simon & Schuster, 1991), pp. 107–121.

4. Rothschild, pp. 260–65.

5. Paul Waldie, “Campeau Spouse Ordered to Pay,” globeandmail.com, December 6, 2004.

6. Allan Robinson, “Growth Predicted for Asset-Backed Securities,” Globe and Mail, January 17, 2005, p. B-9.

7. Laurie S. Goodman and Frank J. Fabozzi, Collateralized Debt Obligations: Structures and Analysis (John Wiley & Sons, 2002), p. 289.

8. Frank Partenoy, F.I.A.S.C.O.: Blood in the Water on Wall Street (New York: Norton, 1997), p. 52.

9. Partenoy, F.I.A.S.C.O, pp. 131, 196–97.

10. Partenoy, F.I.A.S.C.O, p. 200.

11. Alexander M. Ineichen, Absolute Returns: The Risk and Opportunities in Hedge Fund Investing (New York: John Wiley & Sons, 2003), p. 416.

12. See www.nickleeson.com.

13. Edward Altman, Andrea Resti, and Andrea Sironi, “The Link between Default and Recovery Rates,” NYU Salomon Center Working Papers Series S-04-4.

14. Standard & Poor’s LossStats Database for loans defaulted between 1987 and 2003.

15. James P. Owen, The Prudent Investor’s Guide to Hedge Funds (New York: John Wiley & Sons, 2000), p. 99.

16. Manmohan Singh, “Recovery Rates from Distressed Debt,” International Monetary Fund Working Paper WP/03/161, August 2003, pp. 8, 10.

Endnotes

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17. Ontario Securities Commission bulletin November 16, 2000.

18. David McLoughlin, “Railroad Bond Plan Exposed as Fraud,” The Dominion (New Zealand), April 4, 2001.

19. See http://www.fi ndarticles.com/p/articles/mi_m1058/is_n28_v111/ai_15839113. Also see http://www.crimes-of-persuasion.com/Crimes/InPerson/MajorPerson/prime_bank.htm.

Chapter 5

GLOBAL BONDS

A Tale of Promises and Defaults

There is good reason to diversify a portfolio by adding for-eign holdings. Whether the extension into faraway lands is

in real estate or stocks or bonds or anything else, theory has it that it is always a good thing to spread risk by asset, by style, by sec-tor, and by geography. The convergence of major nations into one global economy has not prevented individual nations from having their own periods of expansion and contraction. Expansion leads to rising interest rates as central banks try to restrain infl ation. Contraction in other nations leads to expansive monetary policy and lower interest rates. Those nations with rising interest rates may be expected to have falling bond prices. And those nations with falling interest rates will have rising bond prices.

Not everyone needs to have bonds issued by foreign countries. For example, a person who earns a living in Canada and plans to retire in Canada has no need to hedge bets with investments in pounds or euros. Yet if the same investor has substantial stock in-vestments in French telecoms or British banks, he may want to

104 C H A P T E R 5

hedge those equity exposures with sterling bonds or bonds issued in Euros, just as he might hedge domestic stocks with domestic bonds.

Foreign bonds tend to come into their own and to outperform domestic bonds when, for example, major world economies go into tailspins. That happened after the beginning of the Asian currency crisis of 1997 and the Russian defaults and the related collapse of Long-Term Capital Management in 1998. Governments around the world lowered interest rates in 1998 to overcome a world liquid-ity crisis. Global bond prices soared. In 1998, the Citigroup World Government Bond Index produced a 23.75% return compared to a relatively modest 9.18% return for Canada’s SC Universe Bond Total Return Index. The case for investing in global bonds is therefore making the most of an asset class regardless of national geography. That’s the good part. The hard part is timing world government interest rate trends where it counts in the G-7 countries (the United Kingdom, the United States, Canada, Italy, Germany, France, and Japan). Currency moves and monetary policy in faraway places are part of the complexity of the investment process.

It is possible to buy global bonds and then to hedge currency moves so that one is exposed only to foreign interest rate trends. That strategy has a price, for hedging usually reduces returns and tends to be available mostly to large investors. Some bond funds do hedge their foreign bond exposure, but the cost of hedging often comes out of the funds’ net asset values. Only in the event that the bonds’ reference currency declines against one’s own currency will the hedge prove valuable. However, predicting currency moves is at least as diffi cult as predicting interest rate moves. Malaysia, an Asian tiger, had an AA+ rating and Thailand an AAA rating in 1996. A year later, their currency and bond markets collapsed amid vanishing liquidity.1 Foreign holders of Asian corporate debt were clobbered on credit issues. Even if they had hedged their bonds with offsetting currency positions, they would have lost heavily.

105Global Bonds—A Tale of Promises and Defaults

Speculating on global economic trends is perilous, but a person planning to retire in the country whose bonds he buys is creating a natural hedge. The natural hedge does not provide an optimal return, but it allows the bondholder to operate in the foreign cur-rency without fear that the money of his new home country will collapse in value, leaving him with less spending power than he would like.

Default by borrowers is another risk. In spite of promises to make good on Tsarist bonds issued before the Russian Revolution of 1917–1918, successive Communist and post-Communist re-gimes have made only the slimmest of redemptions, leaving holders with essentially worthless paper. Bonds issued during the German hyperinfl ation that culminated in October 1923, other than those collateralized against fi xed assets, have remained worthless. A sur-vey of 113 bond-issuing countries by Standard & Poor’s showed that between 1970 and 1996, 69 had defaulted on their foreign currency debts.2 The list of deadbeats included countries from Angola to Zimbabwe. Recently, Grenada, Pakistan, Indonesia, Venezuela, Cameroon, Uruguay, Paraguay, and the resurrected nation of Russia have joined the club, though Cameroon resumed payments quickly and was thus only briefl y in default.3 The G-7 nations have not defaulted, but as health care costs and pension expenses rise with their aging populations, their credit quality will be called into question.4

If current trends in taxation and spending on health and welfare costs do not change, then the bonds of all European G-7 countries, except Italy, which is reducing the cost of debt service, will be chal-lenged in coming decades. According to Standard & Poor’s, U.S. general government debt will soar to 239% of Gross Domestic Product by 2050, compared to 65% in 2005. France’s public debt will reach 235% of GDP against 65% in 2005. Germany’s public

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debt will rise to 221% compared to 68% in 2005, and the U.K.’s public debt will rise to 160% of GDP compared to 42% in 2005. Italy, the exception to the EU trend, will see its public debt fall to 92% of GDP from 104% in 2005.5 Each of these G-7 nations has the ability to self-fi nance through printing its own money. And Canada, which currently is the only G-7 nation to run a surplus, may turn out to be the Switzerland of the New World, awash in profi ts from its resource industries and able to pay down its public debt at the expense of the nations that import its products.

Rising ratios of public debt to GDP will have a negative ef-fect on the ability of the United States and of most G-7 nations to pay their bills, said the S&P study, In the Long Run, We Are All Debt. Wrote the study’s author, Moritz Kraemer, “All [European] ratings, Italy excepted, would come under severe pressure and all would eventually display fi scal characteristics that would better be-fi t speculative-grade sovereigns,” explained the S&P gloomsters.

In effect, the S&P rating of sovereign U.S., German, French, and U.K. debt will fall from today’s AAA ratings to sub-investment grade, speculative levels. France will achieve junk status between 2020 and 2025, Germany between 2025 and 2030, the United States around 2029, and the United Kingdom by 2035, the report noted.6 Each nation will, however, be able to tax or print money to pay its bonds.

The investor attentive to risk should check the public debt lev-els of sovereign issuers of bonds being considered for purchase. There is no one right answer as to what level of debt is too high, but ratings are infl uential guides to investment. The risk-averse investor should probably stick to medium-term bonds with not more than ten years remaining to maturity. Canada, which has managed to shrink its public debt and to reduce debt service charg-es as a fraction of government spending, could emerge as the best credit in North America.


It is not inevitable that nations’ bonds fall into the abyss of junk. If the governments threatened with the collapse of their debt ratings had moved to balance their budgets in 2005, then “their debt ratios by 2050 would be only half as large as under the ‘no change’ scenario,” Moritz said in GARP News, a publication of the Global Association of Risk Professionals, in a March 23, 2005, bul-letin. One would think that sensible governments would raise taxes, postpone retirement ages, or defi ne health benefi ts more carefully in order to preserve the integrity of their public fi nances.

When a foreign government defaults on its bonds, investors have to resort to diplomacy, for nations, unlike corporations, can make it very hard for foreign creditors to seize assets. A factory or an airplane that belongs to a corporation can be seized, even if with diffi culty. A nation is a much harder case.

THE ARGENTINE FIASCOWhat can happen to foreign bondholders is illustrated by Argentina’s 2001 default on bonds with a principal value of US$81 billion plus accrued interest. Pegged to the U.S. dollar in 1991, the Argentine peso seemed like a good thing to foreigners. The peg meant that there was no foreign currency risk, at least not for U.S. investors. Non-U.S. investors could also take heart that any bonds they bought would not be in anything resembling funny money.

Argentina’s foreign investors did not count on the possibility that the land of the pampas would be unable to earn enough U.S. dollars to make payments on the bonds. Added to the Peronist leg-acy of extensive social welfare payments, the weight of the bonds on the Argentine treasury proved to be too much.

By October 2001, with rioting in the streets of Buenos Aires, Argentine bonds had gained the distinction of being the worst foreign credits in the world.7 The Argentine bonds represented a fourth of all emerging market debt in the world and were trad-ing at 2014 points over U.S. Treasuries, an incredible premium, to

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yield 42.6% for investors with the guts to buy or to hold the bonds against the market’s clear implication, implicit in the sky-high premium, that the government could not and indeed, subsequent-ly did not, pay interest due. The bonds, rated a dismal Caa3 by Moody’s, refl ected the country’s inability to service public debt that totalled US$132 billion.8

The Argentine dilemma was in many ways typical of emerg-ing market defaults. Unemployment in 2002 reached 21.3% of the labour force and half the country lived in poverty, reported The Economist.9 After a run on banks followed by limitation of withdrawals and then a closing of banks, the country had riots in the streets. To pay public debt, the nation had to generate a tax surplus, though it is tough to extract revenues from people living in poverty. Even if the government did make use of its so-called social provision, it would not do much. The nation’s public debt, at US$185 billion, was 143% of its Gross Domestic Product.10

When borrowers default, lenders line up to be paid. The lenders with the most lawyers tend to get paid fi rst. The Argentine default was no exception. The International Monetary Fund wanted to give the country more time to pay, the U.S. government did not want to exacerbate international tensions, and at the end of the line stood the small investors.11 About 44% of Argentina’s debt was held by small investors, including 450,000 Italians, 35,000 Japanese, and 150,000 Germans and central Europeans.12 The Argentine bonds had seemed like good deals in the late 1990s as European interest rates fell. For many investors, the yield advantage turned to a rout, for they suffered not only a decline in income, but also a loss of capi-tal. Some had to forego eating in restaurants and taking vacations.13 To collect on the defaulted bonds, some tried seizing Tango 1, the plane used by the president of Argentina. Another group of credi-tors tried seizing La Libertad, a training ship of the country’s navy. Both efforts were of no avail, reported the Wall Street Journal.14


By the end of February 2005, Argentina had worked out a deal with creditors that was all but legalized theft. Up to 80% of hold-ers of defaulted bonds took an offer that required them to accept a 70% write-off on bonds that had grown to US$102 billion of principal and unpaid interest. Bondholders would receive US$41 billion of new bonds.15 with extended maturities out to 42 years. It is worth noting that no large Latin American government has ever fully repaid a 30-year bond.16 The severity of the reduction of val-ue suffered by holders of Argentine bonds can be seen in the usual workouts of emerging markets debt. According to an International Monetary Fund survey, the annualized returns to buyers of de-faulted debt work out to 57%.17 In other words, investors with the means to speculate in defaulted debt and to hold it until lawyers and diplomats arrange some sort of payments on the bonds even-tually make out handsomely. No such returns are foreseeable for holders of the Argentinean bonds nor even for those who buy them at market discounts. In the end, the Argentinian workout sets what The Economist called a “painful new benchmark for creditors.” As the British newsweekly put it, “In other restructurings, creditors have had to accept either a cut in principal, a lengthening of matu-rity or a reduction in interest payments. Argentina has achieved all three.”18 The lesson for private investors is that the yield gain that often comes with foreign bonds and especially emerging market bonds is probably not worth the risk.

A few emerging markets nations have achieved fi rst world fi nancial stature. Mexico, for example, has moved from being a casualty of bad economic management and kleptocratic govern-ment to being a respected credit whose bonds trade at relatively small premiums to U.S. Treasury debt. It is the exception, and for every Mexico there remain dozens of future deadbeats that come to market with a story, some good recent news, and a prom-ise of exceptional returns. To all of that, one can only recall what

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Robertson Davies had to say about phoney promises: “Prophecy consists of carefully bathing the inevitable in the eerie light of the impossible and being the fi rst to announce it.”19

PARMALAT: A CASE OF BONDS GONE SOURSome of the most egregious defaults on global bonds originate in corporate malfeasance. The case of Parmalat Finanziaria SpA, a holding company for an Italian dairy conglomerate, illustrates the risks of buying into business in faraway places. But the foreign character of Parmalat is not the catalyst of the case, for compa-rable disasters are to be found in the collapse of Enron Corp. and WorldCom. Location puts the Parmalat case into the global bond dossier, and, indeed, the actions of the government of Italy to help its citizens in the case are exemplary.

Parmalat was actually two companies before its fi nancial con-dition began to unravel in 2003. One company operated in Europe and North and South America through wholly owned units that made a good living with dairy products. The other company was the holding entity that put fi ctitious assets on its books, borrowed heavily in spite of its claims that it had billions in cash, and was the personal piggy bank of founder Calisto Tanzi. In 1961, building on his father’s business, he had set up the company that, after four decades of expansive growth, became the biggest corporate fraud in European history.

Parmalat’s undoing was the issuance of a fresh issue of bonds even though the company was supposedly fl ush with cash. Tanzi, the CEO of the company, dismissed analysts’ worries about Parmalat’s debt. Those worries piled up and, on December 19, 2003, Parmalat confi rmed that an account it had claimed to have at the Bank of America with €3.95 billion in cash did not exist. Parmalat quickly became Europe’s Enron, a scandal of operatic proportions. Parmalat was, after all, Italy’s eighth-largest company, and not only had it had


created a global consumer brand, but it was a leading producer of such things as shelf-stable milk that needed no refrigeration. Tanzi, fi ngered as the chief culprit in what has turned out to be a global scandal, has been revealed as a kind of traditionalist. Arriving at an interrogation on January 5, 2004, he told reporters, “I wish you and your families a slow and painful death.”20

It turned out that Parmalat borrowed money around the world from banks and retail bondholders, providing fi nancial statements that were fat with fi ctitious sales. Outside auditors are accused of having been complicit in the brewing of the fi nancial statements, and a company lawyer, Gian Paolo Zini, chief partner in New York-based Zini & Associates, was jailed in Parma, Italy—the company’s global base. Other company offi cials were fi ngered as the frauds unravelled, including treasurer Fausto Tonna and a couple of bean counters from Grant Thornton LLP, a company auditor.

As investigators in Italy and other jurisdictions in which Parmalat operated combed its accounts, they found fables worthy of the Brothers Grimm. To make Parmalat’s books seem right, other accountants cooked up a phoney milk producer in Singapore that purportedly sent 300,000 tons of milk powder to a Cuban importer via a Cayman Islands subsidiary that held the Bank of America account. An investor getting wind of these machinations may have wondered why a milk company had to operate in a tax haven for milk sales to a Communist country. Opacity may have been the reason, for neither Cuba nor the Caymans are known for being forthcoming about their fi nances. The deals booked fi ctitious sales, charged imaginary costs for them, and produced receivables that banks were happy to monetize into real cash. The actual li-abilities went onto books of subsidiaries in the tax havens.21

Journalist Peter Gumbel, writing in Time magazine’s December 13, 2004, issue, made a critical observation about the scandal. “If Parmalat had gone bust in 1995, when it could no longer fi ll all

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its funding needs in Italy, it would have been a mid-sized Italian failure with debts of about €560 million. Instead, Parmalat took its warped fi nances global. By the time of the collapse eight years later, it owed its investors €14 billion.”22

The deeper scandal of the Parmalat fi asco may not be in its fi -nancial misdeeds. Rather, it is in the blindness of fi nancial analysts who kept the company’s rating up to investment grade until just 10 days before it collapsed. Investment analysts around the world were largely happy with the company. According to one study, three-quarters of these analysts covering Parmalat had a “buy” or “neutral” rating on its stock, according to Gumbel.23

What the analysts did not see is that a company that had dabbled in things as distant from cows as television broadcasting had blown its bank accounts on bad deals and then invented deals that covered up what would have been losses for every year from 1990 onward. A global web of spreading subsidiaries around the world in such places as Brazil and Uruguay, not to mention Canada, on top of a method for double-billing Italian supermarkets so it could be paid twice for each shipment, kept receivables looking robust. A compa-ny called Buconero was used to put new clothes on debt. Buconero, which means “black hole” in Italian, was just that. Parmalat’s receiv-er, Enrico Bondi, has pointed to the entity as evidence of the guilt of the company offi cers and agents who were part of the deal—an estimated 300 pencil pushers in the company.

There had been omens of the doom to come in questions raised by auditors in Argentina, Malta, Milan, and New York. One secu-rities analyst in London, Merrill Lynch’s Joanna Speed, found the accounts incomprehensible and issued a sell recommendation on Parmalat’s shares.24 Yet lenders were not overly concerned. Time’s Peter Gumbel reported that Bank of America CEO Kenneth Lewis told Tanzi, “We’d love to do more business with you guys.” Ironically, a Bank of America managing director in Milan, fi red by


the bank for supposedly improper expense accounting, got a job at Parmalat. Later, it was revealed that the banker, Luca Sala, had gotten money from Parmalat under the table. The money went into Swiss accounts held in a pseudonym. And as other Bank of America offi cials wondered why Parmalat was going to the market with yet more bonds in spite of promises it would not add more burdens to its balance sheet, Sala pacifi ed them by fi lling up empty suitcases with cash – as much as US$900,000, Gumbel reported.

By the end of 2003, Parmalat’s global scams were unravelling. Investigators around the world were poring over the accounts of lenders from Citigroup to Deutsche Bank, UBS, and Morgan Stanley, and the affairs of auditors Deloitte & Touche and Grant Thornton. Calisto Tanzi was arrested by police in Milan along with two of his children, a brother, a daughter, and various Parmalat staffers. One employee, Angelo Ugolotti, offi cially a senior clerk, was on the board of 25 Parmalat subsidiaries, many offshore. Ugolotti has said that he did not know he was on some of those boards.25 Parmalat’s fi nancial éminence grise, Fausto Tonna, has negotiated for a relatively short prison term. He has said that, while guilty of much artful accounting, he was only doing what Tanzi told him to do.26

For its part, Italy has stepped up to take fi nancial responsibility for what happened to its investors. About 100,000 Italians bought Parmalat bonds. As well, 450,000 Italians held Argentine bonds. All would be compensated in some fashion by a plan due to be fi nalized by May 2006. The concept appears to be to force banks and invest-ment funds to pay victims of those and other scandals and others in the future.27 For its part, Parmalat Finanziaria SpA is rising like a phoenix out of the ashes of its past: 1.6 billion shares in the new version of the old company, name unchanged, began trading on the Milan bourse on October 6, 2005, at a price of €3.15 each.28

There is a lesson to be learned from the defaults of sovereign borrowers and from the Parmalat debacle: The farther the investor

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is from the asset into which he sinks his money, the greater is his knowledge risk. The investor can cope with the information gap by studious, disciplined reviews of the fi nancial statistics of the borrow-ing countries and by attention to news from corporate borrowers. G-7 nations’ fi nances are accessible and accurate to the permissive international standards. Many third world countries’ statements tend to be inaccessible, unreliable, and politically inspired. One should make an exception for countries in central Europe that are on their way to EU membership and for the statements of an Asian pussycat soon to be a tiger—Turkey. But the investor who plunges into high-yield offerings from nations ruled by military juntas and dictators will have only himself to blame when, as data show, they default. They point to empty pockets even as their leaders send more planes to Zurich packed with lenders’ cash.

THERE ARE NO CINDERELLASIf one stands aside and asks who is at fault in the Argentine and Parmalat cases and others in which lenders offer remarkably high returns for what seem to be low or reasonable risks, then some of the guilt surely falls on the victims. If the market can trade bonds only when they are discounted to yield twice what government bonds yield in the nation of issue, the writing is on the wall. The bond market is dominated by institutions that are able to get good advice and pay analysts handsomely to check the credit of issuers. The retail investor who steps up to invest when institutions will not should recall Plato’s comment, “Everything that deceives may be said to enchant.”29

There is protection against bad deals and it is easy to obtain. Credit raters like Standard & Poor’s provide debt ratings and cor-relate them with observed default histories. Not surprisingly, AAA, AA, and A credits do not default within ten years of bond issue. BBB-rated bonds, according to data, begin to default in the second


year when 0.98% fail to meet their obligations, and in subsequent years rates rise as high as 9.84%. BB-rated bonds have a default rate of 3.66% in the fi rst year of issue, 6.58% in the second and following years. Speculative-grade bonds below CC default consis-tently from 2.68% in the fi rst year to 4.39% in subsequent years.30 Meanwhile, over seven years following issue, corporate bonds in local currency have default rates from 0.24% on AAA bonds, rising to 3.36% on BBB+ credits and then to 13.84% on BB credits and fi nally to an extraordinary 53.39% on CCC and CC bonds in the local currency.31 With this evidence of default, the prudent investor will stick to A-rated bonds or better and buy lower-grade foreign bonds only through pools or funds that specialize in such invest-ments. But the Parmalat case and other sudden-death insolvencies show that rating agencies are fallible. The cautious investor will recognize their potential for error and create a buffer by limiting commitments to the losses he can afford. After all, if a distant com-pany offers an asset with a return that is out of scale for its industry or country, it’s probably because the market is expressing disbelief by marking down its price. The chance that a bond issue that other investors scorn will turn out to be a golden coach is slight. In the end, if an asset looks like a pumpkin, it probably is.

The risk-seeking investor and the sophisticated bond inves-tor can approach the default issue as a cyclical play. Investors who are courageous or canny can buy bonds of issuers moving up in respectability. Such plays have paid off handsomely on the debt of Chile, Mexico, Hungary, Poland, and Slovakia. A common strat-egy in this niche of fi xed income arbitrage is to play the linked phenomena of fi nancial recovery and resulting upgrades. Thus, following the Asian currency crisis of 1997, when the Hedge Fund Research Fixed Income Arbitrage Index dropped by more than 5%, the JPMorgan Bond Index showed a corresponding recovery a few months later. A similar pattern developed with the Russian

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debt crisis in the fall of 1998 with a 10% drop followed by a 10% gain. Finally, the tragedy of September 11, 2001, produced a nearly 15% drop in bond fi xed income arbitrage values followed by a 6% gain in subsequent months. But this is no playpen for dilettantes. After the losses of 1998 associated with the Russian debt crisis and the collapse of Long-Term Capital Management, the fi xed income arbitrage index did not recover until April 2001.32

BRADY BONDSAn epidemic of defaults by emerging markets nations in the 1980s left institutional investors holding wads of worthless paper. U.S. Treasury Secretary Nicholas Brady then headed a plan to restore liquidity to the market for third world debt. The plan not only gave some respect back to third world sovereign borrowers, but restored liquidity to the market for emerging markets bonds, pro-vided a way for institutions to sell their bonds, and created a new market for bonds of defaulting nations that were backed by the U.S. government.

The plan, which Brady launched in 1989, required that credi-tors would grant relief to the borrowers in exchange for improved chances of collecting at least something on outstanding debt. The borrowers promised economic reforms. The result, cobbled together by the Treasury, made dubious and defaulted debt marketable.

Brady bonds have helped to produce strong returns for emerg-ing markets bond funds. Brady bonds are fading away as older issues mature. According to Morningstar Inc., a Chicago-based mutual fund data service, there were US$150 billion of Bradies outstanding in 1995 compared to just $25 billion as of January 2005. The decline of volume has left the Brady market as a core of emerging markets bonds with complex but valuable U.S. Treasury guarantees.

Brady bonds, in spite of the handiwork of the U.S. Treasury, are targeted at institutional more than individual investors. Bradies


are intricate, diffi cult to value, and tend to trade in a narrow mar-ket of specialists. But some U.S. bond funds available to the public hold them. To understand those funds, it’s useful to know about the background to the Bradies.

The issuing nations are a list of past defaulters like Mexico—the country whose 1982 default eventually led to the Brady debt relief plan. There are rehabilitated borrowers like Poland whose bonds have produced superb returns for holders and which are close to entering fi rst world bond markets. And there are countries like Bulgaria which, relieved of their past dictatorships, have joined the world’s community of open economies. Other Brady issuers have included Costa Rica, Ecuador, Peru, and the Philippines.

Shopping in the Brady market takes well-honed bond skills. There are par bonds due to be redeemed at the face value of the original sovereign loan. The principal of these bonds is collateral-ized and guaranteed by the U.S. Treasury using zero coupon bonds held in escrow. There are discount bonds that are supposed to rise to an original face value of sovereign loans with fl oating interest rates. The principal of these bonds is also guaranteed by the U.S. Treasury. There are also debt conversion bonds and capitalization bonds with stepped interest rates with deferred payment schedules.

Figuring out the value of Brady bonds is a demanding task. Each bond is treated by the market as having three components, each priced separately. The bonds contain a U.S. Treasury-guaranteed principal component that can be viewed as though it is a U.S. bond. There is a stream of future interest payments that is not guaranteed. And there is a future market price for the bond that may be affected by the future value of the U.S. dollar and the ability of the borrower to pay off the bonds or loans.

As one might expect, the complexity and coupon risk of Brady bonds makes their market prices volatile. Investors interested in Bradies can check research and the state of the market for specifi c

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issues at www.bradynet.com. The discussions are frank, as in this comment on Brazilian 12% bonds due November 17, 2006: “Get a life, if you have this kind of doubts [sic], you should not be holding Brazilian bonds….”

GLOBAL REAL RETURN BONDSInvestors buy bonds for their estimated total return over the term of the bond or the period during which it is expected to be held. With a conventional bond, that’s the present value of the coupon stream plus the principal at maturity. There are numerous valuation tech-niques, but all refl ect the issues of the dependability of payment and the effect of infl ation on the future value of the cash fl owing from the bond and the ultimate redemption of principal.

Government bonds in their local currency are assumed to have little or no credit risk. Indeed, the bond market refl ects a zero level of worry that bonds from G-7 nations or from the senior govern-ments of Australia and Sweden will be dishonoured. The risk to holders of these top-level government bonds is infl ation.

It is a valid worry. In 2005, soaring oil prices have renewed the spectre of infl ation moving up to levels not seen for a decade or more. In March, as oil hovered in the mid-$50s range, Goldman Sachs Group Inc. predicted prices could rise to as much as $105 a barrel, far above its previous call for oil to rise to the $80 range.33 (All prices are in US$.) Stir oil into the global recovery story and the spectre of unrelenting growth of the Chinese economy. Then suspend disbelief, for $100-a-barrel oil would be likely to stifl e economic growth and a good deal of Chinese expansion. But the smell of infl ation is in the air and the prospects for long bonds are dimmed by what could be rapidly rising infl ation rates.34

Infl ation-linked bonds are the antidote to infl ation fears, for they are structured to push their payouts upward as infl ation rises. Faced with rising infl ation, these bonds, often called “linkers,” gain value, even as conventional bonds drop in price.


The concept of infl ation-linked bonds is venerable. In 1780, the Massachusetts Bay Company sold a kind of infl ation-linked bond tied to the price of beef and shoe leather. The concept didn’t take off and went dormant until, in 1950, Iceland sold its version of linkers to deal with a 15% infl ation rate then raging in the North Atlantic island state.35

The idea of connecting bond payments to infl ation rates came back into fashion in 1981 as consumer price indices in the United States, Canada, and several European countries showed double-digit growth. In 1981, the United Kingdom sold a £1-billion package of linkers, followed by issues of similar bonds in Canada in 1991, Sweden in 1994, and Australia in 1985. In 1997, the United States brought its Treasury Infl ation Protected Securities to mar-ket. In 2003, Greece and Italy sold linkers and, fi nally, in 2004, Japan brought out an issue.36 Linkers have also been issued by Mexico, South Africa, and Israel.

Linkers, including Canada’s Real Return Bonds, work on simi-lar principles no matter where issued. Sold as long bonds, they have a fi xed coupon and reset their cash payments by adjusting the value of the bonds’ principal. The infl ation link concept gives comfort to investors who no longer need worry that their assets will fi zzle in value.

For example, a $1,000 10-year linker with a 2.0% annual real coupon purchased in 2005 with a 3% annual infl ation expectation would be paid 2% of $1,000. The principal would begin to rise, reaching $1,344 at the end of the 10-year life of the bonds. Actual interest payments will rise. In 2015, the holder would receive $26.88, which is what $20 would have risen to after a decade of 3% infl ation. The bond would then be redeemed at $1,344.

The concept is irresistible to investors worried about infl ation, but it works only if infl ation runs at a rate above the rate implicit in the bonds’ market price. If a conventional bond with a 30-year

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term yields 6.0% to maturity and an infl ation-linked bond is priced to yield 2% to maturity, then the infl ation rate implicit in the 2% nominal coupon of the linker assumes 4% infl ation on average for the next three decades. If infl ation exceeds 4% on average for the period, then the linker will turn out to have been a better bet than the conventional bond. If infl ation is less than an average of 4% per year for 30 years, the linker will have been a costly error.

Linkers have discounted most of the infl ation that consensus forecasts predict for many years ahead. The world has come to have faith in the ability of major central banks to control their domestic infl ation rates. That confi dence has set break-even infl ation rates above which the linkers have recently paid a return over conven-tional bonds at 2.56% in the United States, 2.95% in the United Kingdom, 2.72% in Canada, 2.23% in France, 2.17% in Sweden, and 2.65% in Australia. Making long-term predictions for interest rates is a hazardous profession, but it is clear that the market has been willing to pay a premium for infl ation protection, a premium so high that it will take infl ation at rates not expected in G-7 and other senior issues of linkers.

Bond market watchers have at times been perplexed by the exceptional popularity and success of linkers, the value of which is diffi cult to determine in comparison to conventional bonds. Linkers, after all, guarantee only a post-infl ation return, not a known or agreed cash return. Yet linkers are wildly popular with institutions and individuals. In Canada, for example, the $1.7-billion TD Real Return Bond Fund posted an 11.84% average annual return for the three years ended December 31, 2005, com-pared to the 6.77% average annual gain of the SC Universe Bond Total Return Index for the period. The TD fund has a 1.62% man-agement expense ratio, so the fund’s gross return was really 13.46% per year for the three-year period. That kind of return, which is based on trading four Canadian Real Return Bonds and a few small


issues issued by Quebec, speaks not only to the skill of the fund manager, but to the keen desire of fund investors to avoid being ground down by infl ation. So far, owners of linkers have suffered very little, for the market has kept rising even as the prospects for long-term global infl ation have been modest.

Infl ation-linked bonds have had robust support around the world for a variety of reasons. Governments have issued them in preference to conventional bonds because, given the market’s appe-tite for infl ation insurance, the bonds have sold well with relatively low nominal coupons. Insurance companies have used linkers to provide infl ation-adjusted pensions for annuitants. Perhaps the most unusual launch for linkers was in Japan where, on March 4, 2004, in the midst of a continuing defl ation, the Ministry of Finance sold ¥100 billion (equivalent to US$920 million at the time) of infl ation-linked debt as a part of a plan to issue up to ¥700 billion by the end of March 2005. Linkers should fall in payout and value under defl ation, but the bonds were received by the market with the understanding that the episode of price declines would end in 2006. The Bank of Japan, a major holder of conventional bonds, can use the linkers as a hedge against the infl ation it would like to generate. As infl ation returns, the conventional, fi xed-rate bonds it holds will tumble in price. The linkers would soar with the same scenario.37

It is tempting to buy linkers, for they seem to provide a fl oor for any portfolio intended to cover the costs of retirement. If you want to retire in, say, Mexico, which has issued linkers, then its linker is a natural. There are problems, however. Only the United States, the United Kingdom, France, and Canada have AAA rat-ings on their linkers. Mexico has a BBB– rating, which is not quite as secure as one might like a retirement account. Some linkers are thinly traded. The only nations with linkers with face values at issue over US$10 billion are the United States, the United

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Kingdom, France, Sweden, Israel, Canada, and Italy.38 Smallish bond issues suffer from lack of liquidity and are often traded with large spreads between prices quoted for sale and purchase. If the bonds are held to maturity, the lack of liquidity is not a problem. For investors who may want to trade linkers, lack of liquidity, espe-cially on trades below $1 million, may require giving up substantial return. Nevertheless, the global market for infl ation-linked bonds is signifi cant. As of the end of 2004, it had about US$600 billion in tradable bonds.39 That’s about twice the size of Canada’s outstand-ing federal bonds.40

IN SUMGlobal bonds offer an opportunity to reduce portfolio risk through ownership of assets that do not dance in synch with domestic Canadian economic trends. Global bonds also add minefi elds of additional risk from foreign currency variation and default by for-eign governments to systematic risk such as unforeseen increases in foreign interest rates that drive down prices of foreign conven-tional bonds.

The wise bond investor should sort out the advantage of hav-ing at least some issues that do not move in lockstep with Canadian bonds with the costs and risks of managing what may be faraway assets. The farther away the asset or the less proven the issuer—the critical problem in emerging markets bonds—the more important it is either to use a professional bond manager or, if the costs of such management appear to outweigh the potential gains from holding global bonds, to stay with domestic bonds. Plans to retire in a ju-risdiction increase the usefulness of owning its debt. Investment theorists like to say that return increases with risk. It probably does, although it is hard to prove. The theory may work for stocks over long periods that may stretch out for decades or even centu-ries, but for almost all bonds, time is fi nite. The wise bond investor


should therefore realize that money put into the bonds of compa-nies and governments of faraway places can present risks that make a problem like the insolvency of a domestic airline seem hardly a diffi culty at all. Global bonds trade in markets in which rules either do not exist or are determined only after costly international litiga-tion and workout that can take years. May the global bond investor beware of the problems of managing assets far from home.

1. Annette Thau, The Bond Book (New York: McGraw-Hill, 2001), p. 226.

2. Thau, The Bond Book.

3. John Chambers, 2004 Transition Data for Rated Sovereigns, Standard & Poor’s, March 9, 2005, p. 10.

4. Moritz Kraemer, In the Long Run, We Are All Debt: Aging Societies and Sovereign Ratings (London: Standard & Poor’s, 2005).

5. Kraemer, In the Long Run, We Are All Debt.

6. Kraemer, In the Long Run, We Are All Debt.

7. Bloomberg.com, October 29, 2001.

8. Bloomberg.com, October 29, 2001.

9. Economist.com, December 4, 2003.

10. Economist.com, December 4, 2003.

11. Tony Barber, “Italy aims to redress retail investor loss,” Financial Post, January 13, 2004, p. FP9.

12. Wall Street Journal, January 14, 2004, p. A-1.



15. “Holders of Argentine debt to take 70% ‘haircut,’” Globe and Mail, February 25, 2005, p. B7.

16. “Short back and sides all round,” The Economist, March 5, 2005, pp. 40–41.

17. Manmohan Singh, Recovery Rates from Distressed Debt—Empirical Evidence from Chapter 11 Filings, International Litigation, and Recent Sovereign Debt Restructurings (International Monetary Fund Working Paper WP/03/161), p. 10.

18. The Economist, March 5, 2005.

19. Robertson Davies, Samuel Marchbanks’ Almanac, quoted in John Robert Colombo, New Canadian Quotations (Edmonton: Hurtig, 1987), p. 304.

20. Securities Litigation Watch, January 6, 2004.

Endnotes

124 C H A P T E R 5

21. Peter Gumbel, “How It All Went So Sour,” Time Europe, December 13, 2004.




25. Raphael Minder and Fred Kapner, “Tanzi relatives arrested in Parmalat case,” Financial Post, February 18, 2004, p. FP-4.

26. Alessandra Galloni, “Parmalat talks may lead to prison terms for executives,” Wall Street Journal, February 24, 2005, p. B-12.

27. Barber, “Italy aims to redress retail investor loss.”

28. “Parmalat returns to Milan market,” October 6, 2005, BBC News, http://news.bbc.co.uk/.

29. Plato, The Republic, Book III, 413.

30. Chambers, 2004 Transition Data for Rated Sovereigns, p. 12.

31. Chambers, 2004 Transition Data for Rated Sovereigns, p. 18.

32. Alexander M. Ineichen, Absolute Returns: The Risk and Opportunities of Hedge Fund Investing (New York: John Wiley & Sons, 2003), pp. 229–33.

33. Reuters, “Goldman Sachs: Oil Could Spike to $105,” Energy Bulletin (www.energybulletin.net), March 31, 2005.

34. Reuters, “Goldman Sachs: Oil Could Spike to $105.”

35. “A Guide to Global Infl ation-Linked Bonds,” PIMCO, January 2005.

36. “A Guide to Global Infl ation-Linked Bonds.”

37. One should note that infl ation has indeed returned to the land of the rising sun. In November 2005, Japanese prices rose for the fi rst time in two years, heralding the nation’s long-awaited refl ation. See TimeNet News, December 27, 2005.

38. Barclay’s Capital Infl ation-Linked Bond Indices January, 2004, p. 9.

39. “A Guide to Global Infl ation-Linked Bonds,” p. 1.

40. Bank of Canada Weekly Financial Statistics, December 30, 2005, p. 16, table G-4.

Chapter 6

WHAT’S A BOND WORTH?

Bonds trade in an auction market that makes a stock market seem like a slow game of checkers. Bond prices change by the

second and it’s only the swift who know what they are prepared to pay who can get really good deals and the best returns available at any moment.

Bonds are priced on the amount and the security of their in-come streams. Two major factors infl uence that stream: one, the sensitivity of the bond to future changes in interest rates, and two, the odds that the issuer will make all payments due and pay back principal on time. Interest rate sensitivity is math that we’ll handle without formulas. Credit issues are much more a matter of instinct cultivated by common sense and experience.

PRICING GOVERNMENT BONDSA bond with a high coupon interest rate relative to current interest rates will, prior to its maturity date (at which time it will sell for its face value), sell at a premium to a new bond issued at the current interest rate.

126 C H A P T E R 6

Thus a bond issued with a 7% coupon and, say, 30 years to run to maturity, will sell for about twice the price of a new bond issued at a current interest rate of 3.5%. If a bond were issued at 6% with the same 10-year term to maturity and interest rates rose to 12%, the 6% bond would sell for about half the price of the 12% bond. The fi rst bond, if purchased at a premium price, will generate a capital loss if held to maturity; that loss will reduce the sum of annual returns prior to maturity. The latter bond, purchased at a discount, will rise in price and produce a capital gain that raises the sum of annual returns prior to maturity.

Government bonds that have no question of credit qual-ity, given that their coupons are certain to be paid and their face value paid at maturity, trade solely on duration, which is the sum of the time-weighted fl ows of cash that they produce. Corporate bonds, which can default since their issuers do not have the power to tax or to print money, also trade on their credit quality. Thus for corporate bonds, duration and credit issues determine price. As credit quality declines, credit issues become more important than duration. And at the very edge of credit worthiness, when bonds are near default, all that matters in bond pricing is the chance of default and, perhaps, of even-tual recovery.

DURATIONGovernment bonds provide the foundation of bond pricing. Bonds with no default risk trade on the relationship between bond prices and interest rates. Bond prices rise when prevailing interest rates fall. That’s because the stream of fi xed interest payments becomes more appealing when new bond issues are more stingy. Conversely, if interest rates rise, existing bonds with fi xed coupons are less de-sirable. The prices of old bonds must then fall to let their current yields match what the market offers.

127What’s a Bond Worth?

Unfortunately, bond prices do not work on this perfect teeter-totter principle. Long bonds, those with maturities of 10 or more years, tend to rise and fall more than short bonds, those with ma-turities of less than 5 or 10 years (the defi nition varies, depending on application), for any interest rate change, and high-coupon bonds fl uctuate less in price than low-coupon bonds when inter-est rates rise. Both maturity and coupon are part of the pricing process. The problem is to understand how they work together.

Bond investors had nothing more than hunch or experience to guide them in trading bonds until near the end of the Great Depression. The year before German troops invaded Poland, American economist Frederick R. Macaulay published his classic work on the movement of bond prices and yields. His book, Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields and Stock Prices in the United States Since 1865, was a defi ning moment in the history of fi nance.1 Macaulay created an equation that for the fi rst time allowed bonds with no default risk to be priced accurately. Using the formula, both sellers and buy-ers could determine the exact value of a bond and then haggle on either side of it to arrive at a trade.

Macaulay’s formula calculates the value of a stream of repeating coupons over time to produce a weighted average of the present value weights of every payment. The result, called Macaulay dura-tion, puts a value on the sum of the components of the payment stream. It is the length of time until the investor receives the average present value-weighted cash fl ow.2 The concept of duration may seem hard to comprehend, but it is one of the major concepts in bond investing. One need not understand the mathematical basis for duration, but every bond investor needs to be sensitive to its im-plications. With that understanding, the bond investor achieves a level of sophistication that was rare until a few decades ago.

128 C H A P T E R 6

That understanding comes down to this and we’ll put it in caps as an indication of its importance:

AS DURATION RISES, BOND PRICES BECOME MORE VOLATILE. AS DURATION FALLS, BOND PRICES BECOME LESS VOLATILE.

Macaulay’s formula helped distinguish bonds with similar total payments but very different ways of producing them. For example, for two bonds with 10-year terms to maturity, one a strip that pays $2,000 at maturity, the other a bond that pays $100 for 10 years and $1,000 at maturity, Macaulay duration shows that the second bond is a better choice for the buyer. The cash fl ow of the two bonds is identical, but the strip makes the holder wait 10 years for his money, while the coupon bond will serve up about half the total cash fl ow before maturity. The average time to cash for the coupon bond is much shorter than that of the strip.

This understanding is insuffi cient to put an accurate value on the two bonds, however. Macaulay’s innovation was to measure the average time to receipt of a cash fl ow in which each cash fl ow’s time to receipt is weighted by its present value as a percentage of the total present value of all the cash fl ows. The sum of the present values of all the cash fl ows equals the price of the bond.

Calculation of Macaulay duration is an elaborate process that can tire the most dedicated of bean counters. Fortunately, many websites and fi nancial services and many handheld fi nancial calculators and programmable scientifi c calculators can produce duration numbers as fast as one can enter bond data. All the investor really needs to know about a government bond’s duration is the fi nal number.

Duration is the equivalent of beta for stocks. Beta, which measures a stock’s historical volatility in comparison to its index or benchmark, assumes that past is prologue and uses previous behaviour to predict the future. The higher the beta, the more


volatile a stock should be if, at least, the stock behaves as it has in the past. Duration, on the other hand, looks forward to the intrinsic character of a bond. The higher the duration number, the more the bond will jump as prevailing interest rates change. A bond with a duration of six years will tend to move 6% for every 1% change in prevailing interest rates. A bond with a duration of nine years will move 9% for every 1% change in interest rates. Past behaviour has nothing to do with the volatility prediction expressed by duration.

Short treasury bills have durations approaching 0. The reason is simple: First, the only payment one can receive is the principal, which the market discounts as the price of the bill. There are no periodic payments in a treasury bill. In comparison, strip bonds that have no coupons and that pay their full return at maturity have durations equal to their time to maturity. A 20-year strip has a du-ration of 20 years and therefore will move 20% in price for every 1% change in prevailing interest rates.

Duration is a measure of sensitivity to interest rate changes. Thus duration tends to grow with the term of a bond. The longer the time to maturity, the higher the duration. But duration grows less than proportionately as maturity grows, for later coupons are discounted more heavily than earlier ones. As well, for any given maturity and yield, duration will decline as cash fl ows rise. Thus a high-coupon bond will produce more of the total cash fl ow of the total return (that’s coupons plus return of principal) sooner than a low-coupon bond. Finally, if yield rises while total payments and maturity are held constant, then duration declines. The reason—cash fl ow rises faster than the time discount. Thus we can lay out the implications of Macaulay duration in two vital statements:

DURATION INCREASES WITH TERM TO MATURITY because the longer you have to wait for your money, the more risk you take.

130 C H A P T E R 6

DURATION DECREASES AS COUPON INCREASES because getting your money sooner reduces the time risk of waiting.

In the four decades following Macaulay’s insight into bond price behaviour, little use was made of the formula or its implica-tions. With interest rates holding at single-digit rates, there were not many problems for managers to decide. Managers matched bond terms to the need for money, for example, when employees would retire or kids were due to begin university. Approved bond lists for pension funds often permitted nothing more than govern-ment bonds or bonds of public utilities. With short shopping lists, there was little choice and little issue. Macaulay’s insight into bond price behaviour remained an academic concept.

Macaulay duration was rediscovered in the late 1970s and early 1980s, as interest rates soared into double-digit levels. Bond fund managers needed a way to compare old, low-coupon bonds with the high-coupon issues that hit the market. Bond managers were trying to isolate yield from term and to devise ways to immunize portfolios from losses if interest rates rose even higher.

Infl ation generated by the way the United States fi nanced its struggle in Viet Nam pushed up interest rates until, in 1981, the entire structure of interest rates was at double-digit levels. Prices of existing bonds were crushed by the combination of infl ation, high interest rates, and stagnating economic growth. Bond managers, confronted with shattered portfolio values, needed to fi nd ways to immunize their holdings from further damage. An academic cot-tage industry generating duration formulas was ready to help.

Macaulay duration assumes a constant interest rate. That’s a simple case, but it does not work for bonds with step-up interest rates, one of the twists that fi nancial engineers use to defer fi nanc-ing costs. A step bond may start at 3% annual interest, then rise


to 5% and 8% at specifi ed intervals. Economists Lawrence Fisher and Roman Weil allowed for variable interest rates in an important study published in 1971.3 A series of duration studies elaborated on the ways the Macaulay formula could be adapted to answer the underlying issue—how can one invest in bonds to produce good or optimal returns under conditions of varying interest rates.4

THE POWER OF REINVESTMENTA bond that falls in price as a result of an increase in market inter-est rates can have some of its value restored if the coupon interest it produces is reinvested at what have become higher market in-terest rates. The effect of this reinvestment is called convexity. It recognizes that, for a long bond, when interest rates rise, while the value of the income stream and the present discounted value of the return of principal may fall, the coupons can be invested at rising rates to produce a compensating growth in total bond return.5 Thus a bond with high duration that tumbles in price when interest rates rise will produce appreciably higher returns if the coupon interest is reinvested at the higher interest rates. Positive convexity is a property of all conventional bonds and is the saving grace for them if rates shoot up. In the opposite case, if interest rates fall and result in an increase in the price of a bond, convexity will reduce the value of reinvested bond coupons. In the end, con-vexity acts to stabilize the total value of the bond whether interest rates rise or fall.

While duration and convexity calculations require some deft work with partial differential equations and their fi rst and second derivatives, the individual investor need only know that if one sets the duration of a bond equal to its holding period, the capital loss from rising interest rates will be offset by the gain from reinvesting the coupons at higher yields. If interest rates decline, the loss of

132 C H A P T E R 6

income from reinvestment of coupons will be offset by the capital gain of the bond. An understanding of duration and convexity allows the bond investor to do some nimble work with his portfolio. One can buy short bonds with low duration, thus maintaining the market value of the portfolio even if interest rates change a good deal. The in-vestor can offset the potential volatility of long bonds with short bonds with low duration, thus getting a combination of relatively high returns and a cushion of market price stability. And the inves-tor can buy a long bond with a maturity to match his need for the money with the assurance that, if coupons are carefully reinvested, he will effectively hedge the bond’s market price variations with cash fl ow compensation.6

One must understand the limitations of this form of basic bond immunization strategy. It requires that long and short interest rates move together and that, indeed, the entire structure of interest rates rise in a proportional and consistent fashion. Bond portfo-lio managers can compensate for changes interest rates by trading to adjust durations to changing market conditions. The individual bond buyer cannot do this, for trading costs cut out the tactical gains from adjusting durations. However, the individual investor can create what amounts to an automatically immunized portfolio by using the easiest of strategies, the bond ladder.

CLIMBING THE RUNGS OF RATES The ladder is just a series of bonds with sequential maturity dates at, for example, 1, 3, 5, and 10 years. Or 5, 8, 10, and 15 years. The ladder’s steps can be when money is needed. The steps can be close together at single-year intervals. If the ladder is evenly weighted or evenly stepped from 1 to 20 years, it will tend to have average index duration, that is, it will mimic the duration of elaborately


constructed bond indices that show the entire bond market’s sen-sitivity to interest rate changes and the way bond managers have traded bonds in anticipation of interest rate changes.

The bond ladder allows for rising interest rates to be incorporat-ed into the portfolio. As rates rise, the principal of maturing bonds and coupon payments of other bonds can be reinvested at the short end of the ladder. If rates fall, the investor can either cushion the effect of declining interest rates by moving to longer terms in order to capture higher income on the yield curve or reduce the amounts invested at the short end where rates have fallen. The cushion of longer bonds will maintain income over time. Trading costs are lim-ited to buys, for bonds are held until paid at redemption. The ladder will tend to have positive convexity as well. In sum, the bond lad-der is a simple solution to the complex problem of how to optimize bond returns under conditions of varying interest rates.

NOT ALL BONDS ARE EQUALIt is not enough to know the duration of a bond, for some bonds are callable at the wish of the issuer before their maturity dates. The call enables the issuer to refi nance debt at lower interest rates if there is an opportunity to do so. But what is good for the issuer is usually bad for the investor, for he will get less for his money when he reinvests. The existence of a call feature on a bond therefore implies reinvestment risk.

Callable bonds offer some compensation for the investor’s risk of loss of what is likely to be superior interest by adding a call premium. If the issuer exercises a call, the holder will receive a small premium over par. The presence of a call feature changes the potential term of the bond. If call is exercised, the bond has its life shortened. Most callable bonds have some assurance that they will not face a call for at least a few years—a feature called “call protection,” but it is modest and it is not the same as a guarantee

134 C H A P T E R 6

that the bond will not be refunded or redeemed early. Each bond’s conditions of issuance, the bond indenture, explains the hazards to the holder. It’s a document that deserves close attention.

The investor needs to be a pessimist and assume that the is-suer will call in the bonds if it is benefi cial to do so. Yield to call is also called “yield to worst,” a phrase that nicely describes the risks of buying the bond. Bond investors should therefore consider yield to call. For example, an 8.75% $1,000 bond due in 30 years that is priced at $1,090.25 and callable in 5 years at $1,070.00, which is what the bond holder will get if the bond is called, has a yield to maturity of 7.94% but a yield to call of 7.66%. The mini-mum yield is the lower fi gure. A bond buyer should consider his worst-case outcome and assume that his return will be 7.66%. If the bond is priced above the call price, the investor should expect that the call will be exercised. Below the call price, the yield to maturity offers the worst case outcome.7

The reason for buying a bond should infl uence selection of specifi c issues.

• The investor who wants maximum income and plans to hold to maturity should consider current yield.

• The investor who wants the maximum compounded yield for the life of a bond should consider yield to maturity.

• The investor who wants some protection against price fl uctuations should select a high-coupon bond, since its duration will be low-er than a bond with an equal yield to maturity based on a lower coupon and a lower price.

• The investor who wants the greatest performance, that is, price appreciation and periodic income, should consider getting his yield at the greatest discount from redemption value. He should buy the bond with the deepest discount from value at maturity.


• The investor who wants no reinvestment risk should buy a stripped bond, for there are no coupons to reinvest and all growth in value is at the rate embedded at the time of purchase.

PRICING CORPORATE BONDSBonds other than government issues of major nations, a group that includes the G-7, Switzerland, non-G-7 Scandinavian issuers such as Finland, and supranational organizations such as the World Bank, should be regarded as having no default risk. All these gov-ernments are called “senior credits.”

In Canada, provinces are regarded as senior credits as well. Although provinces cannot print money, investors assume that any one province at risk of default would be aided by other provinces or the federal government in order to protect the good name of Canada in world debt markets. It is probably a safe assumption.

Unlike stocks, which can trade on fashion or investor enthusi-asm or what a newspaper or market guru has said, corporate bonds trade on closely analyzed credit quality. Much of the risk evalu-ation is taken care of by rating agencies.8 But the diligent bond investor will examine companies’ fi nancial statements and each bond offering circular or contract to ensure that the risk is prop-erly categorized by the raters. There is always a chance that books have been manipulated to increase apparent sales, to decrease ap-parent expense, and thus to boost earnings. In the bond business, prestige alone counts for almost nothing—see the following box of once-eminent U.S. companies that went bust. Some were resur-rected, some turned into criminal prosecutions, and some simply gutted their investors.

136 C H A P T E R 6

Top Dozen U.S. Bankruptcies: A Selected ListInsolvent Filed for Total assets Outcomecompany bankruptcy U.S.$

Worldcom Inc. 2002 $103.9 billion Execs to jailEnron Corp. 2001 $ 63.4 billion Execs to jailTexaco Inc. 1987 $ 35.9 billion ReorganizedGlobal Crossing Ltd. 2002 $ 30.2 billion Chief kept wealthPacifi c Gas & Elec. Co. 2001 $ 29.8 billion ReorganizedUAL Corp. 2002 $ 25.2 billion ReorganizedDelta Air Lines Inc. 2005 $ 21.8 billion ReorganizedAdelphia Communications 2002 $ 21.5 billion Execs to jailDelphi Corp. 2005 $ 16.6 billion PendingFirst Executive Corp. 1991 $ 15.2 billion Int’l scandalKmart Corp. 2002 $ 14.6 billion Now glamorousNorthwest Airlines 2005 $ 14.0 billion Pending Source: Bankruptcydata.com

This list is hardly complete. A worldwide survey of bankrupts would include Barings Bank, brought to ruin by rogue trader Nick Leeson; Bre-X Minerals, the Canadian gold fraud; several luckless chartered banks; and, of course, Air Canada, which has been reorga-nized into a stock that now gets respect. Of the frauds, only Barings Bank, which succumbed to bad accounting as well as bad trading, would have been impossible to predict in advance. The lesson here is that in analyzing bonds, skepticism pays a handsome reward.

In pondering the fate of bonds, the fi xed income investor has an advantage over the stock investor, for the debt holder is in-terested only in having his bonds paid on time and the principal redeemed on schedule.


The most basic test of ability to pay is the interest coverage ratio:

Interest coverage ratio = Earnings before Interest and Taxes/Interest Expense

The higher the interest coverage ratio, the more likely it is that the company can pay on time. One should note that different com-panies have different earnings characteristics. One company may be a steady earner regardless of the state of the economy. Another may be volatile with earnings dependent on consumer confi dence (a problem with retailers), on the price of oil or other resources, or on interest rates (a characteristic of home builders).

Many ratios are used to test interest coverage. They can be used in conjunction with the interest coverage ratio above to in-crease confi dence in the borrower’s ability to pay. Among these ratios are such tests of indebtedness as:

• Debt to equity ratio = debt/equity A very high ratio may show that a company could have trouble paying its debts, though public utilities, for example, tend to have high ratios in comparison to service businesses

• Debt to capital ratio = debt/(debt + equity) This is a fuller measure of debt to capitalization.

DEBT AND RISKBond duration, which shows how bonds behave when interest rates change, and bond credit analysis, which refl ects the borrow-er’s ability to pay, shed light on the bondholder’s single question: Will I be paid in full and on time? This is a simpler issue than the stockholder’s issues, which seek to project earnings, return on eq-uity, market penetration, role of macroeconomic forces, and even the popularity of a stock into the future. The bondholder is al-most always ahead of the stockholder in the lineup for payment in hard times; even deeply subordinated debt ranks ahead of common stock when it comes time to divvy up a company’s income.

138 C H A P T E R 6

The combination of duration risk and credit risk work together to show how risky a bond may be. Risk, as we saw in Chapter 2, is an expression of volatility or price or other asset characteristics. In fi nancial application, it is the difference between what one expects to make from an investment compared to what one actually real-izes from the investment. It is not an expression of the unknown, only of potential fi nancial outcomes that tend to be within known boundaries.

Investments in government bonds can be structured to antic-ipate certain outcomes. If the investor buys the bond of a senior national government, it is just about certain that the bond will be paid at every coupon date and principal refunded at maturity. For such security, the investor can be said to pay an insurance charge in the form of a reduced expected return. Whether that payment, which is really the opportunity cost of not investing in volatile but probably more profi table common stocks, is worth it depends on events and the investor’s own need for security. If the rate of infl ation increases, then the investor may suffer losses in the market value of the bond before maturity. Should he seek to sell the bond before maturity, his paper loss will become quite real. At maturity, his return of principal will have suffered infl a-tion erosion. However, if the economy goes into defl ation, then a government bond, especially a long bond, will increase in value and produce paper profi ts before maturity. At maturity, the bond will have enhanced purchasing power. Prolonged defl ation is not regarded as likely, but the chance that it could happen creates at least a theoretical justifi cation for holding a small part of any portfolio in long bonds.

Corporate bonds usually are rated below government issues. Some companies have sounder fi nances than governments, but companies cannot print money. Risk climbs with impediments to payment. Bond analysts regard risk as rising over time, for more


can go wrong with a company and its bonds as the time to the maturity of bonds increases. Indeed, over extended periods when one company may take over another and impose new standards or ethics, bondholders may suffer. That can happen when, for ex-ample, a company strips out assets in order to pay a large special dividend to a new major shareholder, leaving less asset coverage for bondholders. The lesson, it would seem, is that the longer the time the bond investor must wait for return of principal, the more perilous his position.

It is not surprising that investors in corporate bonds roughly equate time and risk and decide that the least chancy bond in-vestments are those that involve the best balance sheets and the shortest times to payment. Not surprisingly, return declines as risk falls and time to maturity grows shorter. In contrast, the risk to shareholders, which is high in the short run, tends to decline over the long run as earnings rise and share prices follow.

Thus we come to a paradox. The saying that return rises with risk is true, at least in theory, but the concept of chance raising eventual gain hinges on the idea of time. A portfolio of wildly risky stocks could outperform a portfolio of secure bonds, but it might take a lifetime or two for it to happen. Nine out of ten companies in the risky portfolio might go bankrupt, but the tenth could be another Microsoft in its infancy.

Even if the idea of return rising with risk were to be reliable over a period of, say, ten years, there is no assurance that returns are proportional to risk. In some investments created for resale, such as credit card trusts that fl ow returns to holders in order of their priority in the structure of the trust, risk and return are designed to be covariant. But in the larger world, raw returns cannot be said to be proportional, more than proportional, or less than propor-tional to risk. The advantage of doing one’s own credit analysis is thus to provide a sense of the balance of risks and a prediction of the returns.

140 C H A P T E R 6

THERE’S BAD, AND THEN THERE’S AWFULCredit rating agencies like to boast of their meticulous workman-ship in ferreting out weaknesses in the books of the companies that they examine. Most of the time, their diligence leads to timely and accurate appraisals of the risks of buying a certain bond. But it doesn’t always turn out that way. Take the case of sales and earnings manipulation by Sunbeam Corp., once king of the small appliance business and, later, holder of a title as corporate chump.

In 1996, Sunbeam, a maker of a diversifi ed line of kitchen ap-pliances and other household goods, hired Al Dunlap, an executive who had turned Scott Paper Company from a money-losing disas-ter into a stock market darling by fi ring 11,000 employees, slashing spending on research and plant improvements, and selling the company to a competitor. The stock market loved it and drove up the price of Scott’s shares by 225% in the 18 months Dunlap ran the company.9 His action plan at Sunbeam included getting rid of 75% of the company’s fi eld offi ces, eliminating 87% of its product line, and closing down 67% of its 61 warehouses.10 For his labours, Dunlap earned the moniker “Chainsaw Al.”

Dunlap arrived at Sunbeam in July 1996. The very day that Sunbeam had announced Chainsaw would be its new CEO, Sunbeam stock jumped by 60%, the largest one-day increase in the company’s history. By 1997, the stock, which had been at US$12.50 the day before Dunlap’s hiring was announced, peaked at US$52. It turned out that Chainsaw was about more than fi ring people. He had, in his brief tenure, recorded sales before they were really made, released reserves into income, recorded fake revenues, all to the point of making the company seem worth acquiring by a competitor with deep pockets.11

Faking a company’s books can only go on for so long. Eventually, the piper has to be paid. In Chainsaw’s case, that bill came due in April 1998 when Sunbeam had to disclose a loss for the quarter.


The stock dropped 25% on April 3. Two months later, the Sunbeam board began to investigate the accounting practices he had used. Dunlap and his chief fi nancial offi cer were fi red, and the com-pany restated earnings from the fourth quarter of 1996 to 1998.12 In February 2001, Sunbeam went bankrupt, emerging from the process in December 2002 as a private company called American Household Inc. For his part, Chainsaw agreed to pay US$500,000 to the Securities and Exchange Commission and $15 million to set-tle a securities fraud suit fi led by investors who thought they had been deceived by Sunbeam’s handiwork.13

Sunbeam’s debt holders were not immune to Chainsaw’s wiz-ardry with a pencil, for in February 2001, the company defaulted on US$2 billion of bonds. In a judgment rendered March 23, 2005, Florida Circuit Court Judge Elizabeth Maas ruled that in-vestment banker Morgan Stanley helped Sunbeam falsely infl ate its fi nances when it underwrote a US$750-million bond issue to help the company execute a transaction with serial capitalist Ron Perelman.14 Beware tales of joy from investment bankers eager to sell their clients’ debt.

The business press had lionized Chainsaw in his salad days, but a zealous researcher might have learned that all was not well in the house of Dunlap. When he had signed on at Sunbeam, he insisted that the company provide a full-time bodyguard. A few reporters were able to weigh the notion that a company’s earnings could be made to soar by what amounted to shooting it in the heart. Money magazine told readers to sell any Sunbeam stock they owned and buy Black & Decker instead.15 Chainsaw’s days of glory were com-ing to an end.

Other times breed other accounting tricks that bond investors need to watch. One of the most common is cost manipulation. The manoeuvre is achieved by treating ordinary expenses as non-recurring items that allegedly are not part of a company’s regular

142 C H A P T E R 6

business. For example, a company can claim that a loss generated by sale of a factory is nonrecurring (assuming that its business is not selling factories) and therefore does not count. This is fi ne in the-ory, but investors are interested in total return, not crafty excuses. Nonrecurring items do not disappear, however. They can be put on a balance sheet after being purged from the income statement and treated as changes in capital position. The lesson, of course, is that one must read fi nancial statements with great diligence.

Auditors have been willing to let their clients get away with this game. A study of 1,100 third-quarter earnings reports for 2000 showed 18 nonrecurring charges per 100 companies, com-pared with just eight nonrecurring gains per 100 companies.16 Among the companies that branded losses as nonrecurring have been Air Canada in 1998 (estimated strike costs), chemicals maker Nova Corp. in 1999 (currency hedging losses), and uranium miner Cameco Corp. in 1999 (for sale of uranium properties).

There are many lessons to be learned from investigations of accounting skullduggery. Forensic accountant Howard Schilit advises the following:17

1. Watch for excessive charges soon after a new chief executive arrives.

2. Watch for declines in reserves. Having taken excessive charges and created fake reserves, Sunbeam was able to release those reserves and make them income.

3. Watch for receivables growing much faster than sales. 4. Watch for collapsing cash fl ow from operations. Sunbeam showed

plummeting cash fl ow even as it reported a huge increase in operating income.

5. Watch for gross margins growing at an unrealistic pace. Sunbeam’s hopped from 17.3% to 27.8% in just one year.


Credit rating agencies tend to be prescient in their apprais-als of corporate health, but they are not immune to error. As the period of dot-com and growth company exuberance was ending in 2000, major credit rating agencies continued to give high marks to Enron Corp. and to WorldCom, and later, in 2003 and 2004, to Italian dairy conglomerate Parmalat.

The WorldCom case is particularly disturbing, for it illustrates a fl aw in the bond trading system. That’s the use of so-called shelf registrations, which allow large bond issuers to sell debt at will and without giving investors a fresh look at their books. In a deci-sion rendered in December 2004, U.S. Judge Denise Cote of the Southern District of New York held that there is need for fresh due diligence on the part of underwriters when they offer secu-rities. They can no longer rely on the opinions of auditors, and such opinions are no longer a bar to recovery for fraud in secu-rities sales. The case, known as In re WorldCom Inc., stems from WorldCom’s restated 2002 earnings. That restatement showed that the long-distance carrier was capitalizing US$3.8 billion of costs that should have been expensed. That ruse, a crime in the United States, boosted WorldCom’s apparent profi ts and helped it sell US$17 billion of debt.18

Underwriters led by Salomon Smith Barney and J.P. Morgan had claimed that they were not at fault for relying on statements prepared by Arthur Andersen LLP, the defunct auditor, and WorldCom’s dis-tinguished counsel, the New York law fi rm of Cravath Swaine & Moore. The implication of the WorldCom decision is that under-writers, auditors, lawyers, and investors should take an active role in meetings and be alert to representations that the company is per-forming to industry standards. If it appears to be doing far better than competitors, all parties should fi nd out why. The WorldCom case carried an award of US$6 billion for defrauded bondholders.19 In Canada, where due diligence procedures are even more hollow

144 C H A P T E R 6

than in the United States, investors would have been lucky to see a fraction of the award. It is signifi cant that WorldCom founder Bernie Ebbers, an Alberta boy who rose to great heights and wealth in the telecom biz, has been convicted by a U.S. court of numerous counts of fraud. In Canada, he might have had his hand slapped.

Credit risk is summarized by widely used credit ratings.

Moody’s S&P Fitch DBRS InterpretationAaa AAA AAA AAA exceptional security, lowest riskAa1 AA+ AA+ AA (high) excellent security almost AAAAa2 AA AA AA superior, small long-term riskAa3 AA- AA- AA (low) presently secure, more riskA1 A+ A+ A (high) satisfactory securityA2 A A A above average securityA3 A- A- A (low) good credit standingBaa1 BBB+ BBB+ BBB (high) average rated securityBaa2 BB BB BBB questionable securityB1 B+ B+ B (high) speculativeB2 B B B very speculativeB3 B- B- B (low) highly speculativeCaa CCC CCC CCC high risk and could defaultSources: Moody’s Investor Service, Fitch Ratings, Standard & Poor’s, Dominion Bond Rating Service

Investors tend to give the rating agencies the benefi t of the doubt when they pronounce on the health of companies, but in their own defence, the most they can say is that they look at the long-run health of companies rather than their day-to-day troubles. In fact, the rating agencies—Moody’s, the dean of the school since its founding in 1909; Standard & Poor’s, which rates US$30 trillion of debt in 750,000 securities issued by 40,000 corporations; Fitch, a French company; Canada’s Dominion Bond Rating Service; and insurance rater A.M. Best—are fallible.20


The most common criticism of the raters is that they work not for the investor or even for fi nancial intermediaries like in-vestment dealers, but for the companies issuing debt. As well, in meetings with management, the agencies tend to allow subjective issues to creep into their work. Moody’s, once the generator of reports not sought by client companies, no longer does ratings on its own without payment by the client company. Fitch does only about 5% of ratings without being invited to do so by companies it assesses.21

Raters are, in spite of occasional glitches, excellent predictors of corporate performance. Data show a close correspondence of grades and defaults, with defaults rising at the time of observa-tion increases. Note that below BBB, defaults rise to double-digit levels. Bonds with low ratings take away in defaults as much as or more than they give in yield premiums.

Default Rates by Rating Category: U.S. and Canadian Data

Default Rate in %Rating 1 year 5 years 10 years 15 years US CAN US CAN US CAN US CANAAA 0.00 0.00 0.10 0.00 0.45 0.00 0.61 0.00AA 0.01 0.00 0.30 0.56 0.85 0.63 1.35 0.63A 0.04 0.11 0.61 1.11 1.94 1.60 2.98 2.10BBB 0.29 0.35 2.99 2.34 6.10 3.82 8.72 4.60BB 1.20 1.50 11.25 6.37 19.20 8.99 22.59 10.11B 5.71 11.67 25.40 28.33 33.75 28.33 38.63 28.33CCC 28.83 26.67 50.85 33.33 56.45 33.33 59.44 33.33

Sources: Standard & Poor’s Defaults by rating grade 1981–2004; Manroop Jhooty, Jireh Wong,Huston Loke, and Brenda Hsueh, A Historical Review of Corporate Default Experience, 1977 to 2004,Dominion Bond Rating Service, April 2005, p. 5.

146 C H A P T E R 6

The work of the raters is vital to making correct bond invest-ment decisions. A long list of Canadian companies that at one time or another were sound and then failed includes the following:

Defaulted Issuers of Long-Term Debt: A Selected List22

Company Date of InsolvencyCanadian Commercial Bank 1985Northland Bank 1985Campeau Corporation 1990Algoma Steel Corporation Limited 1991Central Guaranty Trustco 1991General Trustco of Canada 1993Confederation Treasury Services 1994Loewen Group Inc. 1999Canadian Airlines Corporation 2000Laidlaw Inc. 2000Algoma Steel Inc. 2001Teleglobe Inc. 2002Air Canada 2003Saskatchewan Wheat Pool 2003Hollinger Inc. 2004Stelco Inc. 2004

Ratings morph from sublime to suspicious to downright dubi-ous, but credit markets mark the changes with major increases in the yields expected as issues decline in quality. There are also major disconnects in the ratings, for yields tend to jump from the invest-ment-grade level of S&P/Fitch BBB+ and equivalents, to lower grades. When a bond slumps out of investment grade, pension funds and many mutual funds have to dump it. The canny investor can pick up bargains when downgrades are announced, but the moment


is often anticipated by bond portfolio managers. At the same time, it is not for nothing that bonds lose their gloss of “investment grade.” It is vital to know what one is buying; doing one’s own research is key to risk management as one travels down the yield curve.

While a stock investor is interested in knowing the basis for ap-preciation of shares over time, the bond investor need only know that coupons and principal will be paid on time. The accounting tests for ability to pay are as complex and diverse as the companies that make up the bond universe, but there are central tests that the investor can do to determine probability of payment. It is worth remembering that, unlike a professional portfolio manager who needs to calibrate returns and diversify holdings according to a mandate, the individual investor just needs to avoid being wrong. What’s more, there are so many bonds in any category that, if one smells bad, there should be something similar that will pass tests of wholesomeness.

It is vital to watch for signs that a company is in trouble. The indicators of potential diffi culty include the following:23

IndicatorCash and equivalents declining relative to total assets

Receivables are growing faster than sales

Inventory grows faster than sales

Prepaid expenses increase in comparison to total assets

Accounts payable grow faster than revenue

Cost of goods sold rises faster than sales

Potential problemThe company may be running out of cash and have to borrow

Aggressive revenue recognition, excessive vendor fi nance, problems with returns

Inventory may be obsolete and need write-off

Operating expenses may be improperly capitalized

Slow payment may indicate lack of cash or earnings management

Pricing pressure compresses margins

Continued on next page

148 C H A P T E R 6

IndicatorMajor portion of income comes from one- time gains

Change of accounting principles

Auditor changes

Chief fi nancial offi cer resigns

CEO fl ees the country

Potential problemCore business may be weakening

Attempt to conceal an operating problem

Company too risky for previous auditor

May spell looming disaster; reason must be determined; possible fraud

Fear of criminal liability for management

RISK AND STRATEGYA troubled bond is not necessarily a bad bond. The investor who accepts only government bonds will receive interest that is perhaps less than half what a portfolio of mixed corporate and government debt, including junk bonds, will yield. Blending riskless government debt with investment-grade corporate debt and sub-investment-grade debt is the work of professional managers.

Individual investors can make the same transitions from in-vestment grade to sub-investment-grade debt by ensuring that the debt at risk is well diversifi ed. The methodology is simple: The riskier the rating, the more diverse the sectors of the issuers should be and the larger the number of names the portfolio has to contain.

At the limit of the diversifi cation process, a portfolio can contain high levels of junk debt. There is a cost to such diversifi cation. For example, at the time of writing, General Motors Corp. bonds due in three years are priced to yield 9%, almost 600 basis points over U.S. Treasury debt of the same term. The company has admitted


that its worldwide cost of borrowing has risen to 460 basis points over the U.S. 10-year Treasury bond, up from 220 basis points in 2004. GM has abundant liquidity, yet did not even try to sell un-secured debt in the period of four months ended April 20, 2005.24 An imminent default is not in store, says Chris Kresic, senior vice president for investments at Mackenzie Financial Corporation in Toronto. A yield boost of such size is a serious warning of default. “The yield boost indicates fear in the minds of investors,” says Tom Czitron, head of income and structured products for Sceptre Investment Counsel Ltd. in Toronto. Czitron, who runs $2 billion of bonds and income trusts, notes that liquidity can also dry up as managers hasten to dump BBB debt and fi nd a shortage of buyers. “The yield boost is there at such moments, but you have to know why the credit markets are apprehensive,” he explains. “A com-pany may be underfollowed by analysts and its bonds may not be visible in day-to-day trading. In that case, the yield boost can be a gift—or an illiquidity premium—for the studious buyer.”

Evaluating bonds for payment prospects is more than an ac-counting exercise. A good deal of intelligence comes from what can be called “shoeleather economics.” That’s the sensibility one gets from reading the fi nancial press. In 2004, the balance sheets of most oil producers improved dramatically and the quality of their debt improved on the sheer power of oil prices. The opposite hap-pened to U.S. auto makers—GM most dramatically, of course.

Other economic forces can send bonds into the territory of the doubtful or rescue them when they are already there. Trade em-bargoes may block the sale of products of designated companies or companies in certain nations whose goods are blocked. Drug com-panies face immense diffi culty when regulators force removal of products from markets, destroying current sales and perhaps even the reputations and future prospects of the company. Some of the regulatory moves are absolutely right, regardless of consequences

150 C H A P T E R 6

for investors. That was the case of the trashing of A.H. Robins, maker of the infamous Dalkon Shield, an intrauterine device that harmed a great many women—harm that the manufacturer concealed. Confronted with a cascade of lawsuits for its behaviour, Robins declared bankruptcy in 1985.

For large companies, the hazards of daily life can be taken in stride. The bondholder who is content to hold to maturity need not be concerned with frequent price changes. The bond trader will see the effect of news on issues as a chance to profi t. There is peril in such concepts, however, for bond desks at major fi nancial institutions are adept at trading on news.

The responsiveness of bonds to news, to ratings changes, and to trading patterns in the market varies with the crisis of the day and the issue of the bond. Highly liquid bonds, which include U.S. Treasuries, Canadian federal bonds, major provincial bonds, and many supranational agency bonds, trade with relatively small spreads between bid and offer. On any given day, the spreads may be no more than one basis point of yield.

Other bonds, including issues of the smaller provinces, bonds of all but the largest corporations, and complex or exotic issues that traders fi nd hard to understand, may trade with spreads suffi cient to boost yield by as much as 40 to 50 basis points. The market dis-tinguishes between bonds like new issues and major government issues outstanding that are actively traded and called “on the run” and those—the majority of all bonds—that are not much traded and termed “off the run.” Examples of off-the-run bonds are the Milit-Air Inc. issues that were used to fi nance various airbases for NATO operations. The bonds are secured by lease payments from the Government of Canada and therefore carry AAA ratings. The Milit-Airs are seldom traded, are not well understood, and thus are prime candidates for the buy-and-hold investor who is happy to capture the yield advantage of the issue. If that investor wants


to sell the bonds, he would fi nd the spread working against him. Thus investing in illiquid or obscure bonds, even those with su-perb credit ratings, is a buy-and-hold concept.

Bond selection and evaluation clearly depend on the investor’s strategy. Since bonds will never do more than return their princi-pal, the investor should limit his expectations to variations on the theme of security. One can buy a portfolio of deeply discounted junk bonds at the bottom of an economic cycle and hope for major gains, though this sort of play is best left to professional high-yield managers. But the majority of bond investors should base their bond strategies on the risks they expect to take. The best bond strategies offer a way out, even if a plan misfi res. The worst leave the investor caught in a trap with no escape.

BONDS AND LIFE PLANSFor the investor seeking to retire in a defi ned period: The intrinsic risk in a long government bond with high duration is minimized over time. Even if the bond moves violently as interest rate changes, the money will be ready at known intervals when the bond price has returned to the issue price. Buying long government bonds can make sense, but for periods of 10 years or more, corporate debt is chancy.

For the investor who wants to insure a portfolio: Buy a strip bond (or a zero in U.S. bond parlance) with a 20-year maturity. At time of writing, an Ontario bond due September 8, 2027, is selling for $358.80 per $1,000 of face value. In 21 years, the bond will rise to $1,000. The intrinsic rate of interest, 4.82%, will be payable at maturity. The investor can invest the difference of $641.20 per thousand dollars of face value bond in even very risky stocks. The worst possible outcome in 2027 is that the bond will cover all eq-uity losses. If the stock purchased does at least a little better than total failure, the total return of the strategy will be that much more. If stocks return a conservative 6% for 21 years, the total gain per

152 C H A P T E R 6

thousand dollars invested will be 240% on the stocks and 168% on the bonds, less any taxes paid on bond interest and stock dividends in the interval and any taxes on capital gains at the end of the pe-riod. This strategy requires a bond with certainty of payment. The bond concept requires a government issue; anything with equity risk or dependent on corporate health could spell disaster for the strategy.

Bond investors who follow debt markets closely can capture yield boosts by adept trading. The more volatile a company’s pros-pects, the greater the potential swings in its bonds’ prices. Air Canada bonds traded as low as 25 cents on the dollar as it moved from insolvency back to respectability. The investor who wants to play in this arena is up against highly trained and very well advised professionals at major institutions. Nevertheless, when the market begins to think the unthinkable about a bond of a venerable insti-tution or company and if the investor can fi nd economic, political, or accounting reasons for the rehabilitation of the company, there can be a speculative gain in its bond.

The gains tend to be most apparent when a bond crosses the line from investment grade to sub-investment grade. At that point, and for what may be only hours or days of uncertainty, managers will dump bonds, leading to large potential gains in yield for only a small move in rating. The yield boost can be in a range of as much as 100 to 300 basis points, says bond manager Chris Kresic. He notes that the debt is going to be a short-term phenomenon. “If it is a hiccup as a result of a company taking on debt for an ac-quisition, then the bond may be acceptable. If you think that the expansion or acquisition won’t work out, then the bond could be headed to default.”

Kresic takes the case of General Motors Acceptance Corp. of Canada bonds with terms of two years or less to maturity. Priced to yield 9.5% for issues due in 2007, the bonds are at risk because the


GMAC’s owner, General Motors, has had trouble selling its cars in North America. But the prospects are that, given the company’s high level of cash and lines of credit, it can sustain operations for two years.

The bottom line on bond investment is not really very differ-ent from what one might tell a tailor. Strategies work when they fi t the investor. The retiree who needs every bit of his pension should not plunge into long-term corporate bonds, even if the yield boost is irresistible. The risk-seeking investor who wants to dabble in small-cap biotech stocks can use the strip bond portfolio insur-ance plan and, if he does not deviate from it, his nominal portfolio value is bound to be returned at the end of the investment period. Considerations of bond duration and volatility, the credit ratings of corporate bonds, and the clear relationship between bond rating and default over time all come later. Knowing yourself is the fi rst and last step in defi ning a bond strategy.

1. New York: National Bureau of Economic Research, 1938.

2. For those with a bent for math, D = � wt t for all periods t = 1 to n where D is duration, w is the weight of the cash fl ow, t is the date of each payment, and n is the number of payments. Duration maps as a partial differential equation, tracing the price to value relationship of the cash fl ows and discounted repayment of the bond.

3. Lawrence Fisher and Roman L. Weil, “Coping with the Risk of Market-Rate Fluctuations: Returns to Bondholders from Naïve and Optimal Strategies,” Journal of Business, October 1971, pp. 408–31.

4. An excellent summary of the studies can be found in Gerald O. Bierwag, “Duration Analysis: An Historical Perspective,” occasional paper, Dept. of Finance, College of Business, Florida State University, Miami, Fla. (January 1997).

5. Mathematically, convexity is the fi rst derivative of duration, per footnote 2 above.

6. A fi ne and very brief explanation of duration and convexity can be found in Mark P. Kritzman, The Portable Financial Analyst (2nd ed.; New York: John Wiley & Sons, 2003), pp. 49–56.

7. This example is taken from Sidney Homer and Martin L. Liebowitz, Inside the Yield Book (Princeton, N.J.: Bloomberg Press, 2004), pp. 59–61.

Endnotes

154 C H A P T E R 6

8. Research on the accuracy of bond ratings tends to show that the major agencies usually get their numbers right. See Thomas E. Pogue and Robert M. Soldofsky, “What’s in a Bond Rating?” Journal of Financial and Quantitative Analysis, June, 1969, pp. 201–208.

9. Howard Schilit, Financial Shenanigans, 2nd ed. (New York: McGraw-Hill, 2002), pp. 164–68.

10. Christopher Byron, Testosterone Inc: Tales of CEOs Gone Wild (New York: John Wiley & Sons, 2004), p. 259.

11. Schilit, Financial Shenanigans.

12. Schilit, Financial Shenanigans.

13. “Morgan Stanley accused of ‘massive fraudulent deal,’” National Post, April 7, 2005, p. FP 24.

14. “Morgan Stanley accused of ‘massive fraudulent deal.’”

15. Byron, Testosterone Inc., p. 260.

16. Charles W. Mulford and Eugene E. Comiskey, The Financial Numbers Game: Detecting Creative Accounting Practices (New York: John Wiley & Sons, 2002), p. 334.

17. Schilit, Financial Shenanigans, pp. 166–68.

18. Sandra Rubin, “Due diligence defence crumbles,” National Post, April 20, 2005, pp. FP6, FP7.

19. Rubin, “Due diligence defence crumbles.”

20. The Economist, March 26, 2005, pp. 67–69.

21. The Economist, March 26, 2005, p. 68.

22. Manroop Jhooty, Jireh Wong, Huston Loke, Brenda Hsueh, A Historical Review of Corporate Default Experience, 1977 to 2004, Dominion Bond Rating Service, April, 2005, p. 1. Note that Confederation Treasury Services was an entity of failed Confederation Life Insurance Company, which wound up in 1998. Confederation Life was not red-fl agged by rating agencies in the months leading up to announcements of its demise.

23. Schilit, Financial Shenanigans, pp. 201–205.

24. Jeff Green, “GM loses US$1.1B in fi rst quarter,” National Post, April 20, 2005, p. FP4.

Chapter 7

BOND FUNDS

Buying a bond is not an easy task. The selection is vast and prices change rapidly. The market is moved by institutional

investors who are in close touch by phone or by watching the shad-ows of each other’s moves. Not surprisingly, many investors who want the security of bonds choose to have managers do the selec-tion for them. Yet there are vast differences between holding a real bond and having a share in a bond fund. A real bond, even if it should fall in price before maturity, will eventually revert to cash at par value. A bond fund never reverts to cash, unless it is closed and its assets sold with proceeds going to unitholders. Thus in a period of rising interest rates, the worst a bondholder can suffer is the mental nuisance of being aware of falling but temporary prices. A bond fund unitholder can sustain permanent loss if interest rates rise more or less continuously.

The dangers of bond fund investments are often outweighed by the appeal of giving the task of selection to a professional with years of experience and vast amounts of research at hand. Bonds can be traded by institutions that buy in lots of $5 million or more

156 C H A P T E R 7

with yield spreads between wholesale and retail of just a few basis points compared to the 25 to even 50 point yield spreads that in-vestment dealers may charge to private clients who may just want to invest $5,000 in a bond.

The principles behind bond mutual funds are much the same as those behind stock mutual funds: For management fees and per-haps sales fees, the investor gets such advantages as the following:

1. Professional management 2. Low trading costs3. Easy reinvestment of income and trading profi ts in the fund

or, for that matter, in other funds in the company’s stable of mutual funds

4. Accounting for taxable and tax-deferred accounts5. Hands-off ease, for once the decision is made, the investor

need never do more than follow the fund’s progress6. Diversifi cation in many bonds in the fund

FEES AND RETURNSSad to say, data fail to show that this wonderful model of mutual fund convenience and performance works. That’s because fees dev-astate managers’ performance, leaving only a very few funds with returns that are more than what the investor could obtain on his or her own in direct bond purchases or through the use of exchange-traded funds that package well-defi ned fi xed income products in low fee wrappers.

An examination of the returns of mutual funds that invest in Canadian government and corporate bonds shows the erosive ef-fects of fees. For the ten-year period ended December 31, 2005, Canada bond funds produced an average annual compound return of 6.1%. That was signifi cantly less than the 7.7% average annual compound return of the SC Universe Bond Total Return Index

157Bond Funds

in the period. The difference of 1.6% refl ects the management expense ratio (MER), which is about 1.4% when fund assets are weighted by sums under management. The unweighted MER works out to 1.9%1 The comparison between fund average returns and the MER varies depending on the period, but the implication is clear: What the manager gets, the investor does not. Managers who take 1.4 % of fund assets to produce a net return of 6.1% are doing their jobs, of course, but the charge is 23% of the residue that goes to the investor. If the managers boosted yield appreciably, their fees might be in line with their achievements. Unfortunately, fees do not have a positive correlation with bond returns. The cor-relation is negative. And it gets worse.

Bond funds, like stock mutual funds, are sold by two basic dis-tribution models. The most common is the fi nancial advisor model in which a third or even more of the management fees charged to client investors are funnelled to the stockbroker or mutual fund dealer supposedly as compensation for having the wit and wisdom to advise the client on the right things to do with his money. The other model is the no-load, direct distribution arrangement used by banks that pay their employees a salary rather than letting them feed directly on the client. Both models usually use fl at fees that do not vary with the amount the investor has on account or invested, though high net worth individuals and smart investors can usu-ally get fees knocked down just by asking for a cut or threatening to walk out. Fund companies know that the days of huge fees are coming to an end as investors discover their bargaining power and low-fee exchange-traded funds.

The bond mutual fund investor or any mutual fund investor should elect a fi xed advisory fee formula in which the advisor is paid a fl at 1% or 2% regardless of how much is on his ledger. Over $100,000, 1% should be enough for a client who buys and holds. Note that if the advice is good, the $100,000 or whatever amount

158 C H A P T E R 7

should grow. There is no need to pay so-called participating fees that are charged by some managers of equity, hedge, and certain combination bond and stock funds who demand 1% just for their existence and then 20% of the amount by which the performance they generate beats some benchmark. Some benchmarks are easy to beat and, moreover, a manager can employ risky strategies to reach and beat an index that measures its volatility as 1.0. Load up on a few stocks supposedly ready to rocket upward or buy some chancy bonds with higher volatility and if they work out, get the 20% fee. If it does not work and the client loses money, the manager still gets the 1% fee. The client may have made out rather poorly, but there are more potential players in the waiting room. Funds that tithe investment advisors with your money are hazardous to your fi nancial health. The harm is erosion of performance received by the investor. If the advisor urges the client to buy and hold, that fee kickback turns into an annuity. Pay 1.9% a year, the unweighted median MER, for man-agement of a bond portfolio and you have given up a huge chunk of performance. If you are just buying government bonds directly and not through high-fee mutual funds and holding to maturity (when the bonds turn into cash) a major loss on a scale of 20% or so would be quite unlikely. However, if government bonds are all you want and you are prepared to buy bonds only when they are selling at or below maturity value, there is a pretty good case for doing your own bond management with a portfolio of domestic government bonds (Canadas and provincials) or with low-fee exchange-traded bond funds.

Management expenses are not the only costs that mutual funds impose on their investors. In addition to management costs, there are trading costs that amount to an average 0.75% of net asset value.

Trading costs take several forms. The most common is the dif-ference between the bid and ask prices for bonds. The more liquid the bond, the narrower the spread. Government bond funds must

159Bond Funds

cover smaller spreads than funds that invest in corporate bonds or emerging markets bonds. There are also market impact costs that result from an investor buying so much of an asset that the price is pushed up. When it is time to sell, the investor pushes down the price. Market impact costs are large on small cap stocks, potentially large on illiquid bonds, and small on widely held, very liquid government bonds. Finally, there are taxable events such as selling a bond in a deal producing a profi t in a taxable account. For the investor in a Registered Retirement Savings Plan or in other tax-deferred plans, tax events do not matter. For the taxable inves-tor, they are serious friction in the realization of potential returns. Trading to adjust bond terms and durations, to shift among global bond issuers, and to hedge bond positions can generate huge tax-able events. Those events translate into tax obligations that can cut the after-tax returns of these funds by 25% or even more.

All these costs would be worth bearing if managers of bond funds were perfectly informed about the future and able to execute perfect trades that capture all the value in bond trends. Sadly, there is no evidence that the average or typical manager is much better than a random player. While there are a few gifted bond manag-ers who do earn their fees and several low-fee funds that allow for even mediocre management to shine, the average manager ap-pears to give nothing to investors except, perhaps, convenience. “Managers tend to add no value to what investors get compared to indices,” says Dan Hallett, president of Dan Hallett & Associates, a Windsor, Ontario, mutual fund research fi rm. “The wider the mandate, the greater the chance that the manager can earn his fee by enhancing investors’ returns over the relevant benchmarks.”

Let’s make the point with Canadian bond funds in operation for the 10 years ended December 31, 2005. The median bond fund in the category was the CIBC Canadian Bond Fund, a $794-million portfolio with an average annual compound return for the

160 C H A P T E R 7

period of 5.98%. That was much less than the 7.70% average annual compound return of the SC Universe Bond Total Return Index in the same period. The CIBC Canadian Bond Fund has an MER of 1.61%.

There is neither black magic nor perversity in the inverse rela-tionship of fees and performance. In an asset category as narrowly defi ned as Canada bonds, dominated by government issues, man-agers can do little except adjust bond durations or seek small yield boosts in provincial as compared to federal bonds.

As the asset category expands, the room for managers to add value grows. Exceptionally intelligent or very lucky managers can improve performance. Hapless or unfortunate managers can buy corporate bonds that default or that are devastated by adverse interest rate changes. The widest potential spreads from top to bottom of the performance range will take place in global bond funds and funds that can invest in domestic and foreign junk debt.

In the following sections of this chapter, we’ll list some of the top bond funds along with their performance to the end of December 2005. We’ll show the minimum investment each fund requires as well, though some funds may, when asked, be willing to lower the minimum, especially if the investor has money in other funds man-aged by the same company.

EXCEPTIONS TO THE RULE:BOND FUNDS WITH STRONG PERFORMANCEA few managers are able to add substantial returns to their bench-marks and to outperform their peers even after fees are deducted. Those funds in which managers can do no more than imitate an index or buy short-term government bonds have little room for ma-noeuvre, even though their companies may charge fees as though they do. Outperformance over bond indices tends to appear in funds that have broad bond mandates, i.e., in which managers can exercise imagination or daring. Outperformance in comparison to

161Bond Funds

peers appears in those funds that have relatively low fees. The fol-lowing funds fall into that category.

Acuity Pooled Fixed IncomeAcuity Funds Ltd. is a Toronto boutique manager with an excep-tional record of brilliant stock and bond picking. The company’s $99-million bond fund, technically classifi ed as a Canadian in-come balanced fund, comes with a 0.18% MER and a $150,000 hurdle to get in. The fund, which boosts bond returns with income trusts, produced a remarkable 11.42% average annual compound total return for the 10 years ended December 31, 2005. For the period from 2000 to 2005, every calendar year produced an above-median result, putting the fund in the top handful of the hundreds of bond funds in the sector. In 1995, 1996, and 1999, its strategy clunked and the fund came out in the back of the pack of Canadian bond funds. Overall, however, Acuity has a remarkable achievement in this fund.

AGF Global Government Bond FundScott Colbourne has managed this $285-million portfolio, established in 1988, since December 2000. The fund, which produced a 3.96% average annual compound return for the fi ve years ended December 31, 2005, invests only in sovereign debt or debt guaranteed by or is-sued by sovereign governments. The 1.90% MER is lower than the 2.24%2 average in this subsector. For a $1,000 minimum investment, the fund provided above-average returns for all standard periods of 1, 2, 3, 5, 10, and 15 years ended December 31, 2005, and above-average returns for each calendar year from 2000 to 2005.

AIC Global Bond FundPicking global bonds is a tough business, for the manager has to con-tend with the yield curves in foreign markets and currency moves.

162 C H A P T E R 7

But Randy LeClair, who has managed the fund since inception in July 1999, has done well, beating the benchmark Citigroup World Government Bond Index for most periods and producing above-average returns for fi ve out of the six years of the fund’s existence. For the fi ve years ended December 31, 2005, the $26-million portfo-lio generated a 4.32% average annual compound return, beating the 1.67% gain of the median foreign bond fund in the period. For the 1.99% MER the investor gets management adept at dealing in cur-rency trends as well as bond markets. It is a demanding combination and LeClair does it very well. The minimum investment is just $250.

Altamira Bond FundAltamira Investment Services Inc., based in Toronto, has packaged mostly Canadian government bonds in this $248-million fund with a $1,000 minimum investment and a middling MER of 1.58%. The fi ne record of the fund was built in part by former manager Robert Marcus (now head of Majorica Asset Management in Toronto). The fund is now headed by Montreal-based National Bank bond manager Bruno Bourgeois. For the 10 years ended December 31, 2005, the portfolio produced an average annual compound return of 8.22%, far above the 5.98% average annual compound return of the median Canadian bond fund in the period.

Beutel Goodman Private Bond FundToronto-based manager Beutel Goodman’s main business is pension funds. They also take on private clients. For their Private Bond Fund, clients who can pony up $250,000 can get a well-run selection of Canadian bonds with a relatively low management fee of 0.73%. That low fee contributed to the fund’s 6.96% average annual compound return for the 10 years ended December 31, 2005, well ahead of the 5.98% average annual compound gain of the median Canadian bond fund in the period. In sum, good fund, low fees, no surprises.

163Bond Funds

CIBC Monthly Income FundCIBC Monthly Income Fund runs $4.9 billion in a blend of gov-ernment and corporate bonds and income trusts. It produced a handsome 11.62% average annual compound return for the fi ve years ended December 31, 2005, far above the 4.55% average annual compound return of the median fund in the Canadian income bal-anced fund sector. The MER is relatively modest at 1.44%, it costs just $500 to get in, and the assets are relatively secure. Sometimes making money means doing the simple, obvious things.

Genus Canadian Bond FundVancouver’s Genus Capital Management Inc. asks investors to ante up $300,000 to get into their individually managed portfolios that blend bonds with terms from 7 to 11 years and some lower-level but still investment-grade corporate bonds with the usual federal and pro-vincial issues to beat the benchmark SC Universe Bond Total Return Index year over year. For the decade ended December 31, 2005, the $120-million fund produced an average annual compound re-turn of 7.84%. That beat the 5.98% average annual compound return for the period generated by the median Canadian bond fund in the same period. On a year-over-year basis from 1996 to 2005, the fund has nothing but high fi rst quartile returns. The goal of the fund is to beat the benchmarks and to provide currency-hedged diversifi -cation to investors, says Brad Bondy, director of research at Genus. “It’s our fi nding that global bond returns have been negatively cor-related with returns from Canadian equities,” he explains.

MB Fixed IncomeMcLean Budden Limited is fi rst and foremost an institutional manager. An investor needs $1 million to get into the MB Fixed Income Fund. The fund has nothing but fi rst-quartile results for

164 C H A P T E R 7

all periods from one to 10 years ended December 31, 2005. For those 10 years, the fund produced an average annual compound re-turn of 7.96% and beat the SC Universe Bond Total Return Index for most standard intervals in the time frame. Excellent manage-ment, above-average returns for every calendar year from 1996 to 2005, and the effi ciency possible in a $3.3-billion portfolio have made the MB Fixed Income Fund a model for what the best man-agement in the business can do for unitholders.

Northwest Specialty High Yield Bond FundIn the business of buying junk bonds, there are few managers bet-ter than Doug Knight of Deans Knight Capital Management in Vancouver. The $245-million portfolio of sub-investment–grade bonds produced an average annual compound return of 7.28% for the 10 years ended December 31, 2005, more than the 5.31% aver-age annual compound return of the benchmark Globe High Yield Peer Index in the period. Knight, who took over the 15-year-old fund in 2000, has boosted performance from trailing to leading. In 2004, the fund returned 14.94% to investors after deduction of the 2.10% MER, which is slightly lower than the 2.14% median MER of the sector,3 yet it was the best annual result of any high-yield fund in that year. Junk bonds tend to be cyclical, rising in price in economic recoveries. Recent performance suggests that Knight can continue his winning ways, but then, as mutual funds hasten to warn, past performance is not an indicator of future returns. Entry into this time-sensitive fund is $500, though it is not what any bond investor should regard as a basic, vanilla-fl avoured bond fund or a fi rst step into the bond market.

Sceptre Bond FundRun by pension and mutual funds manager Sceptre Investment Counsel Ltd. in Toronto by the company’s income and structured

165Bond Funds

products chief, Tom Czitron, the portfolio of Canadian federal and provincial bonds turned in above-average performance for each cal-endar year from 1996 to 2005. The $12-million fund’s 1.04% MER is about half the average unweighted management fee for Canadian bond funds. Czitron, who has run the fund since the summer of 2002, has continued a tradition of astute management that goes back to the fund’s inception in 1985. There should be few shocks for the investor who expects single-digit net returns better than higher-fee peers and usually a little lower than the SC Universe Bond Total Return Index. Entry into the fund can be had for the relatively modest sum of $5,000. Other funds that show high performance in comparison to peers tend to have much higher initial investment hurdles to jump. For the 10 years ended December, 31, 2005, the fund produced an average annual compound gain of 6.78%. That beat the 6.10% average annual compound gain of Canadian bond funds in the period.

TD Real Return Bond FundReal Return Bonds have clobbered other Canadian issues in the last few years as insurance companies and pension funds have latched on to what they see as the answer to their prayers. RRBs pay a base interest rate and then add an infl ation adjustment. For the 10 years ended December 31, 2005, the fund, which requires $1,000 as a minimum investment, produced an 8.77% average an-nual compound return. RRBs are issued as long bonds and have outperformed conventional bonds for most of the last decade. The TD fund, a $2.6-billion portfolio managed by Satish Rai, lost money in only one year in the last decade, 2001, when it dropped a modest 1.09%. The MER is 1.62%, but the performance has been extraordinary. Mr. Rai has added value in the narrow fi eld of RRBs that consists of four federal issues and a couple of Quebec issues with a few U.S. Treasury Infl ation Protected Securities tossed in to

166 C H A P T E R 7

add some foreign fl avour. Investors should beware the effect of this fund on taxable accounts: Annual infl ation adjustments produce capital gains that can add to tax burdens. This is a fund best suited to a tax-deferred account such as an RRSP.

MORTGAGE FUNDSMortgage funds are included in this discussion of bond-like in-vestments and investment funds because, for the most part, they behave like bonds, though with a crucial difference.

Conventional bonds with fi xed coupons and defi ned dates for return of principal have positive convexity. As interest rates rise, pushing down the price of the bond, the yield obtainable from the reinvestment of the coupon rises. Reinvestment return buf-fers the decline of bond value. This amounts to a shortening of duration and a reduction of risk. Conversely, when interest rates fall and bond prices rise, positive convexity acts to increase du-ration. That makes the bonds more responsive to the decline in interest rates and boosts their price appreciation.

Mortgage instruments have negative convexity. That is, as interest rates drop, mortgage instruments increase in price more slowly than conventional bonds. The explanation—borrowers will refi nance and return principal at what is a poor time for the lender. Yield on reinvestment declines. When interest rates are rising and bond prices are falling, mortgage borrowers will lock in their rates and deny the lender opportunities to reinvest interest at higher rates. These disadvantageous characteristics should force those who want to sell mortgage bonds to investors to pay some com-pensation in the form of higher interest rates. They do, but the fees charged by mutual funds in the mortgage sector take the gain away from the individual investor.

A successful mortgage fund with a long-term record, the Mandate National Mortgage Corp. Fund, is an $8-million portfolio

167Bond Funds

with a 7.03% average annual compound return for the 10 years ended December 31, 2005. Its MER is 1.30%. A less bountiful mortgage fund in the sector for the 10 years is the $17-million IAP Ecfl x Mortgages portfolio with a 3.59% average annual com-pound return for the fi ve years ended December 31, 2005. For that return, investors paid a 2.15% MER. In that period, the SC Short Term Bond total Return Index produced an average annual compound return of 5.62%.

Exchange-Traded FundsMutual funds would have stronger returns but for the fees that transfer performance from investors to managers. What’s more, in the narrowly defi ned subsectors of bond funds, fees tend to be the difference between the winners and the also-rans.

Exchange-traded funds (ETFs) provide a vast range of sector funds in stocks and bonds. The fi rst ETFs were launched in Canada in 1990. Toronto Index Participation Units, “TIPs” for short, were created to track the Toronto 35 index, the large-cap benchmark for the Toronto Stock Exchange. TIPs were the model for other ETFs that follow the Dow Jones Industrial Average (symbol DIA on the American Stock Exchange), the NASDAQ (QQQ on the Amex), and the Standard & Poor’s 500 Composite (SPY on the Amex). Today, there are hundreds of ETFs tracking such things as the Bloomberg European Pharmaceuticals Index (traded on the Euronext exchange in Amsterdam as IBEP). All tend to have fees that are downright microscopic in comparison to the fees charged by most mutual funds.

An ETF is bought and sold like a stock. Many can be optioned. The investor can set a limit order, specifying the price at which he or she will buy the ETF and sell it. Mutual funds, by comparison, are priced once a day on a take-it-or-leave-it basis. ETFs have no trailers paid to fi nancial advisors. The buy and sell commissions

168 C H A P T E R 7

are the only fees. Some RRSPs have custodial fees that are not cov-ered by buy and sell commissions for ETFs. ETFs traded through on-line exchanges can have fees that are a small fraction of those of mainline brokers.

Barclay’s Canada, a unit of Barclay’s Global Investors, has three important Canadian bond funds:

• iUnits Canadian Bond Broad Market Index Fund emulates the Scotia Capital Universe Bond Total Return Index. Traded un-der the symbol XBB on the TSX, it has an annual MER of 0.30%

• iUnits Short Bond Index Fund emulates the Scotia Capital Short-Term Bond Index. Traded under the symbol XSB on the TSX, it has an annual MER of 0.25%.

• iUnits Real Return Bond Fund emulates the Scotia Capital Real Return Bond Index. Traded under the symbol XRB on the TSX, it has an annual MER of 0.35%

There are no minimum share purchase requirements to enter any of these ETFs, though investment dealers tend to prefer selling lots of 100 shares. In early January 2006, XRB was priced at $20.19 per unit. A 100-share lot would have cost $2,019 plus whatever commission the investor can obtain through a full-service invest-ment dealer or a discount brokerage. Full-service dealers tend to charge 1% to 2% of the price of the trade. Discount brokers may charge as little as $6.95 for on-line trades.

Global bonds are also available in ETF packages. Barclay’s Global Investors markets several bond funds with the iShares name, including the Lehman Aggregate Bond Fund, symbol AGG on the American Stock Exchange with an annual MER of 0.20%. There’s also the iShares Goldman Sachs GS$InvesTOP™ Corporate Bond Fund ETF, symbol LQD on the Amex with an annual MER of 01.5%.

169Bond Funds

There are other iShares that package European corporate bonds in Euroland in sterling; U.S. Treasury obligations by short, medium, and long terms; and U.S Treasury Infl ation Protected Securities (TIPS), all with very modest expense ratios of about 0.20%. The investor who wants low fees and prefers to pick bonds by sector and term to maturity should look into bond ETFs.4 What’s more, the adept bond investor can trade bond ETFs with discount broker fees far lower than the spreads he would pay on bond deals below $500,000.

Examples of Popular Bond ETFs

ETF Name

iUnits Cdn. Bond Broad Market Index Fund

iUnits Short Bond Index Fund

iUnits Real Return Bond Index Fund

iShares Lehman Aggregate Bond Fund

iShares Lehman 1-3 Year Treasury Bond Fund

iShares Lehman 7-10 Year Treasury Bond Fund

Symbol*

XBB-TSX

XSB-TSX

XRB-TSX

AGG-A

SHY-A

IEF-A

Asset Type and Portfolio Content

Emulates Scotia Capital Universe

Emulates Scotia Capital Short Bond Index with maturities of 1–5 years

Emulates Scotia Capital Real Return Bond Index

Emulates the total investment-grade U.S. bond market defi ned by the Lehman Brothers U.S. Aggregate Index

Emulates Lehman Brothers 1-3 Year U.S. Treasury Index

Emulates Lehman Brothers 7-10 Year US Treasury Index

MER

0.30%

0.25%

0.35%

0.20%

0.15%

0.15%

Continued on next page

170 C H A P T E R 7

ETF Name

iShares Lehman 20+ Year Treasury Bond Fund

GS $ InvestTop™ Corporate Bond Fund

Symbol*

TLT-A

LQD-A

Asset Type and Portfolio Content

Emulates Lehman Brothers 20+Year U.S. Treasury Index

Emulates U.S. corp. bonds defi ned by Goldman Sachs InvestTop ™ Index

MER

0.15%

0.15%

* TSX designates ETF traded on the Toronto Stock Exchange; A designates ETF-traded on the American Stock Exchange

Source: Barclays Global Investors

MONEY MARKET FUNDSThe interests of the fund vendor and the fund investor are clearly at variance in money market funds. The low interest rate environment leaves little for clients in some funds. For example, the National Bank Money Market Fund charged 1.06% for management expenses as of December 31, 2005, leaving a return of just 1.76% for unitholders for the 12 months ended December 31, 2005.

That’s a good deal less than the 3.99% at time of writing that the investor could have gotten in one-year Canada Treasury bills or in bankers’ acceptances, which are short-term IOUs of char-tered banks secured by the general credit of the institution. At the time of writing, bankers’ acceptances are being offered to retail investors at about 10 basis points over Canada Treasury bills of the same term.

The pathos of handing management to others appears in the balance of fees and returns in U.S. money market funds. For the 12

171Bond Funds

months ended December 31, 2005, MERs ranged from 0.56% for the Phillips, Hager & North U.S. Money Market Fund—to an amazing 2.52% for the TD U.S. Money Market Fund. The high levels of fees on low-return fi xed income funds happens only because investors do not know what is happening or know but fail to take their money else-where. There can hardly be a better example of a situation in which the investor should call an investment dealer and buy some treasury bills or bankers’ acceptances on his own, assuming, of course, that he has the $5,000 or so minimum required for such deals. If mutual fund vendors actually want to do the right thing by clients, they should cut fees. The client who does business with a fund whose MER exceeds what he gets as a return has only himself to blame.

BONDS AND BOND FUNDS—CRITICAL DIFFERENCESThere are vital differences between bond funds, ETFs, and actual bonds. Managed products tend to be self-perpetuating. They re-tain some or all of their growth, while actual bonds automatically revert to cash at their termination.

If bonds are held in tax-deferred accounts such as RRSPs, then cash reversion is just a concept, for there will be no payout until the account is converted to a Registered Retirement Income Fund or the money taken as a lump sum or converted to an annuity.

For investors with cash accounts that have no tax postpone-ment, the choice of taking coupon interest and capital gains as cash or reinvesting can be very important. Reinvestment of cou-pons provides automatic value hedging if interest rates are rising. For a large bond position, that reinvestment can mean the differ-ence between a bond that suffers large losses in market value in a rising interest rate environment and a bond that is supported by rising returns from reinvestment.

172 C H A P T E R 7

Investors with, say, six-fi gure investments in bonds or funds can reinvest from time to time. It may not be as often as man-aged funds do it, but reinvestment will provide value support. For investors with bond positions too small to make it possible to buy bonds with monthly interest or annual distributions, a bond fund is a good way to achieve monthly reinvestment or even to set up a process for rebalancing into equities should bonds strongly outper-form stocks. Balanced funds do this rebalancing as a part of their mandate. What is critical is choice of managed product. While managerial acumen is variable, costs are certain. There is hardly another area of investing in which low fees matter as much as they do in bond funds.

SPECIALTY BOND FUNDSSome funds provide bond investing strategies that the retail inves-tor would be hard pressed to imitate. For example, the Arrow High Yield Bond Fund, a $101-million portfolio, produced a 1.61% re-turn for the 12 months ended December 31, 2005. For three years ended December 31, 2005, the fund returned 5.78% per year com-pounded annually. Arrow Hedge Partners Inc. is a fi rm known for alterative strategies, but complexity of play does not necessarily produce a proportionately larger return. For the respective peri-ods, the S&P/TSX Total Return Index produced returns of 1.61% and 21.66%

DIVIDEND AND INCOME FUNDSThis is a book about bonds, but it is useful to discuss investment vehicles that investors may see as bond substitutes. Interest rates are at relatively low single-digit levels and the quite exceptional returns of income trusts and dividend funds in the last fi ve years would appear to be reasons to divert investments from bonds into these alternatives.

173Bond Funds

The case for dividend funds and income trusts appears to rest on their numbers. In terms of gross returns, bonds and bond funds appear to be laggards. See the following table:

Returns in % for periods ended December 31, 2005Fund type 1 year 3 years 5 years 10 yearsCanadian Bond 5.1 5.2 5.6 6.1Canadian Dividend 15.4 15.3 9.2 11.7Cdn. Income Trusts 17.7 22.5 16.9Source: Globefund for periods ended December 31, 2005

Superfi cially, there would appear to be no reason at all to buy bonds. But the data need to be refi ned. First, Canadian bond funds are heavily weighted with government bonds and investment-grade corporate bonds. The default rates in hard times on these vehicles is exceptionally low. The income has a high level of cer-tainty. Income trusts are companies packed in a tax wrapper. They have equity risk built on the fortunes of businesses as narrowly defi ned as mattresses, peat moss, oil, gas, cold storage, and single newspapers. Income trusts’ yield includes return of capital in a diffi cult-to-quantify mix.

High yield is the payment for taking on income vehicles with equity risk. Standard deviation (SD) data make the point. A measure of volatility or fl uctuation of asset price, it shows relative riskiness. The higher the SD, the more volatile and risky the relevant asset is. Now consider that over the last three years, funds of Canadian bonds had an SD of 3.4%, Canadian dividend funds had an SD of 10.0%, and income trusts an SD of 6.5. Bonds help reduce portfolio risk. Equities, whether packaged as income trusts or distilled into dividend funds, add to bond risk.

When severe economic contractions hit, as they did in 2000, stocks sag and bonds soar. In 1998, for example, a tough year for

174 C H A P T E R 7

credit markets around the world, Canadian bond funds returned 9.18% while income trusts lost 3.01% and dividend funds lost 0.56%. Many income trusts, such as the Dynamic FocusPlus Energy Income Trust, which returned 33.56%% in the 12 months ended December 31, 2005, are loaded with hot oil and gas as-sets. The tables could turn quickly if oil prices retreat to US$20 to US$30 per barrel. Other income funds that produce what are widely (and wrongly) regarded as bond equivalents fl ourished in the energy-crazed markets of 2005. But not all income trusts are equally vulnerable to a downturn in energy prices. The Sentry Select Canadian Income Fund returned 22.56% in the same pe-riod and has been a strong performer in the sector since the fund’s inception in February 2002. Sentry Select has diversifi ed holdings and has held oil and gas trusts to a fraction of total assets and thus should not implode if energy prices make a strong retreat.

CLOSED-END BOND FUNDSClosed-end funds are like mutual funds but with a big difference: Unlike mutual funds, which buy and sell at the net asset value of their units, closed-enders trade at the prices per unit the market confers on them. Mutual funds take money in and pay it out at the end of each day at net asset value. The fund’s back offi ce divides the value of their holdings by the number of units outstanding. If a mutual fund has $10 million worth of bonds or stocks and 1 million outstanding units, the unit price is $10. If investors want to redeem 5% of total fund assets, the total fund will fall to $9.5 million after the settlement and there will be 950,000 units out-standing. The unit price will not have changed. A closed-end fund, however, trades at whatever investors are willing to pay. Thus with the same $10 million of assets and 1 million units, the closed-end fund could be priced at $15 if investors think that the assets are due to have a grand time in the future or at $5 or $1 or anything

175Bond Funds

else below the net asset value if investors are pessimistic about its holdings. The number of units of the closed-end fund is fi xed and they therefore sell in an auction process not much different than the market for stocks. And that market can add volatility and un-certainty to the prices of the underlying assets.

The difference between the two fund structures is crucial, for while mutual funds spend considerable sums to keep the public interested and to promote sales, closed-end funds, with a few ex-ceptions, are launched with customary hype and then left to the mercies of the market.

That leaves the bond investor with a curious dilemma. It’s pos-sible to buy into the fund when the discount reaches a suitably low point, pocket a yield enhanced by the discount from NAV, and then sell when, as often happens, the discount narrows or even goes to a premium. Some closed-end funds have annual events at which investors can cash out at NAV; others have built-in liquida-tion procedures. The canny closed-end bond fund investor can go for current yield or play for eventual redemption at NAV. This is clearly a pencil-intensive fi eld of investing.

As we have noted before, there are no minimum investment sums that are required to enter closed-end funds. Investment deal-ers prefer to trade lots of 100 shares and multiples thereof, but an investor can buy fi ve or ten shares if he wishes. It should be noted, however, that commissions on such small trades may take the form of fi xed minimums that are large enough to be effective penalties on small trades.

Closed-end equity funds are common in Canada, for conven-tional income trusts are organized as closed enders. Closed-end bond funds are less common in Canada because investment dealers, who typically take 5% of monies that fl ow into new investments, ef-fectively cut down any advantage that a closed-end fund would offer, says Tom Czitron. “Equities and other assets are more volatile than

176 C H A P T E R 7

investment-grade bonds and can support conventional underwriting fees, but most bonds cannot,” he explains.

Internationally, the closed-end style supports specialized geo-graphic equity funds that invest in Brazil, South Korea, Germany, India, and other lands. In the U.S. market, there are hundreds of highly specialized closed-end funds, often holding blends of mu-nicipal bonds that are free of income tax for residents in the state in which the so-called munis are issued.

An investor can get a market advantage in closed-end bond funds. With what is usually little active management beyond ini-tial bond selection, the funds have low fees, seldom much more than 1%, in comparison to actively managed Canadian bond funds that have a median MER of almost 2% of NAV and foreign bond funds with median MERs of 2.24% of NAV, according to globefund.com.

The leading authority on closed-end funds in North America is Thomas J. Herzfeld Advisors, Inc. of Miami, Florida. Cecelia Gondor, executive vice president of the fi rm, notes that it’s oppor-tune to consider closed-end bond funds now.

“We recommend looking at some of the closed-end bond funds,” Ms. Gondor explains. “As the yield curve fl attens and some bond funds suffer reduced income as the proceeds of reinvestment decline, the funds’ market prices tend to fall more than their net asset values. As a result of the widening discount, the potential leverage to the buyer grows.”

Closed-End Canadian BondsThe Canada Trust Income Investments Fund (symbol CNN.UN) is a blend of fi xed income securities. The MER is just 1%, and the monthly distribution generated 49.26 cents per unit in 2004, a yield of about 5.5% on the average price of the fund—about $9.00 for the year.

177Bond Funds

Closed-End Global BondsThe Aberdeen Asia-Pacifi c Income Investment Company Ltd. (symbol FAP) holds sovereign and corporate bonds issued by Australia, New Zealand, the United States, South Korea, Thailand, Malaysia, India, Canada, the Philippines, Hong Kong, Japan, and Pakistan, priced in several reference currencies. The management company, a global operator based in Scotland, is effi cient. It paid out 421% of NAV since inception in June 1986. The MER is a modest 1.04%.

Closed-End Junk BondsJunk bonds’ risk-adjusted returns rise when they are bought at a discount that reduces money that may be lost through defaults. A diligent investor can fi nd the DDJ Canadian High Yield Fund (sym-bol HYB-UN). There’s also the DDJ US High Yield Fund (symbol DDJ.UN). Both funds have MERs of 1.1%. The advisor to the funds is DDJ Capital Management LLC in Wellesley, Mass. The median MER on high-yield bond funds sold in Canada is 2.17%.

All closed-end funds present two analytical problems. The fi rst is the conventional one of analyzing the underlying asset base. The second is timing the closed-end fund cycle to get the most from the discount from NAV and to time the sale of the asset when it goes to a smaller discount, to par, or to a premium. A lot of high-yield bond funds have gone to premiums as investors, hungry for yield, have bid up fund prices. Many junk bond funds trade at discounts, though a few, including BlackRock High Yield Trust (BHY-N) has traded at a premium to net asset value. BlackRock Inc., based in New York, had US$452 billion under management as of December 31, 2005.

Closed-end bond fund discounts may narrow if interest rates decline or if yields increase. “You can sell closed-end funds when

178 C H A P T E R 7

the discount narrows,” Ms. Gondor explains. “That happens when the discount narrows to a level normal for the peer group. The typical discount for investment-grade bond funds is 6%; for junk bonds it is 8%. Accordingly, if the discount narrows to less than the norms, one can sell.”

Closed-end funds magnify price movements that affect un-derlying assets. They trade on the leveraged popularity of their underlying assets. That enhanced movement adds to risk and, of course, to potential return. “This is a kind of momentum trading,” Czitron says. “When the underlying assets rise in price, specula-tors may pour in and drive up the price. When the underlying assets go down, the players may fl ee and drive the price down.”

Some closed-end funds have price-support programs. A man-agement company may buy shares when their discount is large. There may also be a windup mechanism to realize net asset value at a future date. For an investor who buys into a closed-end fund when the discount from NAV is large and stays with it, then, as the manager retires units in a price-support program, as many funds have, the gain accrues to the surviving investors, Czitron notes. “The knack to investing in closed-end funds is to capture the dis-count and to monetize it,” he explains. “That happens to investors who are good timers or, in funds that have price support programs to the time when the fund is liquidated, as many are.”

The diligent investor can make use of several websites to research closed-end bond funds, including Nuveen’s www.etfconnect.com and Herzfeld’s www.herzfeldresearch.com. Closed-end bond funds are an effi cient though complex way to buy into credit markets.

THE LIMITS OF BOND RETURNSThe essence of a bond is risk control through investment in a promise to pay cash or equivalent value and to repay the loan at a specifi ed date. Perpetual bonds, once called consols, have no

179Bond Funds

specifi c repayment date, but the idea is still that the stream of in-come is predictable and reliable.

Financial engineers can leverage bond returns but not without adding to risk. Customarily, they also add heavy costs. Realism in bond investing is understanding that the baseline return of a bond is the income that can be produced by a low-duration bond or a treasury bill. All higher returns are built on hopes and risks and, ul-timately, odds that would frighten a gambling addict in Las Vegas.

What bonds can return is indicated by their historical record. That depends on the period reviewed, but the wise investor would do well to expect no more than a mid-single-digit return on short, high-quality bonds. Risk adds to return, but the investor who wants to get a double-digit return from a promise to repay a loan in a climate of moderate infl ation should look to stocks. After all, if the investor takes equity risk in junk bonds, he should get an equity return.

Historical experience in bonds and bond products can be seen as setting limits on expectations rather than on performance. Our expectations tend to be rooted in the past based on what we know and have experienced. On the other hand, what happens can be far from our experience. The German hyperinfl ation of 1919–1923 left the Reichsmark at one six-billionth of its 1914 value. The infl ation was engineered by central bankers eager to show that Germany could not afford to repay its reparations. The German event is unique in history in scale, though numerous countries, including Turkey and Brazil, have suffered and then controlled periods of high infl ation. The wise bond investor should estimate the future conservatively and seek to minimize risk in diversifi ca-tion by issuer, by term, by bond fund, and perhaps by country and currency. Bonds are, after all, a risk-minimization device. And risk, like manure, is best when spread.

180 C H A P T E R 7

THE FUTURE OF PACKAGED PRODUCTSCanadian mutual fund companies like to point out that they have a smaller customer base over which to distribute fund costs. That, they say, justifi es their high fees. Consider, however, that fees are half or less in the United States even apart from marketing costs that are broken out separately, and that leading fund vendors, in-cluding Fidelity, have pushed fees down to 20 basis points and even less on index products, and you see the hollowness of the argument that Canada must have higher fees.

A trend toward lower fees will inevitably force investors to do more of their own research, much as they must do now if they choose to use discount brokers rather than full-service brokers that include research (often of dubious value) with their trading services.

Investors have 324 Canadian bond funds from which to choose. There are 85 foreign bond funds, 75 short-term bond funds, a rap-idly rising coterie of income trusts, and thousands of U.S. mutual fund and ETF products from which to choose. In this cashbah of often very loudly touted products, an investor is easily confused.

It is a fair guess that as fees decline, a process already under-way, the fund industry will fi nd ways to rationalize itself. After all, Canada does not need 324 different wrappers on funds of much the same Canadian bonds. Web resources and a well-classifi ed ranking of funds, costs, and characteristics could enable many people to buy bonds and ETFs without the traditional costs of mutual fund management. A better world is coming for investors and, in the tightly defi ned space of Canadian bonds, it is bound to close the gap between net returns after fees and gross returns before fees. “In bond funds, where the opportunity for manage-ment to add value is limited, there is going to be greater pressure than on equity funds for fees to come down,” Mutual fund analyst Dan Hallett says. “We are still in a period of management fees

181Bond Funds

1. On an asset-weighted basis, Canadian bond funds had MERs averaging 1.36% in 2004. Globe and Mail, May 9, 2005, p. B-9; on an unweighted basis, the median MER is 1.9%, Globefund data for periods ended December 31, 2005.

2. Globefund data for period ended December 31, 2005.

3. Globefund data for period ended December 31, 2005.

4. See Jim Wiandt and Will McClatchy, Exchange Traded Funds (New York: John Wiley & Sons, 2002).

higher than they were 20 years ago. As fees come down, bond unitholders are bound to be better off.”

Endnotes

Chapter 8

BOND TRADING TACTICS

If bond investing is a science, then bond trading is an art. A black art at that. Unlike stocks, bonds have no centrally boarded

price. There is no single bond exchange that provides moment-by-moment pricing. If you want to know what a bond is worth, that is, what its price is at a moment and who has some to sell, you have to ask around.

Bond trading in the 21st century has a lot in common with the unregulated stock market of the 19th century. Consider that stock exchange authorities monitor all trades and watch big block movements. A stock investor who wants to start a takeover or even to accumulate a signifi cant position in a company’s shares must disclose his position. Not so in bonds. Bonds, you see, are traded between counterparties, often without the aid of a regulated mid-dleman or investment dealer.

A famous case of ego-driven bond lust is told by Michael Lewis, who worked with the greatest bond traders of Wall Street at Salomon Bros. in 1987. After the October 19 crash, Salomon’s bond guru, John Meriwether (who later piloted Long-Term Capital

184 C H A P T E R 8

Management into days of US$500-million losses and then into insolvency), decided that interest rates were on a long, downward path. He did a straddle on US$2 billion of 30-year Treasury bonds, shorting a new issue and buying an older but nearly identical is-sue. The new bond, which was more liquid, was selling at a small premium over the old bond. The idea was that the premium would shrink once the panic selling in the stock market subsided. And he was right. When the crisis had passed, the bond prices did converge and the bond guys walked away with a profi t of US$150 million, which was pretty good when you consider that Merrill Lynch made just US$391 million in profi ts in 1987. The lesson was that sup-posedly riskless bond arbitrage—selling one issue and buying a similar bond when they were trading at prices supporting different returns—would be hugely profi table.

And it was until the fall of 1998 when events conspired to de-stroy Meriwether’s bond colossus. With US$1.2 trillion total at play, LTCM was operating on mathematical models devised by Robert Merton and Myron Scholes, both Nobel-winning econo-mists with an interest in the pricing of options. The models assumed that trading was always continuous and that price functions—the line prices trace out over time—were continuously differentiable, which is math-speak for perfectly smooth. The reality, of course, is that markets close or subside on some holidays. Yet interest-rate-changing things can happen when markets are closed. Fate and hubris and believing that math is the real world conspired in September 1998. On September 21, LTCM lost US$500 million in one day, the result of bad outcomes on two esoteric deriva-tives plays. The fund had shorted options that suddenly rocketed upward in price, a huge U.S. insurance company appeared to be trading against LTCM, and the curtain had to come down. Afraid that the fall of LTCM would rock the world fi nancial community, the U.S. Federal Reserve organized a rescue plan that brought

185Bond Trading Tactics

in fresh capital and left shock waves in Europe. Losses at LTCM totalled US$4.4 billion, about US$1.9 billion of which belonged to Meriwether and his partners, US$700 million belonged to the Union Bank of Switzerland, and US$1.8 billion to other European banks. The partners and the Nobel laureates lost their money, Meriwether lost his job and eventually started a different hedge fund, and the affair of LTCM was eventually put on the shelf of history. But there are lessons.

The causes of the fall of LTCM were diverse: mathematical over-confi dence, a Russian debt default a month before the September crisis, the Asian currency meltdown, and, fi nally, the black beast of all traders big enough to be noticed—a move by counterparties and even unrelated parties to move the markets. As Michael Lewis wrote in the New York Times more than a year after the LTCM meltdown, quoting LTCM principal Victor Haghani, “The hurricane is not more or less likely to hit because more hurricane insurance has been written. In the fi nancial markets this is not true. The more people write fi nancial insurance, the more likely it is that a disaster will hap-pen, because the people who know you have sold the insurance can make it happen.”

The implication of the comeuppance of LTCM is that, if you are big enough, you can be made to fail. The average retail bond investor has no such risk. But if the bond investor were to decide to concentrate his risks by borrowing heavily to buy one corporate bond, it is possible that others in the market, if they were to learn of the position, could trade against it. Add in the complexity of shorts and straddles on both sides of the bond and the risks in-crease. It is surprisingly easy to move the market by fi ddling with options and changing the risk characteristics of a publicly traded asset. While it is doubtful that any single private investor can make much of a dent in the market for on-the-run government bonds, it is possible to be a major holder or trader of lesser-known corporate

186 C H A P T E R 8

bonds. The careful investor will spread his risks and, if he should build a large position in a single asset whether stock or bond, keep quiet about it.

BONDS COME BACK INTO FASHIONIt is an arguable proposition that bonds will soon move from the obscurity of the ledgers of insurance companies to cocktail party banter. The kids of the post-World War II baby boom are com-ing into their bond years. Cocktail party talk that used to dwell on mergers and takeovers, tech stocks and laments for the losses trig-gered by the dot-com boom will turn to bonds.

Demographics alone should put some force under bond prices, for older investors are likely to move from stocks, which always have a good deal of intrinsic risk, to relatively secure bonds. But the move will not be an easy one. And in the process, the manage-ment of bond portfolios will be critical.

For the 20 years ended December 31, 2005, the S&P/TSX Total Return Index generated a 9.6% average annual compound return. In the same period, the SC Universe Bond Total Return Index grew at 9.5%. This near-equal fi nish by bonds in relation to stocks is uncharacteristic, for interest rates fell from mid-80s high levels to post-World War II lows in the wake of the collapse of the tech boom. Today’s bond investors should look to risk control for their portfolios of investments rather than to maximizing total return.

ANALYZING TRENDSManaging a portfolio of investment-grade bonds is a very different exercise than managing a portfolio of common stocks. The holder of common stocks should take a keen interest in earnings trends, cash fl ow, return on equity, and news pertinent to what amounts to the popularity of the stock in the present and perhaps even in the future.


The owner of investment-grade bonds should study interest rate trends.

The holder of credit-sensitive bonds needs to look into the is-suer’s overall health, measures of its debt, its ability to pay the costs of carrying debt, and the viability of its business model in the fu-ture. Holders of convertible bonds must do all this and examine the trends of the issuer’s shares as well.

Interest rates are intimately linked to the business cycle, a connection that has produced an immense literature and wrecked more than a few reputations of savants who were able to produce a few correct calls and then, in the limelight of public adulation, produced no more.

In one of the most famous gaffes of all times, Yale economist Irving Fisher said that Wall Street was just fi ne and that “stocks were permanently on a high plateau.” His words, uttered on October 16, 1929, preceded the great crash on October 29 by less than two weeks. More recently, at Lehman Bros., a major New York invest-ment bank, Elaine Garzarelli predicted the October 1987 crash that sent world markets on a double-digit, one-day crash that took a year to recover from. Since that prediction, she has been more ap-proximate than on target. Mark Hulbert, publisher of the Arlington, Virginia-based Hulbert Financial Digest, follows investment advisory letters. He concludes that market watchers whose predictions actu-ally beat the market are very rare. A few advisory letters, including Value Line, have good records, but most focus on stocks, not bonds. Simply put, fi nding a crystal ball that never lies is as hard as doing the predictive research oneself. And that problem is as hard for each market forecaster as it is for each private investor.

An individual investor may therefore wonder whether, if profes-sional forecasters seldom get their numbers right, what chance has a player on the sidelines? The answer, oddly enough, is that the indi-vidual investor with an absolutely clear understanding of why he is

188 C H A P T E R 8

in the bond market can often do very well. The reason is a difference of objectives. Institutional portfolio managers compete to outdo one another, trading the same defi ned sets of bonds, arbitraging away variations in returns among various classes of bonds, adjusted for risk, of course, and draining whatever extra value they add to their bonds by the fees they charge their investors.

An investor who wants bonds to pay for a university education or retirement or a hedge against falling stock prices can set up his portfolio to do those things. Viewed as insurance for portfolios that include stocks and perhaps real estate and commodities, bond returns below stock returns become sensible charges for risk re-duction or, if above equity returns, gains attributable to prudent management. Economists may debate whether an amount of bond return is insurance or excess return for prudence, insight, or luck, but the investor can merely be satisfi ed that the portfolio has sailed through troubled waters reasonably well.

Investors can look at any asset category from government bonds to stamp collections with varying degrees of skepticism. The most critical investors, those who believe that the future is entirely unpredictable, can either stay in cash, thus ensuring that they will suffer erosion of value from infl ation, blindly pick assets on the theory that no one can beat random choice, or invest in a balanced fund or an asset allocation fund in which others make sec-tor choices within predetermined limits. Over the 10-year period ended December 31, 2005, Canadian balanced funds with a typical 60/40 ratio of stocks to bonds produced average annual compound returns of 7.3%. In the same ten-year period, Canadian tactical asset allocation funds that vary their stock-to-bond ratios, often by use of complex mathematical models of the economy, produced average annual compound returns of 7.1%. In other words, in making stock-to-bond allocation decisions, doing nothing paid a little better than doing something.


A degree of disbelief can pay a healthy return. That’s not be-cause ignorance is a superior guide to markets—a belief that would lead the reader to discard this and other investment books—but because, as Yogi Berra said, “predictions are hard to make, espe-cially about the future.” One might add that it’s doubly true when it comes to bonds.

The wise investor can do research on a stock and come to the conclusion that the price of its shares will be higher in 20 years. For most stocks, most of the time, that will be correct. He can have no assurance that the prices of the 10-year Canada bond or a long U.S. Treasury issue will be higher or lower in two decades, for he cannot know what central bank policy will be nor, for that matter, what issues the Bank of Canada or the Fed or the European Central Bank or the Bank of Japan will be facing in 2026. This fl ummoxes bond portfolio managers, especially those in charge of long-term investments at insurance companies. It need not disturb the individual investor who seeks not to beat other bond manag-ers, but just to survive the 20-year period, generate a return above infl ation, and take home a decent return for the risk carried.

Much of the future can be read in the yield curve, and more can be read into long-term business cycles. Cycle theorists include those who believe that hemlines and other nonfi nancial indica-tors such as Super Bowl outcomes predict markets and others who believe that the market is predicted by wave cascades based on number sequences.1 Other predictors include a belief that sunspots that affect agricultural output determine economic cycles.2

The investor who would rather not lose his shirt should be an empiricist. It is valuable to look at the duration of business cycles, for they determine a large part of interest rate trends. In the United States, in the period from 1945 to 2001, contractions have lasted 11 months and expansions have lasted 52 months. A complete cycle therefore lasts fi ve years and three months. The

190 C H A P T E R 8

implication for the bond investor is that interest rates will tend to fall in contractions, boosting bond prices, and rates will rise in expansions, reducing bond prices.3

Canada’s economy is not congruent with that of the United States. Canada, an exporter of energy, may have a boom that leads to a bust in the United States. As well, no two business cycles are identical. The investor would do well to weigh investment plans in the framework of the cycle. Stock investments are opportune at the bottom of a trough, for share prices are likely to rise in the suc-ceeding months of recovery. A bond investor can buy bonds with terms of less than fi ve years as a recovery gets underway, pushing up interest rates. A few years into an expansion, the bond investor can lengthen his terms in order to capture the full benefi t of inter-est rates that are likely to fall once the recovery falters.

The timing of cycles shows a good deal of variability. The sustained economic expansion of 18 years ended with a recession following the collapse of the tech bubble in 2000. That put an end to the recovery that began when the Fed and the Bank of Canada broke the back of double-digit interest rates in 1982. It was one of the longest expansions on record and the contraction, which lasted 28 months, was relatively short, though severe. Given the variabil-ity in duration of business cycles, a bond investor can make only an estimate of where interest rates may be in several years and just a crude guess of where they may be in a decade. For example, Canada and the United States are fi ve years into an expansion that began with the bottom of the tech bust in November 2001.4 Interest rates appear to be on a rising path in the United States and should rise in Canada in 2006, possibly declining late in the year. On a short-term basis, the investor would do well to be cautious about holding long bonds. Even so, interest rates remain in a low band compared to their average in the preceding two decades. For periods of more than fi ve or six years—which is a full average economic cycle—the


investor can do a little arithmetic and decide whether to hold short or longer bonds. But there is a caveat: If bonds are for conserving wealth, then caution pays. The bond investor who chases yield in long bonds with terms of 10 or more years could be in for substan-tial transitory losses or years of regrets if he misjudges the timing of the business cycle.5 Short is safe, even if it is not heroic.

For a bond investor with a specifi c time-framed goal, the busi-ness cycle matters less than effi cient investment for the years ahead. Financing a university education ten or more years away can be done with a stripped bond or bonds that mature at the start or dur-ing intervals in the student’s anticipated period of study. Interim values that might be affected by the business cycle will not be of critical importance. A retirement can be handled the same way.

BOND SELECTIONStocks trade on exchanges. The numbers of issues, the numbers of issuing companies, and the value of daily trading in each stock can be ascertained in seconds from numerous databases that are avail-able on line. These things are harder to do with bonds, for they are traded over the counter without exchanges. There is no single register of all bonds in existence. Bonds that are “on the run” trade often enough to provide continuous pricing and trading trends. Those that are “off the run” may trade only once a day, or a few times a week.

Picking bonds is, in a sense, an exercise in defensive shopping. Government bonds are almost always liquid, so the holder need not fear that he will be forced to swallow a huge discount if he wants to sell. Yet the problem of selection of government bonds, while eso-teric for institutional managers that want to push performance by a hundredth of a percent, is actually fairly simple for a private inves-tor. For the individual investor, one Government of Canada bond due in 2015 is as good as another. There may be small variances

192 C H A P T E R 8

in yield and price, but the market quotes may not be as important as dealer inventories. For corporate bonds, it is vital to check the indenture to verify conditions of issue, call dates, credit conditions, and to verify the issue’s credit rating. In the end, for investment-grade bonds, the private investor with a need for cash at a certain date can shop with confi dence that small price differences may not even be apparent on deals below $1 million. For ratings, especially on Canadian issues, see www.dbrs.com. For ratings generally, see www.standardandpoors.com.

CUSTODYBonds used to be elaborately engraved. They were lovely things, but trading them generated a marathon of footwork. Couriers had to take bonds to the dealer, tender coupons for payment at the bank, take payments to the bank, etc. It was enough to wear out a pair of brogues in a month. Most bonds today exist only on the screens of investment dealers. Electronic record keeping and settlement make life easier for investment dealers and clients, though it may have reduced couriers’ prospects for continuing employment.

There remains a market for paper bonds, however. Some cor-porations continue to issue fully registered bonds that show the name of the benefi cial owner. As well, bearer bonds, so-called because they are regarded as the property of the person who holds them, continue to be used in some European jurisdictions that put a premium on the confi dentiality of transactions. They come with tails of coupons that have to be detached and cashed. In Canada, however, the great majority of new bonds and govern-ment bonds are virtual and exist only on the ledgers of brokers and transfer agents.

The Canadian Depository for Securities (CDS), an entity owned by the Investment Dealers Association of Canada and the major chartered banks and the TSX Inc. (the Toronto Stock


Exchange and related businesses), is at the core of the securi-ties transfer business in Canada. CDS has over $2.3 trillion of securities on deposit and takes part in more than 62 million secu-rities trades a year. It also takes part in settlement of cross-border trades and settles trades with its peers, the U.S. Depository Trust & Clearing Corporation and Euroclear, an operation in Brussels that handles securities trading and transfer and custody for European stocks, bonds, and related instruments.

Since the fall of 1995, all issues of Government of Canada marketable bonds and Treasury bills have been issued in a global certifi cate form and registered in the name of CDS & Co., a nomi-nee of the Canadian Depository for Securities. Prior to December 1993, Government of Canada bonds were issued in bearer as well as in fully registered form in the name of the benefi cial owner. Canada bonds were available in denominations from $1,000 to $1,000,000. Beginning in the 1990s, Government of Canada bonds were moved to the CDS book-based system and issued only in ful-ly registered form. Canada Savings Bonds, which are convenient though not very remunerative, can be purchased in either paper or book-based form. CDS also handles custody and settlement for all provincial bonds, many municipal bonds, and the majority of corporate bonds issued in the last two decades.6

For most investors, the book-based form of issuance is excel-lent. Brokers can alert their clients to bond calls sent out by issuers. They collect and forward interest payments, handle bookkeeping chores, and select bonds for redemption if the issuer is on a sinking fund system and calls bonds for payment prior to maturity.

The choice of whether to hold bonds in paper or digital form can be affected by the investor’s sense of ease with the world. Investors who fear a collapse of the economy or worry about bank failures may want paper bonds. They then must fi gure out what safe custody arrangements they can make. Investors who prefer to

194 C H A P T E R 8

leave custodial worries to the broker can be happy that they need not fetch bonds from brokers, take them to their vaults, run to their banks when there is a redemption, and plan their vacations around bond or stock trades. What’s more, an investor who has lost a bond and had to go through the complexities of replacement will appreciate the simplicity and effi ciency of holding virtual bonds.

VIGILANCEAs the 21st century opened, the spread of computers and of high-speed Internet connections led to the rise of day trading. The notion that one can trade on the small movements stock prices make every moment of the day led to the bankruptcy of many in-vestors. It is harder than it looks.

Day trading bonds is even tougher, for the intrepid investor has to fi nd a counterparty with a bond, buy it, and fi nd a buyer on the way out of the position. Large institutions do these trades in massive trading rooms. Major banks and investment dealers hire mathematicians and physicists to extend and improve option the-ories into fi xed income trading. Pricing models are installed on supercomputer networks that are the envy of the world. Big insti-tutions can trade bonds and do swaps for one or two basis points of yield. The individual investor cannot operate on these margins if only for lack of the capital needed to do $100-million trades. Recall that Long-Term Capital Management with Nobel Prize-winning mathematical economists and billions in the bank blew its brains out in 1998 trying to do riskless arbitrage. This is no place for the private investor to play.

All this means that the private bond investor should take a well-informed position and hold it until the bond matures or needs to be sold. It is not necessary to hover at a computer screen or to worry about daily movements in bond prices or the ceaseless gos-sip about what central bank governors may or may not want to do.


The private bond investor needs a goal and a strategy. Buy and hold is the simple and sensible thing to do.

Like any rule, this one has an exception. The investor who buys a long bond in a period of low interest rates and then fi nds rates rising rapidly would do well to consider either a swap into shorter bonds, a swap to bonds with higher coupons—which tend to do better under conditions of rising rates—or a sale into cash. Once the process of rising rates is underway, the sale of relatively low coupon bonds will involve a measure of loss. The investor who is sure that principal is not needed until maturity can just be fi rm and hold. But for the investor who may want cash in the interim before maturity, a loss reduction plan has to be considered. He should reduce his durations.

It may be convenient for the investor to have a set of refer-ence points or triggers for action. For example, a leap in the core Consumer Price Index by ½ of 1% or more in a single month can be an indicator for the Bank of Canada or the Federal Reserve Board to hike short rates by the customary 25 basis points at the next regularly scheduled meeting. Likewise, if new unemploy-ment claims decline by several percent in a single month, there may be a move to higher interest rates. Other leading indicators include building permits, the trend of stock prices, and average weekly hours worked. Many of these indicators are published in composite indices. The wise bondholder will hesitate to trade on small trend changes, but may withhold purchase or accelerate sales previously scheduled if interest rates appear to be rising.

TRADING SMARTA careful bond trader will watch the market for trends that can offer profi table deals or pose risks to his positions. The leading Canadian bond trading platform for dealers and institutions is CanDeal, which has done C$200 billion of trades since inception

196 C H A P T E R 8

in 2002. CanDeal is now part of TradeWeb, a network that has done US$77 trillion of bonds since opening for business in 1998.

A trader for a mutual fund or an insurance company with a few billion in bonds gets calls from sellers and queries from buyers, and has many investment dealers knocking at his door and proffering gifts and hospitality. The trader can also price a deal at conven-tional investment dealers and push the spread on a large deal, say C$100 million of federal bonds, down to one or two basis points on yield. That still gives a commission of $10,000 to $20,000, which isn’t bad for a couple of minutes work.

On the other hand, an individual bond buyer is at the mercy of the market and of the traders who process retail orders. Sceptre Investment Counsel Ltd. bond chief Tom Czitron says that bond trading is “less orderly than a bazaar in Damascus.” And some-times less ethical too, say experienced bond dealers, for when a dealer quotes a price, he could be fi shing for business, low-balling the client, protecting his inventory for a bigger deal, or just trying to fl ush out a sucker. Always do some research on recent prices before you ask the price of a bond. It’s just self-protection.

Bond trading allows little time for contemplation. It works with fast bidding and an assumption that the investor knows what he is doing. It’s “what you see is what you get.” The private inves-tor, alias the little guy, knows or ought to know that he will seldom get as good a deal as the large institutional investor. At the same time, the deal the private investor gets may be a lot better than paying a 2% average annual management expense to a professional to manage bonds with a gross return of 5%.

The individual investor can improve his returns by making shrewd buys. That requires narrowing the spreads between whole-sale (what the dealer pays) and retail (what the investor pays). The spreads are made up of actual price or yield differences and com-missions tacked on by the investment dealer, usually one’s broker.


Trouble is, a lot of the commissions and related fees are invisible. To bargain well, you have to shop around to learn the spreads that apply to each bond you are considering. That means checking fi -nancial websites, the bond prices in the Globe and Mail’s Report on Business and other fi nancial sections of major newspapers, and talking to major investment dealers that handle bonds.

The best bond deals go to investors with $10 million or $100 million to spend. It is to be expected that if you buy $100,000 fi ve-year Canada bonds, the deal will have a higher trading cost than an institutional-sized order over $5 million. Corporate bonds, which are always less liquid than government bonds, will have higher fees too.

The worst deals are Canada Savings Bonds and retail market provincial bonds. The issues tend to pay interest at less than mar-ket rates. All impose restrictions or disincentives on sale such as limiting cashouts to one day or one month a year, or offer fl oating rates that lack a clear defi nition of the standard against which in-terest is set. Some investment dealers make a market on what some market professionals call “sucker bonds.” The defence for these issues is that they can be had for as little as $100, can be purchased on payroll savings, and require no relationship with an investment dealer. Canada Savings Bonds do make good presents for children, can teach the value of saving, and, if lost or destroyed, are replaced by the Bank of Canada with much less fuss and expense than con-ventional bonds. CSBs offer a lot of service to the bond buyer who is a complete novice.

Convenience aside, what retail savings bonds pay is pathetic. For example, the S95 Series of Canada Savings Bonds issued in April, 2005 paid 1.55% in 2005 while orders under $25,000 for Canada Treasury bills, which are sold to more experienced inves-tors than those who may be attracted to CSBs, pay 3.50% as I write this in February, 2006. The issuer is the same, the credit rating is

198 C H A P T E R 8

the same, and the only difference is that the CSB is bait for the uninformed. The Ontario Savings Bond, alias the “Osbie,” issued in 2005 with a three-year fi xed rate of 4.0% that is non-redeem-able until maturity is crummy compared to a fi ve-year Canada with semi-annual coupon that pays 3.73% with no restrictions on sale. Ontario also has a seven-year fl oating-rate bond with a coupon reset every six months with a starting rate of 2.35%. Resale of most of these bonds is possible if the holder or an investment dealer can fi nd a buyer who, for whatever reason, wants the issue. The most that can be said for medium-term bonds with submarket interest is that they have no built-in capital loss, as would some premium bonds. But they also have higher durations due to fi xed or lower reinvestment returns.

Provincial and federal step bonds that reward holders for sticking with them by providing higher interest in successive years merely cloud the issue. The bottom line is that a retail bond with interest inferior to a negotiable issue sold on the market between experienced investors is a ripoff for the holder, and a transfer of the investor’s wealth to the issuer.

DIRECT SALESBond trading and investing work a lot better when brokers and portfolio managers don’t impose heavy sales charges through fees and spreads. Instead of paying for the privilege of being retail cus-tomers, savvy investors can buy Government of Canada bonds and Treasury bills and U.S. Government debt direct from issuers with no wholesale-retail spreads. The Bank of Canada does direct sales to investors at the price major dealers get at weekly auctions. The U.S. Treasury has a web-based system called Treasury Direct that lets anyone bid with the biggest dealers on Wall Street and get the yields they get. In a fi eld of investing in which portfolio managers and investors sweat to get an extra 25 basis points of yield, trading


with issuers is an important way to improve performance. It can be done every week at the issuers’ auctions.

Buying bonds through the Bank of Canada’s retail process or from U.S. Treasury Direct (www.treasurydirect.gov) saves spreads of 20 to 50 basis points of yield charged by securities dealers and the average 1.9% management expense ratio of Canadian bond mutual funds. The total charges of bond funds are actually higher, for fund trading also generates costs through the spreads dealers pay, just as any investor would. The funds pay a lower spread between what bond dealers charge and what the “retail” price turns out to be, but it is still there and still large if funds trade their bonds very of-ten. However, bond spreads are not part of MERs, making the full costs of bond funds higher than the reported MERs. The only way to determine full costs of bond funds is by comparing funds’ costs for each bond in the portfolio with trading in the bond in question on the day or days they were purchased. That is research beyond the abilities of the average investor.

In Canada, one can make a bid on a bond order as small as $100,000 through a competitive bid on yield. Forty minutes before each auction closes, the Bank of Canada issues a state-ment accessible on its website (www.bankofcanada.ca) updating what it expects to be the reasonable range of acceptable bids 20 basis points on either side of an expected yield at the auction. That prevents an uninformed investor from being taken advan-tage of in an auction, but within the 40 basis point total range, the investor’s bid would be accepted, says a spokesman for the Bank. Alternatively, the buyer may make a bid for a quantity of bonds with no specifi cation of price. At the end of the auction, the buyer gets the average price of the auctioned bonds. Small institutional investors often take the noncompetitive bid route, adds the spokesman. The limit on the noncompetitive bid is

200 C H A P T E R 8

$3 million at any one auction. Above that limit, one has to make a competitive bid at the auction, the Bank says.

For federal bonds purchased at auction of 5, 10, and 30 years, settlement is three days, for bonds of three years or less, including treasury bills, settlement is two days. Payment is through a gov-ernment securities distributor—they are the big brokers—which also submits bids for the investor who has an account at the Bank of Canada. (Visit http://www.bankofcanada.ca/en/markets/mar-kets_auct.html to learn more about the process.) There cannot be a fee charged for handling the payment, according to the Bank of Canada. Bonds are listed by the Canadian Depository for Securities. Investors pay for bonds and receive payments for matured bonds through the securities dealer that the investor has chosen. It would be a good idea to have other business with the dealer, for the dealer is not allowed to charge for its service in pipelining money in and out of bonds sold without fees or spreads by the Bank of Canada.

The U.S. Treasury’s more extensive system makes it possible for retail investors to participate in auctions of Treasury bills, notes, and bonds. Treasury Direct supports purchases with a lower limit of $1,000 per household per auction to $5 million at any one auction. Participants can enter competitive bids or submit a noncompetitive bid that will purchase bonds at whatever the auction price turns out to be. The investor who puts in a noncompetitive bid for an issue gets the same deal as the bond desk at Goldman Sachs, the 900-pound gorilla of the bond market. It doesn’t get any cheaper than that.

There is a downside to direct purchase. You don’t get to shop the bond when you do direct purchase. Therefore, you may miss the chance to buy from a dealer who offers a sound bond like an off-the-run (less liquid) Canada or a provincial bond that actually yields more than the bonds at the current auction. But the bottom line remains the direct sale price, which is the lowest attainable for the issue on sale.


Selling bonds in a portfolio of direct purchases can be done through investment dealers in Canada at whatever prices and spreads are available. In the United States, Treasury Direct will sell U.S. bonds in its accounts through the Federal Reserve Bank of Chicago, obtaining the best price available at the time of offer. It then trans-fers the amount received to the investor’s own bank account.

Do-it-yourself bond buying is not well known. Canadian investors and advisors have not shown much interest in it, accord-ing to the Bank of Canada in a recent paper.7 For their part, the larger securities dealers, said the Bank of Canada, “were in favour of maintaining the current system of … access to bond auctions, which they viewed as fair, given their larger shares of the market and larger capital commitments.” Their argument boils down to what could be summed up as a justifi cation for their spreads and a threat that without the returns the spreads generate, they might not put up capital to make markets in government bonds. Odds are that even if a few more informed investors or advisors make use of direct sales, the vast majority of bond investors, operating through mutual funds and brokerage accounts, will still reward investment dealers with abundant profi ts.

The value of participating in auctions and arranging settle-ment of deals lies partly in the education one gets. Saving 25 basis points on a $100,000 bond trade amounts to $250—good money for a few moments of work, though it may be a headache the fi rst time around. Move up the learning curve, however, and the bond market will become more intelligible and potential deals easier to evaluate. Besides potentially richer returns, that’s the benefi t of di-rect trading.

BOND TIMINGIn the stock market, it is said that “that there are no famous market timers.” Translation: Figuring out the patterns of market ups and

202 C H A P T E R 8

downs and even of individual or sector ups and downs is almost impossible. Trends exist, of course, but knowing when trends will turn is the work of sorcerers, not of humans. So say the critics of market timing.

Bonds are not stocks. In many ways, they are more like com-modities. Commodities do lend themselves to timing, for seasons, inventories, and trends of substitutes have obvious implications for each commodity.

Government bonds, in particular, are the refl ection of macroeco-nomic trends. If one can predict GDP trends and unemployment, then one should be able to time bond trends.

It is harder than it looks. Technical traders who study charts and their wiggly lines have a lexicon of indicators from absolute breadth to zig-zag patterns. Proponents of the study of price and volume, which is the basis for most technical systems, fi nd cor-relations between past and future price behaviour. Indeed, those correlations do exist. Data mining can produce numerous corre-lations that work in the past but that vanish in the future. Critics of technical analysis say that there is more in a commodity’s be-haviour than just past price. It is naïve to say, as the technical traders do, that all information is summed up in a price or price trend. Moreover, observation systems that merely see what can be visualized are ignoring brief price trends that last only min-utes and long trends that may last for decades. It is hard to make money at either extreme. Day traders go broke trying to trade on brief momentum. Long cycles do not lend themselves to specula-tion.

Financial analysts have invested a great deal of brain power in trying to fi nd black-box technical systems that work. To date, the exercise has been futile. Reports of success tend to ignore periods of failure. Moreover, proprietary timing systems tend to peter out over time as other traders glean how they work and copy them.


A balanced view has to take account of the fact that some systems give the investor an edge, but at the cost of frequent transactions, accelerated taxation of capital gains achieved through trading, ad-ditional turnover costs, and the opportunity cost of staying out of the market when indicators recommend it. To make a technical system work, the investor must have a dependable indicator or col-lection of indicators and be right about two-thirds of the time. And the fact that there are few investors who can make technical systems work is an indication that what is possible in theory is very hard to do in practice.8

DEALING SMARTBuying negotiable bonds is relatively easy. Call a couple of brokers, ask for prices on a bond, check your Internet resources or the daily newspaper’s quotes on the bond in question or a bond of similar term and issuer, and you have a sense of the price. If the price vari-ance is small, the result on yield is also going to be small. Thus the yield variation on a bond with a 4% annual coupon priced at $100.50 and one priced at $100.40 is going to be about four one-thousandths of 1% or 3.980099502% versus 3.984063745%. Don’t sweat the small stuff.

The problem for the investor is one of discovering what a bond’s true price is. The experienced buyer who knows the spread gets the best deal. The novice trader is probably going to get less than the best deal.

Selling is harder. Many brokers have systems that produce a selling price only if the caller already owns the bond. If you have a broker or a contact at a full-service brokerage or a discount trader, you may be able to get an indicative price.

Some of these trading issues are self-resolving. If you have only $100,000 of Canada bonds, you can take 20 minutes and search for prices and sell. Or if you are a buy-and-hold investor, you can wait for the bond to mature at par. No problem.

204 C H A P T E R 8

If you want to trade bonds actively, you can use a standard ref-erence bond such as a Canada fi ve-year bond that is priced every day in the Globe and Mail’s Report on Business and in the Financial Post section of the National Post.

The frequent bond buyer can also use brokers that price bonds with explicit fees. Fidelity, as a part of its U.S. operations, offers online trades in U.S. Treasuries with no charge. Treasuries that are not in current auctions go for 50 cents a bond, U.S. agency debt trades at $1 a bond, and corporates at $2 a bond. But Fidelity charges $50 to trade commercial paper, which is cheap on a $1-million deal but an awful lot for a 30-day ride on a 3%, $25,000 note that has a gross yield of about $61.60.

The frequent bond trader becomes less a potential victim and more a potential winner as he moves up the learning curve. The experienced bond trader will sense spreads and be able to shop or haggle. He or she earns his stripes in the trenches. To the experi-enced go the spoils.

TRADING TIPSBond traders are accustomed to working in sums with many zeros. They tend to regard the retail investor as a mutt in a kennel of pedigreed pooches. Traders fi gure that retail investors lack experi-ence and so widen their spreads, fi guring that what the poor slob in their clutches doesn’t know can’t hurt the bond trader. A 50 basis point spread on current yield means that, for a trade under $500,000, the dealer will price the bond high enough to reduce yield to the investor by one-half of 1%. This kind of return reduc-tion is common in the land of the small investor. By comparison, the bond that the dealer wants to swipe half a percentage point off each year in interest would consider himself brave to ask for such a spread from a pension fund manager and blessed by angels if he actually got it.


The retail investor who knows how a bond desk works can often improve his returns. Bonds with the fairest pricing tend to be the most liquid. Called “on the run” bonds, these are usually actively traded new issues offered on the market by the Bank of Canada, the provinces, and the U.S. Treasury. Price information is widely available from websites and, as we have previously noted, from the business sections of the major national newspapers. For these very liquid, frequently traded issues, dealers tend to slice no more than 10 to 15 basis points off the reported return.

Less actively traded provincials, older issues of Canada federal bonds, and old corporate bonds tend to have wider spreads of as much as 25 basis points off the yields reported in the fi nancial pag-es of major newspapers and on web-based trading systems. These are “off the run” issues held in inventory by dealers and sold at markups customers will accept. The more obscure the bond, the larger the potential spread, for in the absence of competing quotes, the dealer has the upper hand.

A retail bond investor may not be able to get a competitive quote on a bond, but by checking prices of bonds of similar term, coupon, and credit rating, he can come close. The more complex the bond, the harder this is to do. Thus if a corporate bond has a couple of potential call dates or a step-up interest feature, comparisons are tougher. As well, corporate bonds tend to be less liquid than govern-ment bonds. A 50 basis point spread is not uncommon.

Global bonds priced in foreign currencies bear two charges: one, the bond spread, and two, the forex cost, also expressed as a spread. The investor must discern the bond price and the fair cur-rency exchange rate. A euro issue may be attractive, but the wise investor will improve his terms by being aggressive in seeking an attractive price. The difference between what an institutional in-vestor might pay and what a retail investor might pay could be as much as 200 basis points.

206 C H A P T E R 8

In practice, a dealer’s inventory infl uences the spread that will be charged. If a retail customer asks for a better price or talks about walking across the street to the next dealer, it can bring the price down by 5 or 10 basis points—just for asking.

GETTING A GOOD DEALA retail investor can improve his odds of getting a decent deal with preparation. Government of Canada bonds, most provincial issues, U.S. Treasury bonds, U.S. federal agency, and suprana-tional organization bonds (e.g., World Bank) issues have visibility, respect, and liquidity. The spread between bid and ask is as little as one basis point of yield. The individual investor’s quest is to get close to that one-point spread on any trade. With less liquid bonds, the trick is to buy at the bid or close to it and to try to sell at the ask.

Get competitive quotes. Open more than one investment ac-count with dealers, urges Randy LeClair, who runs $2 billion of bonds for AIC Ltd. in Burlington, Ontario.

Try to get dealers to be competitive, LeClair adds. This can be done by a variety of trading tactics from saying to Broker A that Broker B has priced an issue fi ve basis points below what A wants. “C’mon, Herbie, match B and I won’t walk.” This is a form of whining, but it often works, he says.

Stick with traditional dealers, LeClair suggests. Some old-line dealers run their bond desks as break-even operations. The newer, leaner, and meaner brokerages may run them as profi t centres and try to squeeze the best profi ts out of small, relatively defenceless accounts. “In the old days, which is ten years ago in the bond busi-ness, dealers like Midland Walwyn gave retail clients prices not much different than they gave institutions,” LeClair adds.

Schmooze the dealer. Take him or her out to lunch. “If people can fi nd out from their advisors what commissions are tacked on


and buried in the price, they are much farther ahead,” LeClair rec-ommends. His advice: Ask how the charges are laid on.

For corporate bonds where there is a potential for default, look at the Financial Post’s annual bond guides that cover government and corporate issues in Canada. Check databases or ask brokers to determine S&P, Moody’s, Fitch, or DBRS ratings.

Beware synthetic bonds that are really just conventional bonds and strips repackaged to be priced at par. The retail investor is too anxious about booking a probable capital loss and is a potential customer for synthetic bonds that have the same term and a simi-lar interest rate but no capital loss. Trouble is, the synthetic bonds have higher durations because, with lower reinvestment returns from their lower coupons, they take longer to generate the bond’s total return. Marketed under such names as CARS and PARS, the synthetics tend to be less liquid than the big issues of the bonds from which they are distilled. What to do? If you are a real buy-and-hold investor, then the higher durations of the synthetics are okay for you since you will avoid the capital loss of the premium bonds. But if you want to trade the bonds prior to maturity, then keep the premium bonds because spreads will be lower in a more active market.

Chasing yield alone is not the answer. Don’t get stuck with ob-scure bonds from relatively unknown issuers. For example, a Quebec municipal bond with a high yield could be almost impossible to sell without taking a bath on price. Sometimes insurance companies will match a life policy with an obscure bond, confi dent that mortality will match the bond’s term. If you, as the buyer, become the entirety of the secondary market, you’ll have to fi nd another customer when you want to sell. Your dealer may take the bond on a best-efforts basis and it may take a month to sell, LeClair says.

Information is your ally. If you can bring a good source of price data on a bond to a negotiation, you are making your transaction

208 C H A P T E R 8

more transparent. On-line data are even more useful in negotiating. The more complex and cleverly structured the issue, the more it may turn into a lemon in future when tax conditions or market conditions have turned against it or the holder. The simplicity of government bonds compensates for yields that are always inferior to the payments on corporate bonds enhanced or encumbered with call features that allow the issuer to take back the bond at a price that may be lower than what the investor has paid for it. The long-term investor should remember that market sentiment on bond décor is as changeable as interest rates themselves. The most cautious investor will stick to ba-sics. The investor who wants yield can switch to junk bonds or to income trusts. Or go to the common stock of the issuer, which usu-ally gets boosted in value by increasing dividends or earnings to keep up with infl ation. Know the beast before you buy it.

Simplicity is the key. The temptation is to raise yield by mov-ing to higher durations, lower ratings on credit-sensitive issues, or to bond derivatives that add risk to low base returns. Beware.

An investor in the stock market can calibrate the risks he ac-quires by looking at the multiples of price to earnings, price to sales, cash fl ow, return on equity, or numerous other measures. Bonds do not lend themselves to that kind of risk analysis. Interest coverage and debt-to-equity ratios are signifi cant measures of the ability of a company to pay its bond interest, and agency ratings are vital signals of risk exposure. But the reference point for a bond investor should be risk reduction in comparison to the risk acquisi-tion of a stock buyer.

Buying risky bonds for enhanced yield makes sense in the con-text of a broadly based bond portfolio. It makes less sense in the context of a stock and bond portfolio. As a philosophical problem, it makes no sense at all to buy bonds to offset equity risk and then to compromise that risk reduction with other bonds that compro-mise one’s initial purpose. All investment strategies and certainly


all trades have to be anchored in the investor’s purpose, not on the deal of the day.

1. On hemlines, a coincident market measure, and Super Bowl indicator, which does correlate NFC wins with market gains, see Aswath Damodaran, Investment Philosophies (John Wiley & Sons, 2003), pp. 394–95 and 214–15.

2. Damodaran, Investment Philosophies, p. 216.

3. U.S. Department of Commerce, Bureau of Economic Analysis.

4. Geoffrey A. Hirt and Stanley B. Block, Managing Investments (New York: McGraw-Hill, 2005), pp. 108–109.

5. Intrepid students of business cycles can refer to Beating the Business Cycle by Lakshman Achuthan and Anirvan Banerji (New York: Random House, 2004).

6. Interview with Janet Comeau, Manager, Corporate Communications, The Canadian Depository for Securities Ltd., Toronto.

7. “Debt Distribution Framework Consultations,” available on-line at www.bankofcanada.ca/en/notices_fmd/2005/not210305_distribution.htm.

8. Damodaran, Investment Philosophies), pp. 430–32. For a compendium of technical indicators, see Thomas N. Bulkowski, Encyclopedia of Chart Patterns (New York: John Wiley & Sons, 2000).

Endnotes

Chapter 9

THE FUTURE ENVIRONMENT FOR BONDS

A long-term investor who wants to reduce portfolio risk has to contend with the changing environment for different as-

set classes. At times, such as periods of recovery from recessions, stocks tend to outperform bonds. When economies go into reces-sion and interest rates fall, bonds perform well and can compensate for a measure of stock losses. When interest rates are relatively low, as they are today, the costs of home ownership tend to be relatively modest and people rush to buy houses, driving up their prices and shifting money from other asset classes to real estate.

Commodities thrive during periods of high infl ation, for rising commodity prices are part of the defi nition of infl ation. The early 1980s, when the Consumer Price Index rose at double-digit rates each year, drove people to gold, the defi nitive monetary commod-ity. Each asset class—stocks, bond, real assets such as property and commodities—has its day. The trick is to be at the right place at the right time.

That’s market timing and, even in a single asset class or a sin-gle asset, such as shares of Royal Bank, it is nearly impossible to

212 C H A P T E R 9

be right all the time. To pick consecutive winners in every asset class is the equivalent of winning a trifecta, in which one has to pick the fi rst three fi nishers of a horse race in their exact order of precedence. Given the impossibility of being right all the time, it is probably enough to avoid major losses. Not only must the investor avoid making unprotected narrow bets that are as likely as single bets on a single number in roulette to be wrong, but he must cover all bets with an insurance policy for expected losses and unexpected chaos. As we will see, fi nancial markets offer plen-ty of the latter.

THE TRENDSThe fi rst years of the 21st century have seen interest rates in North America plunge near their historic lows. The long-term trend of interest rates by rolling 50-year periods shows a downward trend from the 13th century, when rates averaged 10%, to 4% in the early 16th century, then an ascent of rates to 6% leading up to the be-ginning of the Thirty Years War, which raged in northern Europe from 1618 to 1648. Interest rates declined to 2% in the late 17th century, rose to 3% in the early 19th century, and plunged from 1814, the end of the Napoleonic Wars, to 1914, the outbreak of World War I. Rates fell to less than 1% in England and in its se-nior dominions (including Canada) in the Great Depression, rose after World War II, peaked with a 22.75% prime rate in Canada in 1981, then began a long slide to as little as 1.5% for U.S. Treasury bills in 2003.1

The lesson of these trends is that interest rates follow politics, rising in times of chaos driven by the need to compensate for risk, and falling when risks appear to subside or when, as in depressions, the demand for loanable funds declines.

The key to understanding the different roles of stocks and bonds is how they respond to risk. Stocks, with their greater volatility, tend

213The Future Environment for Bonds

to rise and fall more than bonds. Bonds, however, can lose huge sums if interest rates swing a great deal, as they did in the early 1980s in Canada and the United States. Bonds can also generate huge gains, as they have done in Japan in the 15 years since the bubble of growth subsided into the well of recession, dragging down interest rates to near zero levels.

WEIGHTING BONDSIf one concludes that bonds have a place in a portfolio, then the only issue is what proportion in which to hold them. That requires that we take a panoramic view of the risks facing Canada and the world economy.

Warren Buffett, head of Berkshire Hathaway and billion-aire many times over, is perhaps the most respected capitalist in America after Bill Gates, who is richer but perhaps a techie before all else. Buffett sees the potential for terrorists to gain and use nu-clear weapons as the greatest event risk to civilization and to capital markets. Robert McNamara, who managed the Viet Nam war for President Lyndon Johnson, thinks the world faces huge risks in what he sees as the nearly inevitable misuse of nuclear weapons (we might say that any use would be a misuse) or in some accident in-volved in their handling. Either way, it is a sure thing that a nuclear strike anywhere in the world would shock stock and bond markets. Stocks would tend to crumble as they did following the attack on the World Trade Center in September 2001. Markets for govern-ment bonds would tend to thrive, as they do when capital fl ees to havens of safety.

There are other risks, hard to quantify, but still huge in their potential impacts on capital markets. A fl u pandemic that would kill a third or a half of all people on earth, worse than the Spanish fl u outbreak at the end of World War I and perhaps on the scale of the Black Death in Europe between 1348 and 1350, would be a

214 C H A P T E R 9

catastrophe as great as a major war. The stock market would have to react negatively, for the fundamentals of saving and investing would be crushed. There would be fewer consumers and fewer in-vestors. The infrastructure of human capital would be devastated. Titles to land and to capital assets would be uncertain if owners died, if heirs died, bureaucrats who run real estate title registration died, and the airline pilots, highway engineers, computer system administrators, etc. who make modern life work were to be cut down by the disease.

Any widespread population disaster would cause a tsunami in capital markets. Holders of government bonds would be in a posi-tion to buy others’ assets at deeply discounted prices.2

The wise investor can buy bonds at least in amounts that pro-vide risk insurance. If we assume that stocks would drop 50% following nuclear terror and that long government bonds might rise 20%, the calculation of the ratio of bonds that should be held to neutralize shocks to a stock portfolio is straightforward:

Bonds as Portfolio InsuranceStocks held $ 400,000 50% Potential Loss $200,000 Bonds held $1,000,000 20% Assumed gain $200,000

All bond portfolios are time-sensitive if only because debt instruments, with the exception of stocks and the very few per-petual bonds still in existence, expire at term. Thus any decision to buy bonds has an intrinsic time preference. The buyer, by adding bonds at a moment in time, has declared that he is interested in the value of the money he puts into bonds at a specifi c date, perhaps for retirement, perhaps just for trading purposes.

Asset allocators are investors who know that the most infl u-ential determinant of return is the asset class (stocks, bonds, cash, real estate, commodities) in which one invests. Unfortunately,


these investors have relatively little profi t to show for their in-sight, but the concept of timing has to be given its due.

After stocks rise to excessively high valuations, they eventu-ally fall. At the time of writing, the S&P 500 Composite index is selling at about 27 times earnings. Other methods of setting the ra-tio (forward earnings, smoothed earnings, adjusted core earnings, etc.) give different ratios, but students of market valuation trends have found a strong law of return: When stocks get well above their historical trend average multiple of 14 times earnings, they are due to revert to this mean. The adjusted mean may be higher these days, perhaps as much as 17 or so, due to improvements in market liquidity or effi ciency. But the argument for reversion to the mean is a strong one.3

Investors who use bonds to balance the risks of stocks or who use bonds for a defi ned future purpose like retirement are intrinsically cautious. But how much caution is excessive? Historical data suggest that there is no limit to the “right” amount of apprehension. The 22.6% drop in the Dow Jones Industrial Average that took place on October 19, 1987, should not have occurred with a normal bell curve of distributions of events defi ned by probability. In the October 19 disaster, mar-kets behaved as they would be expected to in normal probability theory once in a period of 520 million years.4

The events of October 19, 1987, were not unique. If we tally up the 14 largest stock markets drops of the 20th century, we fi nd a median drop of 15.9%. Portfolio insurance via bonds or some other form of protection is therefore not the fi nancial equivalent of a survivalist who stocks up on canned soup and ammo, but is prudence as ordinary as locking one’s house before driving away for a weekend holiday.

But what range of bond assets should one hold? “If you are going to be very careful, you’d want to be 70% in bonds,” says

216 C H A P T E R 9

Sceptre Investment Counsel Ltd. bond chief Tom Czitron. “If your portfolio is $100,000 and your time horizon is 10 years and interest rates on the 10-year bond are 4.5%, then with 70% of your wealth in government bonds, $70,000 in fi xed income should be worth $108,000, including returns from coupon reinvestment at bond maturity. Therefore, even if your stocks, $30,000 in this example, go to zero, you would be whole on a nominal basis (not adjusted for infl ation or defl ation),” he says.

A truly pessimistic view of potential equity market collapse suggests that long-term bond returns that are a fraction of stock returns are actually a good deal. Stock insurance via an inversely correlated asset that can rise in price as equities fall and that pays a decent return regardless of what happens is cheap. Most other forms of insurance, say covering a house for fi re, bear an explicit cost. Whether bond returns are therefore a gift in a period of looming high risk or a cost in a period of low equity risk depends on the assessment of the risk. The stock optimist will tend to see bond returns as having too high an opportunity cost. The stock pessimist will shift to bonds and see the lost potential gains in comparison to formerly expected stock returns as a trifl ing cost for the protection obtained.

So is a fi nancial meltdown in the offi ng? Chaos happened in senior capital markets every few generations in the 20th century. Yet capital markets recover quickly, perhaps because technologi-cal innovation has created wealth and raised productivity, Czitron says. There is no reason that should stop. But bonds are still a way to hold wealth in the periods of the collapse of equity markets.

The analysis of interest rates would be incomplete without an assessment of the chances of a return to high infl ation. There have been three periods of sustained and widespread price rises in the last 500 years: First, the period when gold was looted from South


America by Spain in the 15th century and then spent on making war on Protestants. The result drove up prices throughout Europe and reduced Spain to a wasted, spent power. Second, the period of the Napoleonic Wars when the English blockade of Europe drove up food prices and interest rates. Third, the period following the Viet Nam confl ict, which was fi nanced by the Johnson adminis-tration’s policy of letting consumers pay for the war by infl ation, and culminating in 1981 when prices posted annual double-digit gains.

Bonds in each period were devastated, particularly in the epi-sode from 1973 to 1981, when American war fi nance produced perhaps the worst sustained bond bear market in modern history. But bond bear markets are more the exception than the rule. They tend to be less frequent than bear markets in stocks, of shorter duration, and only a transitory inconvenience.

THE ELDERBOMBWe could be slowly but inexorably moving into another bond bear market in which rising interest rates force down bond prices. A demographic process that has the power to push up interest rates is already underway. Over the next 35 years, baby boomers born as late as 1960 will be moving from young old age, the years from 65 to 75, to middle old age, the years from 75 to 85. They will need more medical care, more income support, and more infrastructure services like public transport. At the same time, the younger mem-bers of the labour force will become scarcer. Canada’s population of those over 65 will double by 2030. By 2030, the percentage of the elderly in Canada’s total population will be “just” 40% com-pared to 52% for Japan and 48% for Italy. By 2050, the elderly will comprise 72% of Japan’s population compared to 44% in Canada.5 The following table gives some projections:

218 C H A P T E R 9

Elderly (65+) as a part of the totalpopulations G-7 nations

Country % 65+ in 2005 % 65+ in 2030 % 65+ in 2050U.S. 19 31 32Canada 20 40 44U.K. 25 33 38France 25 40 46Germany 28 47 50Italy 30 48 68 Japan 30 52 72Source: Canada, Department of Finance, Budget, 2005, Annex 3.

In a paper published by the U.S. Center for Strategic and International Studies, economists Richard Jackson and Neil Howe showed that G-7 nations will soon have to face immensely higher costs of taking care of the health and welfare of the exploding pop-ulation of the elderly.6 The process will put upward pressure on interest rates, for governments will be faced with the lesser of two evils—raise taxes or postpone higher taxes by borrowing. Chances are that governments will choose the path of borrowing.

The problem of caring for the elderly has grown from a fi nancial afterthought to a fi scal nightmare because of advances in medicine. For most of history, the elderly, which Jackson and Howe defi ne as anyone over 60, were a small part of the population. Forty years from now, they will amount to 35% of the populations of nations, and in Europe, where the median age will exceed 50, the elderly will be half the population.7

Let’s look at the numbers closely. Jackson and Howe provide data showing that Italy, in which the elderly were 24.4% of the population in 2000, will have 46.2% of its people over 60 by 2040.


In Japan, the elderly will rise from 23.9% in 2000 to 44.7% in 2040. In Canada, the elderly will rise from 17.0% of the population to 33.3% in 2040. In the United States, buffered by heavy immigration from Latin countries and a strong Latino birth rate, the elderly will rise from 16.3% of the population in 2000 to 26.0% in 2040.8

Who will pay for the medical and social benefi ts for the el-derly after they retire is the issue. Jackson and Howe note that the dependency ratio, which measures the number of non-working persons to working persons, will grow from an average of 30% in 2000 to 70% in 2040. In Italy, there will be 1.03 elderly persons for every younger person aged 15 to 59. In Japan, it will be 1 to 1. In Canada, it will be a more manageable 0.63, and in the United States, just 0.47 elderly to non-elderly supporters.9

Supporting the elderly will be very costly. In Spain, 43% of after-tax non-elderly income will have to be transferred to the elderly by subsidies paid out of taxes levied on the incomes of younger workers. The intergenerational transfer payments will be 37% for Italy, 36% for Japan, 30% for Canada, and 27% for the United States.10 The population-driven tax load will grow to 50% of GDP in Canada and more than 60% in France and Sweden. Even the United States would have to divert 44% of its GDP to cover growth in public benefi ts, mainly for the elderly.11

The costs to government of supporting the elderly can be met in a variety of ways: by transfers, by borrowing, or by infl ation. Transfers out of current income taxes would impoverish and per-haps drive away younger workers. Borrowing is feasible, though the room for countries to borrow without turning their public debt into junk is questionable. Jackson and Howe estimate that net gov-ernment debt would reach 150% of GDP in Canada in 2024, in the United States in 2026, and in Japan in 2020.12 Only a declining ratio of children to the working population can temper the effects of the demographic elderbomb. And that “solution” would have dire consequences.

220 C H A P T E R 9

The most democratic way to fi nance public spending is, in a sense, through infl ation. If governments generate spending in excess of what the economy produces or obtains through trade, prices will rise. Infl ation is both visible in price trends and invisible in the way it affects different groups. Younger workers can demand higher wages. But the elderly, often with only partial indexation of pensions, may feel infl ation driven by their own demographic weight relatively se-verely. Governments, which have to choose between keeping taxes reasonably low to stimulate production and high enough to fi nance spending, may tend to favour infl ation. If not well managed, benefi ts fi nanced by infl ation could turn economies into the abyss of stagfl a-tion, the mid-70s experience of Canada and the United States. It would not be pretty.

For the bond investor, rising prices and rising levels of public debt imply rising interest rates. The demographic bomb will take time to be fully felt, but unless the economies of the G-7 countries become far more effi cient in generating goods and services, espe-cially for the elderly, infl ation is part of the scenario of mid-21st century public fi nance.

BEYOND GOVERNMENT BONDSIn the interests of full disclosure, we must discuss the question dear to survivalists: What if government crumbles into anarchic dust and the only values left are to be found in cases of beef jerky, bul-lets, and gold?

Real assets have their day, usually in periods of high infl a-tion when stocks and bonds are devastated by high interest rates. Commodity prices were high in 2005 without high infl ation be-cause of world economic recovery and the widespread belief that China’s growth will produce scarcities of every resource.

Each commodity marches to is own drummer and gold, in par-ticular, marches to a band of drummers with substantial knowledge


of mining. We make no judgment of which commodities in future may emerge as king of the heap. But there is a large difference between fi nancial assets and commodities and real estate. Most fi nancial assets pay a periodic return in the form of interest or divi-dends or can be structured to do so. Commodities in pure form have no periodic payments and may generate storage charges. Real estate, like commodities, has costs of maintenance, though apart-ments and offi ces, shopping centres, and parking lots built on land can generate periodic returns through rent.

Bonds, however, are the ultimate life jacket in collapsing econ-omies. A commodity, perhaps copper, might fall to low price levels, and shares in the business of mining copper would also tumble. Parking lots may lack for customers and shopping malls may not have enough traffi c to sustain their tenants. But in the worst of worlds, bonds’ coupons will remain precious and will rise in future value as the value of other assets falls.

CALIBRATING BONDS FOR LONG-TERM PORTFOLIO PROTECTIONAll this brings us to the question of what bond duration to hold as a hedge against stock market collapse and utter chaos in the larger world of business. The best price appreciation, when money runs to the safety of government bonds, will occur in long duration is-sues. The worst damage when infl ation drives up interest rates will be in long duration issues too. We need to balance the price sen-sitivity of the bond portfolio to provide insurance without undue duration risk.

Held as insurance, one can argue that a bond portfolio should begin with an average term of years no more than the life that the portfolio is supposed to benefi t. A 70-year-old investor with a life expectancy of less than 20 more years need carry bonds with no more than 20-year terms. The 60-year-old investor could go to 30

222 C H A P T E R 9

years, but may want the lower duration implied by a shorter term. The value of money is not symmetrical: the $1,000 you lose is worth more than the $1,000 you gain. The investor can therefore have a reasonable bias that favours shorter, less volatile bonds. Holding short bonds means that, in the event of a prolonged collapse of interest rates, the investor will suffer from relatively low returns when reinvesting his matured bonds and coupons. Low interest rates tend to go along with low rates of infl ation or even defl a-tion. On the other hand, given the propensity of governments to spend, the investor may want to tilt toward protection from rising interest rates and increasing infl ation. Real return bonds provide such protection. The optimum balance of RRBs and conventional bonds is as unpredictable as future events themselves. In the end, it is enough to say that the prudent investor should have high-quality bonds for portfolio protection.

There is one climate of infl ation and defl ation for which nei-ther stocks nor bonds are particularly well suited. Stagfl ation, defi ned as a combination of high infl ation and high unemploy-ment, characterized the U.S. and Canadian economies in the 1970s. It devastated stock returns and drove down bond returns. Double-digit unemployment and double-digit infl ation would be the triggers. If we did return to stagfl ation, short bonds and high coupon bonds could generate rising returns through the rising in-terest rates available on reinvestment. On balance, stagfl ation has to be counted as a remote possibility.

Can one have too high a ratio of bonds to total assets? Absolutely. Moshe Milevsky, professor of fi nance at York University in Toronto, suggests that a good fi nancial strategy is one that will produce few regrets in the future. Noting that $1 invested in the TSE in 1950 would have been worth about $23,000 in 2000 and only a tenth of that if it had been invested in T-bills in the same period (all dividends and interest reinvested), he suggests a Probability of


Regret (PoR) function that is an inverse function of time.13 Thus, in Milevsky’s view, the investor who chooses the asset class that is likely to rise the most over time, stocks in this case, is likely to have fewer and fewer regrets over time. The investor who bought bonds for short-run capital preservation will have more regrets as time marches on and he fi nds he lacks growth in comparison to stocks and may not even have much infl ation protection. One could say that the aphorism that “time heals all” is as true for capital markets as it is for the lovelorn.

An implication of the PoR function is that young investors need have only slight bond protection. What’s more, if the bonds in question are low-duration T-bills, they are counterproductive. “Short-term money has no place in a long-term game,” Milevsky explains.14 That is not to say that there is no bond strategy suitable for a young investor. If long bonds are used to insure an equity portfolio against loss, or if bonds are used to reduce the volatility of equities in a portfolio, they still have value, even to the investor in his 20s. The point is, however, that for any strategy focused on loss reduction in the event of an equity meltdown, the quantity of bonds required diminishes over time. We can see this in a strip bond strategy attached to a portfolio of equities. The longer the period in question, the lower the price of the strip, i.e., the smaller the commitment to bonds needed to provide a sum of money at a future date.

The risks that lie ahead can be conceived, if not measured. One can suggest that we are in a period of returns to stocks lower than those that prevailed from 1982 to 2001 when U.S. shares produced a nominal annual compound return of 14.1%. It is more likely that we will return to the longer run nominal return of 8.3% per year on an annually compounded basis, which prevailed, on average, from 1802 to 2001. The former period included the decline and fall of Communism in much of the world, a singular event in the

224 C H A P T E R 9

last 50 years that is not repeatable in the next 50 years. The longer period, however, includes the crumbling of Japanese military pow-er in 1945, the defeat of the Nazi menace in the same year, and, if we go back, the elimination of other menaces to the United States, at least, in various wars of the 19th century, the ending of the Civil War in 1865, the conquest of the West by means of military elimi-nation of earlier occupants, and numerous scientifi c achievements that were basic to building the infrastructure of the United States. Canadian stock prices do not have the same historical reach nor the same exposure to the winds of fate. It is enough to say that Canada’s national businesses of banking and mining have been relatively persistent if not consistent generators of wealth with the fates of prosperity and contraction linked to those of the United Kingdom and the United States.

Expanding economies tend to produce handsome returns for investors. Those economies that contract—witness Japan with its slowly shrinking and not-so-slowly-aging population—tend to have poor returns. Currently, there is a shift of purchasing power and productivity from the Western world to the East. The United States is mired in defi cits and war, Europe is immobilized in reces-sion, Russia is trapped by corruption, the Middle East is captive to plutocracy. Africa is dissolving in AIDS and kleptocracy. South America, and Brazil in particular, has never been able to realize the potential of its immense resources and its huge population base. The brightest spot on the horizon of economic growth is the Far East. China, the centre of growth, the largest national economy in the world until the end of the 19th century, has resumed its place as a leading engine of growth.

What will happen to the American economy? The United States is a debtor that would ordinarily have to raise interest rates to sell bonds to the rest of the world. The United States custom-arily exports its defi cits to its bond customers abroad. Yet at some


point, interest rates will have to rise. U.S. bondholders everywhere will feel the decline in the value of existing bonds when interest rates begin a long, compensatory rise.

THE CHINA SYNDROMEAs I write this chapter, the term structure of interest rates in the United States hovers not very far above post-World War II lows. The trading partners of the United States are awash in Treasury obligations. Running at over US$600 billion per year, U.S. trade defi cits are ultimately fi nanced by foreign central banks that ac-cept Treasury bonds to settle their accounts. If China were to change the terms of trade with the United States—something that the Bush administration is on record as urging the coun-try to do—then a part of the defi cit might be adjusted. Chinese exports to the United States would rise in price, reducing de-mand for them. At the same time, U.S. exports to China would be less expensive for Chinese to buy. Manufacturers in countries that compete with China would be happy while retailers that buy from Chinese factories would be challenged to fi nd other suppli-ers with the low costs and large volumes characteristic of Chinese industry.

China long resisted revaluing the yuan15 for reasons that are perhaps as inscrutable as its blend of communism and capitalism. Decisively raising the value of the yuan would cut the value of China’s holdings of U.S. Treasury bonds. The costs to China’s U.S. Treasury Bond holdings would be huge. Reduced exports to the United States would cripple the process of industrialization. Yet a major revaluation of the yuan and of other currencies against the U.S. dollar is inevitable, argue international economists.16 Declining real purchasing power in the United States would then lead to a global recession, triggering a period of disinfl ation (a sharply reduced rate of infl ation) or outright defl ation (a period of declining real prices).

226 C H A P T E R 9

Explains Richard Duncan, a U.S. trade theorist based in the Far East, “This global recession will be exacerbated by the inevitable correction of the U.S. current account defi cit…. If it corrects at the same time that falling consumption sharply curtails America’s im-ports, the global economy will suffer a depression unlike anything experienced since the 1930s.”17

If China exported less to the United States, Beijing’s holdings of U.S. bonds would decline. To refi nance the debt and to continue selling bonds, rates on U.S. debt would have to rise. That would push up the entire term structure of interest rates. Meanwhile, higher consumer prices would be infl ationary. Funds would fl ow from stocks to bonds to capture rising rates. U.S. stocks would tumble.

This is only one scenario and a very pessimistic one at that. Good economic management and the self-interest of U.S. trading partners in maintaining the present status quo in which nations send goods to the United States and the United States sends Treasury debt to its trading partners could forestall the time of reckoning for many years. But the risk-averting investor alert to the potential for global defl ation should take heart. A portfolio well stocked with G-7 government bonds in native currencies will rise in value if a global depression drives money out of stocks and if global defl ation drives down interest rates. The global depression could drive the U.S. dollar down if America were to become a threadbare pauper. Regardless of the currency effect, U.S. G-7 government bonds would become among the most desirable of assets as stocks fall and strapped corporations default on their bonds.

The process of increasing the value of the yuan will reduce China’s trade surplus with the United States. China will then be able to reduce its purchases of U.S. Treasury bonds. The low in-terest rates maintained by China’s willingness to hold U.S. debt would have to rise. Rising interest rates would take the largest toll


on high duration bonds. A strategy of staying with fi ve-year bonds to capture some of the yield boost over Treasury bills that mid-term bonds offer and of being ready to roll into higher interest rates would appear to be prudent. For now, Chinese central bank-ers hold the fate of the U.S. bond market in their hands. At the time of writing, the yuan has risen from 8.27 to 8.06 to the U.S. dollar. The offi cial Chinese government view is that a full fl oat cannot happen until 2010.18

THE IMPLICATIONSThe China syndrome and the elderbomb suggest a return to a cli-mate of infl ation. The cost of caring for the elderly will build over time, then decline as the baby boomers die in large numbers after the middle of the century.

Infl ation will tend to drive up bond yields and to take money out of the stock market. Equity markets will tend to fall in this infl ationary environment. For the investor, a return to infl ation implies a need to be nimble. You don’t want to be holding long bonds and interest-sensitive stocks as infl ation quickens. Short to intermediate bonds and defensive stocks look better in an infl ation-ary environment, but if CPI increases move into the double-digit range, there may be nowhere to hide save for commodities.

Arguably, government bonds remain the anchor for all in-vestments. Corporate bonds bear substantial equity risk, as the bankruptcies of Kmart Corp., Global Crossing and WorldCom, Pacifi c Gas & Electric and Enron Corp. have shown. General Motors debt was driven down to junk status in 2005. Even the bonds of the largest banking corporation in the world, Citigroup, could have turned to junk had the company not settled a class action for frauds arising from misleading securities reports in the tech boom. For the greatest security for the greatest term, there is no substitute for gov-ernment bonds, though it is wise for the cautious investor to spread bond investments among several major bond-issuing nations.

228 C H A P T E R 9

Trends are called that because they change. The risk-averting investor can buy an assortment of bonds through an exchange-traded fund holding debt from nations in Europe, Australasia, and the Far East. At the minimum, the careful investor can buy su-pranational agency bonds issued in the U.S. dollar, the Canadian dollar, the euro, and the yen. There is no need to create a bond portfolio congruent with that of a managed global government bond fund, only to spread some risk beyond North America.

What the careful portfolio manager must do is to avoid high-fee mutual funds. Bond exchange traded funds are available with fees of 50 basis points or less. Even half a percent paid for 30 years will take 15% off long-term bond returns. A manager can prob-ably add that much value to a government bond fund. But fees of 1.9%, which are actually typical of investment-grade bond funds sold in Canada, increase the chances that the investor will have a lacklustre long-term return.

On balance, there is an argument for all investors to have some bonds, for there is no certain scenario nor any outlook for interest rates that will sustain a single asset allocation to stocks, bonds, or real assets.

The bottom-line question always comes down to a riddle: What sort of bonds should one have? A doctrinal answer is pure bonds, which means riskless government bonds. All corporate bonds, all corporate bond derivatives such as credit default obligations, and all structured credit card trusts are tinged with equity and have some of the risk and return characteristics of the stock market. They are all sensitive to the ups and downs of the economy and, in that sense, they are stock-ish. The investor who wants an asset uncorrelated with stocks must use government bonds and accept their relatively low return as the price of high-quality insurance. But selecting those bonds demands study.

Now we turn to the matter of specifi c bond strategies.


1. Sidney Homer and Richard Sylla, A History of Interest Rates, 3rd ed., revised (New Brunswick, N.J.: Rutgers University Press, 1996), p. 565.

2. There would doubtless be problems in verifying and trading assets, for bonds and stocks are now book-based for the most part. Stock and bond certifi cates are relics, though they continue to exist in Europe and in old issues. Holders of physical certifi cates for stocks and bonds would probably be able to trade them, though registration for dividends could be problematic if the electronic clearing systems of the world failed.

3. John Mauldin, Bull’s Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market (New York: John Wiley & Sons, 2004), pp. 40–41.

4. Didier Sornette, Why Stock Markets Crash: Critical Events in Complex Financial Systems (Princeton, N.J.: Princeton University Press, 2003), pp. 50–51, 61.

5. Sornette, Why Stock Markets Crash.

6. Richard Jackson and Neil Howe, “The 2003 Aging Vulnerability Index: An Assessment of the Capacity of Twelve Developed Countries to Meet the Aging Challenge,” Center for Strategic and International Studies, March, 2003.

7. Jackson and Howe, “The 2003 Aging Vulnerability Index,” p. 1.






13. Moshe Milevsky, Money Logic (Toronto: Stoddart, 1999), pp. 202–203.

14. Milevsky, Money Logic, p. 202.

15. Andrew Browne and Greg Ip, “Don’t Rush Us on Yuan, China Says,” Wall Street Journal, June 8, 2005.

16. See Richard Duncan, The Dollar Crisis: Causes, Consequences, Cures (Singapore: John Wiley, 2003).

17. Duncan, The Dollar Crisis, p. 176.

18. Neil King Jr., “U.S. to Be Patient on Yuan in Talks With China,” Wall Street Journal, October 10, 2005, p. A-2.

Endnotes

Chapter 10

BOND STRATEGIES

A Summary and a Conclusion

The question of how much and what sort of bonds to own has no single solution. Stocks outperform bonds over the long

run, but, as Lord Keynes said, “in the long run, we are all dead.”Comparing bond and stock returns over periods shorter than a

lifetime is in some respects a game that cannot be won. Over shorter periods, stocks or bonds may outperform one another. The bond investor interested in getting the highest possible returns regardless of risk should probably ignore all bonds except for the riskiest junk bonds and perhaps the most doubtful tranches of credit card trusts that are paid only when all higher tranches are paid. Of course, this is risky and unwise except for specialist investors in distressed debt. The wise bond investor who seeks a steady return or a solid if not spectacular risk-adjusted return can make use of a blend of govern-ment and investment-grade corporate bonds and rely on patience as his reward.

At the beginning of 2006, bonds offer returns were not very handsome. The 5-year Canada was paying 4.0%, a 10-year Canada

232 C H A P T E R 1 0

paid 4.15%, and a 30-year Canada offered 4.21%. An investor who paid half his interest return in income tax wound up with net, after-tax returns of 2.0%, 2.07%, and 2.10%, respectively. Take off infl ation that was running at 2% and the entire exercise seems futile. Bond yields could, of course, head lower. At the time I am writing this, the Bank of Canada appears to favour higher rates for the most of 2006. Clearly, investment-grade bonds are not the way to instant riches. Their value, instead, lies in their role in stabilizing portfolios and in supporting future needs for money for retirement or education. Cash would do that, but bonds could, if stocks tumble, be life jackets for investors. What’s more, they would tend to rise in price as investors rush to safety. The wise in-vestor will already be in place to profi t from others’ late realization that bonds do, after all, have a valuable role in a portfolio.

WHAT IS SAFETY WORTH?Over shorter periods and especially in periods when stocks go into long declines, bonds are often safer and may even produce offset-ting gains. But what is a short period? If the referent of shortness is a day or a week, then there can be no strategy. In-and-out bond trading is the business of professionals. Day traders may try to compete, but most go broke trying to estimate volatility. They will wind up playing against the brains and computers of the world’s largest banks and will lose.

In order to decide what is a reasonable period in which to es-timate the relative weights of bonds to stocks, we need meaningful benchmarks. One’s remaining life expectancy is a reasonable pe-riod. Financial planners use a rule of thumb that advocates holding bonds in the same proportion as one’s age. So at age 20, one need have only 20% bonds in a portfolio, at age 50, 50%, and at age 80, 80%. This is too crude, for a portfolio of solid bank stocks has less volatility than a portfolio of junior technology stocks. A major role

233Bond Strategies—A Summary and a Conclusion

of bonds, after all, is to stabilize a diversifi ed portfolio. Putting 60% bonds into a portfolio that has a complementary balance of 40% fi nancial institutions is therefore like setting a 10-tonne anchor to hold a rowboat.

The lack of a single, hard rule on bond allocation does not mean that the question should not be addressed. Bonds produce steady income. With the cash yield on the S&P 500 Composite and the S&P/TSX Total Return Index hovering just over 1% at the time of writing, bonds represent not just stability, but income cer-tainty. The more income dependent one is, therefore, the greater the need for bonds.

Bonds stabilize portfolios heavy with stocks because, most of the time, stocks and bonds do not dance together. In the two de-cades that began in 1982 following the stern measures taken by the Fed and the Bank of Canada to break the back of what was then double-digit infl ation, interest rates began a steady slide. That produced immense bond gains and stimulated stocks as well. But in periods of severe distress, such as the Great Depression, bond prices rose as interest rates fell. Falling rates and rising bond values were not enough to rescue stocks, which tumbled to successive lows. More recently, the Japanese stock market, which peaked in 1989 with the Nikkei at 28,000, dropped as much as 60% while returns on Japanese bonds soared. Government efforts to restart Japan’s consumer spending were driven by persistent efforts to re-duce interest rates. Even at what amounted to 0% interest on short bonds, consumer spending would not rise. But bond investors made money hand over fi st before the Japanese stock market awoke from its Rip van Winkle sleep and began to rise once more. Today, the Nikkei average has doubled from its 2003 low, though it has not even recovered half of its former peak. Investors in Japanese bonds have nevertheless enjoyed steady and sometimes spectacular gains in the last 15 years as the Bank of Japan drove down interest rates.

234 C H A P T E R 1 0

The lesson is this: When stock markets panic, which they do rather frequently, bond investors can smile. They may even feel a frisson of pleasure as they watch other investors who were smitten with stock lust lose their shirts.

In a practical sense, the bond vs. stock decision need not be answered all at once. Bonds pay holders for waiting. Thus one can invest 10% of a portfolio in bonds, then stand by in cash on depos-it in a guaranteed investment certifi cate or treasury bills. If bond prices rise, the investor can book a profi t. If stock prices fall, the investor may wish to remain on sidelines awaiting further declines or to buy stocks at what may seem attractive prices. The process of averaging decisions over time cannot produce optimal returns, but it does minimize the odds of making the worst of all possible decisions.

The best contrarians make the toughest decisions when they go against popular wisdom. Buying stocks in 1981, as Canadian prime interest rates peaked at 22.75%, was a tough thing to do. Stocks plunged, even as bond reinvestment income soared. Looking back, buying stocks at the bottom when prices were at or approaching all-time lows, was wise. It may have even been the obvious move to someone who believed that trends, by their nature, are temporary. But as bond analyst Annette Thau has said, “As you look back over the investment returns … it becomes clear that no two decades have been alike. Don’t count on repeats.”1

Asset allocators who spend their days deciding whether to put money into stocks or bonds use a model worked up by the Federal Reserve. Known as the “Fed model,” it says that stocks are fairly valued when their earnings yield (earnings/price) matches the 10-year Treasury bond return. Recently, the Fed model has implied that the fair value for the stock market is 24.5 times earnings. The S&P 500 has recently traded at less than 20 times last year’s earn-ings, so, implies the model, one should buy stocks and dump bonds


until stocks rise in price and their multiple in relation to earnings comes down. This is transitory information. The point is—and this is the essence of a long-term, risk-averse bond investor’s creed—buy bonds for a long-term purpose, not a short-term trad-ing opportunity. What the stock market gives or the bond market gives, it can just as quickly take away.2 In sum, trading increases risk, for one can err in interest rate predictions. Structured bond investing reduces risk since it overcomes predictions or guesses about market trends with more predictable cash needs or portfolio balance requirements.

BOND PRICE CYCLESStock prices move in cycles driven by a cacophony of expecta-tions of returns, the actual returns, interest rate changes, political events and the changing moods of investors. Those cycles tend to converge to long-run vectors. Plot the seemingly incoherent fl uc-tuations of daily stock prices over periods of 20, 30, or 40 years, using moving 10-year averages and the fl utters disappear. U.S. stocks’ real returns from 1802 to 2001 compounded at an aver-age annual rate of 6.9%, while long-term government bonds’ real returns in the period rose at an average compound rate of 3.5%.3 The difference of 3.4% is what may be called the cost of insuring temporary changes in stock returns against the mayhem that af-fl icts short-run stock returns.

Bond returns are fundamentally different from stock returns. The convergence that one sees in stocks, driven by the basic long-run returns to capital in national and global markets, is absent from bond markets. Bonds tend to move in response to government interest rate policy and investors’ infl ation expectations. Government policy is a tenuous thing that varies from brilliant to abysmal. Infl ation var-ies with world events, the business trends of major trading partners, and government fi scal policy. That policy ranges from enlightened

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service to the public to the appalling pursuit of self-interest through cascades of spending designed to win votes. Canadian taxpayers and voters should be able to recognize the style. Reversion to average long-run trends that can be described as a single, long-term straight line is not characteristic of bond returns.

An investor aware of the fundamental anomaly in the returns to stocks and bonds might well decide that the 3.4% opportunity cost of not having stocks is not worth it. We come back, therefore, to the fundamental question: Why have bonds at all? If income trusts and bank stocks that pay, say, 2.5% to 3.0% dividends that are, in fact, taxed at preferential rates that boost the value of $1 of dividend to about $1.28 of equivalent, fully taxed interest, could it be said that bonds are simply unnecessary?

That would be a wrong conclusion, for equity risk, expressed as volatility, is far higher than bond risk. In the end, bonds are insur-ance that pays a tidy, steady return less than stocks’ long-run returns in the past. But the past is not a foolproof guide to the future, and bonds, even if they are not as profi table in the long run as stocks, still offer certainty. A government bond will pay its coupon. Period. No stock, witness the sad case of General Motors Corp.—which had to cut in half its historic US$2.00 per share dividend in order to survive—has the certainty of payment of a British gilt, a Canada bond, or a U.S. Treasury bond. That certainty is worth having.

A RATIONALE FOR ALLOCATIONNow we can derive a basic plan for allocating a portfolio between stocks and bonds. Buy bonds for their certain income. Let’s take a sample asset base of $3 million. It will work just as well with other amounts of investable capital if you adjust the following numbers proportionally.

If you need, say, $80,000 a year of income in retirement begin-ning at age 60 and you are 50 today, allow, say, 2% infl ation for the


next ten years or 20% in all. Infl ation compounding will push this up a little, so make it a 22% boost in income to compensate for infl ation. Now you need roughly $100,000 in income. If $2 million of stocks that pay a 3% annual dividend already yield $60,000 then you need $800,000 of bonds to produce another $40,000 income, assuming that your bond portfolio produces a 5% annual return. You now have $60,000 dividend income from stocks and $40,000 interest income from bonds. You have achieved considerable in-come stability, reduced the effect of stock market fl uctuations on your portfolio, and created a balance in which there is poten-tial bond insurance against stock market declines. You still have $200,000 in cash or other assets, so you are not trapped by your portfolio.

The insurance is not perfect, however. Bonds can move in par-allel with stock returns, as they did in the early 1990s when falling interest rates drove up bond prices. Bond gains drove the stock market and bonds were covariant with stocks for much of the de-cade. But when stock markets became overheated in the dot-com frenzy and then cracked, bonds performed strongly. In 2000, dur-ing the tech meltdown, the SC Universe Bond Total Return Index gained 10.25% compared to a 36.9% decline in the NASDAQ Composite Index in Canadian dollars. The ability of bonds to re-tain value in periods of massive stock market meltdowns is widely understood in fi nancial markets. The amount of bonds one should have in a portfolio will vary with the investor’s needs for cash and the general level of risk in the portfolio. But there should always be a signifi cant level of bonds in a conservative, balanced portfolio. What is signifi cant will vary with the individual, but it is likely to be in a range of 10%, a minimum amount of portfolio buffering for down times in the stock market, to as much as 70% or even more for an investor who is unable to tolerate any portfolio losses. In the end, the level of bond in a portfolio turns into a comfort question, one of tolerance for loss versus eagerness for gain.

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Loss limitation is a basic plan and assumption of balanced fund managers and asset allocation managers. Balanced funds tend to hold 60% of assets in stocks, 40% in bonds. Asset allocators may vary their relative weights more widely. The returns of asset alloca-tion have been unspectacular. For the fi ve years ended December 31, 2005, Canadian tactical asset allocation funds produced a 4.2% average annual return compared to the 6.3% average annual re-turn of Canadian equity funds and the 5.6 % average annual return of Canadian bond funds. Results vary for different periods, but it is clear that asset allocation managers have not as a group shown a distinct ability to time economic expansions, when they should be relatively heavily into stocks, and contractions, when they should be in bonds. It may therefore be suffi cient to hold a target level of bonds, adding to bonds when one’s stocks have done well and add-ing to stocks when bonds have done well. Do this at a fi xed date each year and one’s portfolio should have smoother performance during the phases of economic cycles.

An example will show how this works. If at the end of year 1, stocks in a portfolio have gained 30% and bonds 10%, take some or all of the difference of 20% and buy the asset class with the low-er return. If bonds have outpaced stocks by 30%, sell 20% or some other measure of the bonds and buy stocks. This kind of dynamic asset allocation works best with entire indexes of assets. One can buy those indices as exchange-traded funds (see Chapter 7). It is what balanced fund managers often do as they seek to maintain the bond-to-stock ratios of their funds at the customary 60% to 40% respective levels. The individual investor must ensure, however, that trading costs in the form of commissions and spreads do not unduly reduce gains and that taxes on non-registered accounts do not unduly reduce gains to be reinvested.


THE OPPORTUNITY COST OF BONDSIt should be said that not all investment theorists think bonds are worth having. Toronto-based portfolio manager Pat McKeough, who is also the publisher of the market letter, The Successful Investor, has said that bonds are a very expensive way to insure against the fl uctuations in the stock market.

McKeough notes that stocks, trading at about 20 times earn-ings on the TSX, have an earnings “yield” of 5%. Add 3% average dividend on senior large caps in fi nancial services and utilities and you get an 8% total return. Investment-grade bonds with a return of 4% to 5% are an inferior vehicle for asset growth, he explains. “If you settle for 4.5% from bonds instead of an average 8% from stocks and you accept the tax disadvantages of interest, compared to the tax advantages of dividends and capital gains, you are at greater risk of having to make drastic spending cuts as years pass.”4

McKeough is right in the sense that the opportunity cost of hold-ing bonds during stock market booms is high and that, over time, equities beat bonds. However, for the investor designing a portfolio, the ultimate question in buying and holding bonds is therefore what it’s worth to counterbalance the yin and yang of stocks with what is usually the yang and yin of bonds.

PORTFOLIO METRICSGiven a portfolio structure that calls for a certain weight of bonds that mature in various time periods, the investor is left with selec-tion of duration. Duration, which is explained in Chapter 6, shows the price sensitivity of bonds. The higher the bond’s coupon rate of interest, the lower the duration and the lower the sensitivity of a bond to interest rate changes. Duration calculations can be made with handheld fi nancial calculators or found already worked out in

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various databases. Canadian bond data with duration calculations can be located at http://globeinvestorgold.com. The investor who wants to minimize fl uctuations in the market value of a bond port-folio will select issues with high coupons and short terms. Short terms sacrifi ce the higher yields usually available on longer terms. And high coupon bonds that tend to be traded at prices over par expose the investor to capital losses when, at term, the bonds are paid only their face value. Clearly, there needs to be a system for maximizing bond return and minimizing transitory risk.

If bonds are held only to pay for a retirement house or the fi rst year of a child’s university education, a single maturity will be suffi cient. A portfolio that has only one term is called a “bullet portfolio” for the obvious reason that it can hit a perfectly defi ned target. An investor can buy a fi ve-year bond for an obligation due in fi ve years and be done.

In the absence of the simplicity of targeting a single term, in-vestors usually try to match obligations with average systematic risk of changing interest rates and to get the most yield for the risk undertaken.

Bond ladders with the rungs spaced at times of need for cash disperse risk over the term of the ladder. If an investor wants to plant one foot in short term bonds in order to ride a curve of rising interest rates and to capture some of the yield premiums offered for long-term investments, he can split a portfolio into a barbell. It is essentially a ladder with the middle rungs cut out. Ladders merely space out bond maturities and average out the returns along the yield curve. One can have a ladder with maturities spaced at 2, 5, 10, and 20 years or, for a shorter life expectancy or for kids about to start university, at 1, 2, 3, and 4 years. The barbell is just the ends of the ladder, a combination of the safety of short-term bonds with the higher rates (and risks) of longer-term bonds.


The question of whether to select a bullet bond, to barbell, to ladder, or to use yield-substitution devices like preferred stocks with quarterly dividends or income trusts that may have monthly distribu-tions, depends on timing and risk control. Bond and term selection are fl exible criteria, for various bonds rise and fall in popularity. As a result, the yield spreads offered by investment-grade corporate bonds and high-yield bonds over their benchmark Canadian federal bonds or U.S. Treasury bonds vary widely.

PORTFOLIO INSURANCEBonds can also be used to provide portfolio insurance. The method, which uses strip bonds, is really a “no-brainer” that, once put in place and left alone, always works. There is no annual cost, no pay-ment for the guarantee that adds huge costs to annual management expenses of mutual funds with what is actually incomplete protection against decline in value, and virtually no chance of failure. Here’s how it works.

Assume that you want to put Junior, now one year old, through university. You have 16 years to build up a fund for him. You can use stocks or mutual funds, but you fear that they could tumble in value just when he needs the money. Rather than buy an insurance-based segregated or “seg” fund that guarantees to return most or all of the value of the mutual fund at cost (a costly process that may strangle your returns), you set a target investment amount of, say, $100,000 for Junior’s costs, and buy a bond stripped coupon that will mature in 16 years. A $1,000 Province of Ontario coupon due June 2, 2002, can be had for $477.34. It offers a 4.65 annual yield to maturity. You will need to spend 100 times $477.34 to build up the $100,000 in the next 16 years. Now take the difference between the cost $477.34 and $100,000, $52,266, and invest it in stocks or anything else. The worst possible outcome is that the $52,266 shrivels to zero. Junior still has his $100,000 for university costs when the coupon matures. If the sum not invested in a bond merely stays in cash with a zero

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return, Junior’s fund will have $100,000 plus $52,266 for his univer-sity expenses. If the $52,266 not invested in the strip grows at 6% per year, it will amount to $132,756 after 16 years. Now Junior has $232,756 for his university expenses.

The strip bond strategy works, but periodic taxes, will reduce the return. The process can work within an Registered Education Savings Plan, but rules limit contributions from all contributors to $4,000 per benefi ciary per year. Strips work as well in RRSPs, for they lock in a maturity and capture interest rates at the initial rate. Timing is everything with strips, however, for there are no cou-pons to reinvest. Strips, therefore, should be purchased only when interest rates appear to be peaking. And that is a tough prediction to make. In a progressive bond ladder to which one adds every year, strips have to be added each year, but the outcome would av-erage out interest rate fl uctuations. Any taxes paid before maturity, as would be necessary if the plan were operated outside a deferred tax structure, would reduce eventual returns.

The strip bond insurance plan is fl awless provided that the bonds used are immune to default. The plan guarantees return of capital, though it provides no infl ation compensation in the worst case in which the residue not invested in strips falls to zero. Real return bonds that have no predictable cash return to maturity do not work as well in the plan. The concept of the strip bond guar-antee is to build capital with certainty. However, if the funds not invested in a strip are put into common stocks, the portfolio will tend to have infl ation protection through rising equity values and rising dividends.

GLOBAL BONDSAt times, bonds issued in foreign jurisdictions can provide far stron-ger performance than domestic bonds. As the Bank of Canada or the Federal Reserve raises rates, central banks in Europe and Japan


may be lowering them. The potential therefore exists to invest in offshore bonds for substantial gains.

A strategic move into eurobonds or yen bonds makes sense for the person planning to retire or to make substantial invest-ments in the European Union or in Japan. The investor can lock in buying power in the foreign jurisdiction, fi x a cost base for further investments, or prepay the cost of a chalet or a university education abroad.

The investor who wants to stay in Canada or, indeed, who may be resident in Florida and who merely makes occasional trips to Italy is in a much more complex position. While the eurobond or the yen bond is a natural hedge for a person with a residence or business in the relevant country, the outsider who merely plays yen bonds is a speculator.

Gambling on the value of the euro when it was trading well below the U.S. dollar at the beginning of the 21st century or on yen bonds in the long period of Japan’s post-bubble economic contraction appears in hindsight to have been brilliant. But major currencies have a way of moving into long-term stable relation-ships. One cannot say how long the cycles may be, but economic forces such as unit labour costs that defi ne productivity tend to move currencies into long-term equilibrium. Betting on trends is further complicated by the unpredictability of political events.

As I write this chapter, the value of the Canadian dollar has hit a 17-year high. In recent months, rumours that the government of China would revalue the yuan have raised profound concerns in glob-al currency markets.5 Even a misphrased article written in early May 2005 by a rookie reporter for a Chinese news service, later mistrans-lated into a story that China would revalue its currency, was enough to propel nervous foreign currency markets into a US$2-billion trading frenzy in the wake of the story until traders fi gured out the error.6 Global currency values are nothing if not volatile.

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The returns of global bonds are intertwined with the currency moves. It is possible to hedge the currency exposure in foreign bonds, but that tends to leave the bonds hedged with nothing more than the domestic Canadian interest rate—the starting point for a Canadian who wants to be isolated from foreign currency moves.

Over short periods, fl uctuations in foreign currency values are an important driver of global bond returns. The investor in a for-eign currency bond is also exposed to devaluation crises such as those that struck Asian bonds in the fall of 1998 when some bonds lost half their value overnight.7

The speculative risks of buying global bonds grow with the implicit costs of currency trading and the costs and diffi culties of obtaining timely information on fi nancial and political events af-fecting those bonds.

Some corporate bonds issued by major companies operating in the EU provide foreign business cycle exposure and Canadian or U.S. or euro or even Swiss franc currency exposure. Sophisticated investors can make use of these varieties of obligations, variously called eurobonds and, when denominated in U.S. dollars, Yankee bonds. It is suffi cient to say that they provide heightened levels of risk and challenging management requirements.

REAL RETURN BONDSInfl ation-linked bonds that compensate for changes in the purchas-ing power of a basket of goods used to measure the Consumer Price Index have been immensely successful as both asset plays and in-come vehicles in Canada and other nations that have issued them.

They are, nevertheless, peculiar in their operation and fraught with peril. Their popularity has reduced their base or intrinsic Canadian interest rate to just 1.55% at the time of writing, on top of which the bonds add an infl ation compensation adjustment. The investor who buys Canadian RRBs is accepting what may be


an inferior short-term return below the Treasury bill rate. In ad-dition, the bonds, which are adjusted by means of increases in the underlying principal to generate infl ation-equivalent income, cre-ate a liability for tax on the asset price change. The increase in the value of principal will be subject to annual income tax if the RRBs are not held in a tax-defferal account such as an RRSP. An inves-tor planning to use RRBs outside an RRSP for a retirement fund with the idea that infl ation compensation will protect his RRB’s value is actually pre-paying income tax on his eventual retirement income.

The only way that RRBs can work effi ciently for the investor is therefore in a tax-deferred account such as an RRSP. It is not a bad idea to have some RRBs in an RRSP or other tax-deferred account. To bet one’s entire retirement account on them is merely to shift from the roulette wheel of infl ation risk to the potential money pit of paying too much for infl ation that may not materialize. In infl ation-protection as in every other investment decision, it pays to diversify.

QUALITY: A LONG-RUN VIEWInvestors in search of yield are often tempted to go below invest-ment-grade bonds. According to Merrill Lynch, whose indices measure yield spreads of various categories of bonds over U.S. Treasury bond yields, the average 10-year corporate bond pays 100 basis points over the 10-year T-bond while the average below-investment-grade bond pays 400 basis points over the 10-year T-bond. These yield pickups compensate for substantially increased risk. An investor who wants the yield boost and is willing to accept default risk to get it should remember that risk increases with time. It may be acceptable to buy an investment-grade cor-porate bond for a fi ve-year hold. That bond becomes far more speculative when the holding period grows to 20, 30, or 40 years.

A portfolio structured for yield and limited to investment-grade bonds needs to expand the number of names held as the

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holding period grows. Recall that General Motors Corp. bonds were regarded as strong, investment-grade credits a few decades ago. In early May 2005, GM bonds and the debt of subsidiary General Motors Acceptance Corp. traded at 700 basis points over an equivalent-term T-bond to pay 10.5%. Ford Motor Credit Corp. (Canada) bonds traded at 470 basis points over federal debt to yield 9.7%. Each company’s bonds are now deeply discounted and are rated as junk by the market.

BOND FUNDSAn investor who wants the best security in investment-grade bonds for a long-term hold has no need for a bond fund. Consider that the SC Universe Bond Total Return index generated a 7.7% aver-age compound return for the 10 years ended December 31, 2005. Canadian bond funds produced an average return of 6.10% per year on the same basis in the same period. The difference is mainly the management fees funds charge and sales fees charged to inves-tors. An investor who wants a packaged bond portfolio can buy low-fee exchange-traded bond funds through a discount broker that will have low entrance and exit charges and management fees a small fraction of domestic bond funds.

The investor who seeks a yield pickup through foreign bonds, long corporate bonds, and high-yield bonds should consider us-ing a manager through a bond fund. Managed bond funds that carry corporate debt, foreign bonds, and junk bonds tend to have higher volatility than plain vanilla Canadian government bonds. That volatility leads to timing issues that are diffi cult if not impos-sible to anticipate. As well, bond trading in relatively complex debt instruments is more diffi cult than buying straight government or investment-grade corporate bonds. In the area of relatively elabo-rate products, bond managers can shine.


RISK MANAGEMENTThe proposition that return rises with risk is true at a theoretical level. What is missing from the statement is a time boundary, for it may take a lifetime for return to compensate for risk. In some sectors, such as the dot-coms that fl ourished in the period before the 2002 collapse of the industry, total returns have been strongly negative. An exceptionally high level of bankruptcy eliminated the chances for recovery of many companies that were, at one time, valued to hundreds of times their earnings—if they had any earnings at all. Worse—for investors who saw what was coming, many small stocks were too illiquid to sell quickly. Investors were locked into impossible situations in which they could either suffer anticipated losses or realize those losses by offering their stocks at huge discounts to the market.

The decline and fall of the dot-coms illustrate the problem of investing in esoterica. In yield substitutes, Canadian investors have gravitated to income trusts, many of which have narrowly defi ned products such as canned fi sh. In the fall of 2005, Connors Bros. Income Fund (CBF.UN – TSX) reported that tuna it wished to can were not biting and the market punished the stock with a 17% one-day drop. No asset is immune from the market’s lack of mercy when problems develop. The investor’s only protection is diversifi cation. For the long term, therefore, the investor with a taste for income trusts should either buy several, preferably in unrelated sectors, or use a fund of income trusts such as the Sentry Select Diversifi ed Income Trust. Each structure adds fees, but if management adds to return through apt asset selection, it may be an effi cient investment.

In selecting bonds and yield substitutes, the investor should remember that the core concept of a bond is certainty and security of return. In moving away from short government bonds in the

248 C H A P T E R 1 0

investor’s own currency, there is growing risk of adverse interest rate change, default, and perhaps adverse currency moves. When all those risks are combined, as they are in long-term foreign cor-porate bonds, the potential for return rises to at least equity levels and the potential cost of failure is as great as that posed by volatile stocks. The investor who wants equity-level returns from bonds should probably put his or her money into stocks. Stocks, after all, offer the potential of unbounded gains, something that bonds can-not match. Those investors who seek to engineer bond portfolios to emulate equity levels of performance are deviating from the es-sence of the bond: time-bounded certainty of return. In buying bonds and their substitutes, simplicity is its own reward.

CONCLUSION: THE VIRTUES OF BONDSWe have seen that bonds and stocks are very different in their behav-iour. Stocks have an upward trend over time if only because company management seeks to increase earnings and usually succeeds. Bonds, on the other hand, fl uctuate in value with interest rates and infl a-tion expectations without a clear upward path. But, paradoxically, the prices of investment-grade bonds are knowable with perfect ac-curacy at their future maturities and highly predictable within the limits of duration calculations at periods prior to maturity.

The combination of upwardly rising stock prices and the vola-tility that goes with them and the predictability of bond returns will tend to improve investment returns overall, to lower port-folio risk and, mostly likely, to make it easier to sleep at night.Investment-grade bonds, especially those issued by senior national governments and Canadian provincial governments, are the cor-nerstone of this portfolio strategy. The investor who seeks higher bond returns in lower-grade issues, synthetic bonds, structured products with sub-investment grade ratings, convertibles, and so


on may be raising returns, but in so doing is venturing into the territory of stocks.

Purity of purpose goes along with purity of plan. Stocks abso-lutely have a place in a portfolio, as may real estate and commodities and, who knows, art and collectibles. But bonds function as a corner-stone of certainty. That quality is the foundation of secure investing. How much one should invest in bonds is as individual as a tailored suit, but risk control through bonds, even at the cost of the poten-tially higher return available on some stocks, is an expression of maturity and wisdom. After waves of stock market enthusiasm have passed, after future dot-coms have turned hope into disaster, gov-ernment bonds and senior investment-grade corporate bonds will still be paying interest and, perhaps, generating capital gains. That is the wisdom of the ages. Nothing, lately, has changed.

1. Annette Thau, The Bond Book (2nd ed.; New York: McGraw-Hill, 2001), p. 359.

2. Derek DeCloet, “Bond market provides clues on equities, but don’t bet the farm,” Globe and Mail, May 28, 2005, p. B-1.

3. Jeremy J. Siegel, Stocks for the Long Run (3rd ed.; New York: McGraw-Hill, 2002), pp. 13, 15.

4. Canadian Wealth Advisor, May, 2005, p.1.

5. Mary Kissel, “Pulling yuan’s peg to U.S. dollar may not slash trade surplus,” Globe and Mail, April 25, 2005, p. B-6.

6. Andrew Browne, “How a News Story, Translated Badly, Caused Trading Panic,” Wall Street Journal, May 12, 2005, p. A1.

7. Thau, The Bond Book, p. 222.

Endnotes

Glos sary

Alpha—a measure of the risk-adjusted performance of a stock, bond, or portfolio in comparison to its referent, such as a market index or asset class.

Allocation—the process of deciding the relative value of asset classes, such as stocks and bonds, to be held in a portfolio.

Asset-backed debt—loans or bonds with designated collateral, such as a parcel of real estate, railroad cars, or aircraft.

Balance sheet—the fi nancial statement that lists assets, liabilities, and net worth.

Bank of Canada—the central bank of Canada, responsible for issuance of currency, borrowing to fund the national debt, and paying interest on that debt.

Bellwether—a stock or bond or other fi nancial instrument that is regarded as a proxy or weather vane for a market or asset class; the 10-year bonds of various issuing countries are regarded as bell-wethers for their respective markets.

252 G l o s s a r y

Benchmark (see Index)—a statistical referent, such as the SC Universe Bond Total Return Index, which tracks all government and investment-grade corporate debt in Canada.

Beta—the measure of response of a stock to variations in its mar-ket or market segment; by custom, the beta of the referent is 1.0, so that an asset with 50% greater volatility than the referent is said to have a beta of 1.5.

Bill—a short -term obligation due in 365 days or less.

Bond—an interest-bearing security issued to formalize a loan from various individuals or companies.

Bond fund—a portfolio of bonds, usually operated as a mutual fund, in which many investors, called unitholders, contribute money in exchange for participation in the risks and returns of the bonds in the portfolio.

Bowie bonds—bonds backed by the copyrights and revenues of the music of David Bowie; the Bowies, sold in 1997, were the model for other intellectual property issues based on revenues of musicians, dress designers, and other producers of copyrighted, patented, or trademarked products; see Intellectual property bonds, below.

Brady Bond—a U.S. Treasury obligation designed with the guidance of Nicholas Brady, Secretary of the Treasury in the governments of Ronald Reagan and of George H. W. Bush, that guarantees payment of principal and certain interest on bonds of emerging markets nations.

Bubble—asset price infl ation driven by investor enthusiasm by which the market value rises far in excess of replacement value or reasonably

253G l o s s a r y

predictable cash fl ow or profi ts; bubbles occurred in the 17th century in Holland when tulip bulb prices soared, in England in the 18th cen-tury when shares in the South Sea Company rose astronomically and then collapsed, and in the developed world in the late 1990s when the value of shares in dot-com companies, some with no sales and no business plans, rose to unrealistic levels before collapsing.

Canada bond—a bond issued by the Government of Canada.

Canadian bond—bonds issued by the Government of Canada, the governments of the provinces, by Crown corporations, by federal agencies, and by corporations domiciled in Canada.

Cash fl ow—the money generated by a business from its opera-tions that, when positive, indicates that a company is covering its expenses and that, when negative, indicates that the company is unable to cover expenses from its operations.

Central limit theorem—the fundamental condition for generation of the Gaussian or normal bell curve that shows the amount and fre-quency of events or things, subject to the condition that the variance of any one variable in the distribution should not dominate.

Closed end (see also Open end)—a portfolio or fund with a fi xed number of units or shares. Closed-end funds are bought and sold on stock exchanges and do not absorb fresh contributions from investors nor redeem shares for holders, subject to amendments that provide for occasional redemption, often at year end, at the net asset value of shares.

Collateralized debt obligation (CDO)—a debt device or struc-ture with bond attributes that assembles such things as credit card

254 G l o s s a r y

receivables with the understanding and design that such payments will fl ow through to the CDO’s investors.

Commercial Code—a set of laws governing markets, exchange of value, structure of contracts, and remedies for violation of rules.

Commodity linked bond—a bond the price of which is infl u-enced by or dependent on the price of a commodity such as gold.

Consols—perpetual debt created in 1751 by Sir Henry Pelham, Britain’s prime minister, with no maturity date but, by custom, a fl oating rate of interest.

Corporate bond—a promissory note of payment issued by an en-tity constituted as a corporation under the applicable laws of the place of its domicile.

Convertible bond—a bond that may be transformed into shares of the issuing company.

Conversion rate—the rate at which dollar amounts of the con-vertible bond are transformed into shares.

Convexity—in bonds, the property of the weighted average re-turn of cash fl ow to the time of receipt of that cash fl ow that increases return as interest rates rise, refl ecting higher returns from reinvestment, or that falls when interest rates decline, re-fl ecting lower returns from reinvestment; mathematically, the fi rst derivative of duration.

Coupon—the periodic commitment to pay interest, usually in fi xed currency amounts. Once represented by paper tags appended to

255G l o s s a r y

bonds, coupons now are time-defi ned commitments to pay interest in fi xed currency amounts, in other forms of consideration—such as additional shares (see Pay in Kind) or in infl ation-determined currency units (see Real return bonds and TIPs).

Covenant—the rules and regulations for a bond or other loan agreement that specify borrower’s conduct with respect to how much debt may be carried or entered into after issuance of the bond or loan in question, how fi nancial targets such as earnings should be attained, that limit payment of dividends on stock.

Credit default swap—an insurance arrangement created through a structured portfolio of debt at risk of default by which one party, paid a premium or fee and acting as insurer against default, agrees to compensate investors hurt by a default.

Currency—generally, the monetary standard in which bond inter-est is paid or through which transactions take place. Currency may take the form of paper bills and small change or in monetary units, such as dollars held in chequing accounts.

Custody—the means by which a bond or other fi nancial instru-ment is held by a third party, typically a trust company or other trustee, for a benefi cial owner.

Death spiral—the process by which a convertible bond that al-lows the holder to transform his bond into a suffi cient number of shares to protect his principal in the event of a major decline in the share price accelerates conversions and amounts of stock issued, with such new stock falling in price and further accelerating the conversion process until shares reach a point of no value.

256 G l o s s a r y

Debenture—a debt or bond not secured by specifi c assets and therefore payable out of the general revenues and from the capital of the issuer.

Default—the failure of a bond issuer to pay coupon interest due or to return principal on time; in bank loans and other forms of debt, it may also indicate the failure of the issuer to abide by the terms or covenants of the loan or bond.

Defunct bond—a bond no longer traded as a security but that may have value to collectors for its ornateness of design or histori-cal signifi cance.

Depression—a period and condition of an economy marked by declining gross domestic product, falling prices, rising unemploy-ment, and falling interest rates, all of which happened in the 1930s following the stock market collapse of October 1929 and related declines in international trade.

Derivative—a fi nancial instrument whose value is derived at least in part from the value or condition or performance of an underly-ing asset.

Dividend—the periodic or special payments to shareholders of corporations as a reward for holding the shares of the company.

Dividend fund—a mutual fund that specializes in or holds a large part of its assets in dividend-paying stocks.

Dominion Bond Rating Service (DBRS)—a Canadian bond rating company.

257G l o s s a r y

Duration—the average time to receipt of a bond’s cash fl ow in which each element of the cash fl ow (coupon and principal) is weighted by its present value as a part of the total present value of all the cash fl ows. Also called Macaulay duration.

EAFE—Europe, Australasia, and the Far East.

Earnings—the income of a business.

Exchange traded fund (ETF) iUnits—defi ned asset portfolios that replicate major bond or stock indices that are managed by Barclays Global Investors in Canada. iShares—defi ned asset portfolios that replicate major bond or stock indices that are managed by Barclays Global Investors in the United States.

Exchequer—the antique name, still in use, for the treasury of the United Kingdom.

Fibonacci—a sequence of numbers named for Leonardo of Pisa (1175–1250) in which each term, after the fi rst two, is the sum of the preceding pair, e.g., 1, 1, 2, 3, 5, 8, 13, 21. The sequence is regarded by some fi nancial analysts as capable of predicting asset values, a proposition for which evidence is occasionally found but which is inconclusive.

Fitch Ratings—a service that supplies evaluations of the ability of bond issuers to pay their debts.

Fixed income—the branch of fi nance that involves sale of assets with obligations to pay defi ned sums of money in the form of pre-ferred stock dividends or bond coupons.

258 G l o s s a r y

Giscards—French Treasury bonds with default reference pricing in gold that were issued in the term from 1969 to 1974 of Valéry Giscard d’Estaing as Minister of Economy and Finance.

Global bonds—bonds issued by governments and corpora-tions domiciled outside of the investor’s country of issue. From a Canadian perspective, bonds issued by the U.S. Treasury and Mitsubishi are global.

G-7—collectively, the group of nations and their economies con-sisting of the United States, Canada, the United Kingdom, France, Germany, Japan, and Italy.

G-8—the G-7 plus Russia.

High-yield bond (see Junk bond).

Indenture—the bond contract containing conditions under which a bond is issued and by which it is regulated, including issuer’s rights and investors’ rights.

Index—design of a referent measurement system, usually a port-folio of assets established by the mandate of the portfolio manager to track a given market or market segment.

Infl ation—the process by which prices of goods rise over defi ned time periods.

Infl ation-linked bonds—debt issues that pay interest based on changes in a referent such as the consumer price index; typically infl ation-linked bonds such as Canadian Real Return Bonds pay a base rate of interest that rises in proportion to increases in the national Consumer Price Index.

259G l o s s a r y

Insurance—a fi nancial compensation mechanism whereby, for a sum of money called a premium, the insurer promises to restore the insured to the position he was in prior to the loss.

Intellectual property bonds—bonds backed by copyrights or pat-ents, usually embedded in a special-purpose corporation or trust, in contrast to conventional bonds backed by hard assets or by the full faith and credit of issuing bodies (see Bowie bonds, above).

Investment grade—bonds of superior quality that rating agen-cies such as Standard & Poor’s believe to have a low probability of default.

Junk bond—sub-investment–grade debt that is regarded by the market and/or by rating agencies as having a signifi cant risk of default; often called high-yield or speculative bonds.

LIBOR—the London Interbank Offered Rate employed by inter-national banks as the price for short-term bank-to-bank loans.

Long-Term Capital Management—a hedge fund based in Con-necticut and managed by Wall Street bond guru John Meriwether with the assistance of several Nobel prize–winning economists that came close to defaulting on over US$1 trillion of investment positions when, in the fall of 1998, its mathematical models failed to behave as the markets required.

Macaulay duration (see Duration).

Management expense ratio (MER)—the charge for manage-ment, usually expressed as an annualized fee; in Canada, the MER is inclusive of offi ce and selling expenses and can be calculated by

260 G l o s s a r y

dividing total fund operating expenses by the number of units of the fund outstanding.

Money market fund—a mutual fund that holds short-term obliga-tions that have low volatility and that are readily converted to cash.

Money supply—the amount of money in an economy, a fl exible measure that moves from the narrow base of currency plus chequ-ing account balances to the inclusion of time deposits and on to readily saleable fi nancial assets.

Moody’s Investor Services—an agency that provides credit rat-ings on bonds.

Mortgage fund—an investment fund the assets of which are in-vested in mortgages.

Nations Emergent—developing countries, sometimes called third world nations. G-7—the world’s most senior nations in terms of the size or maturity of their economies including the U.S., Canada, the United Kingdom, France, Germany, Italy, and Japan. G-8—the G-7 plus Russia.

Open end—the form of organization of a mutual fund or other investment portfolio that accepts fresh contributions and buys and redeems assets at market price and pays sums redeemed to investors. Pay in kind (PIK)—a bond that pays its periodic interest coupons in more debt obligations rather than in cash.

261G l o s s a r y

Preferred securities—hybrid bond/stock instruments that pay interest but that allow extended periods of non-payment of inter-est before enabling creditor remedies.

Present discounted value—the current value of a future payment; the sum of money that, at a designated or present rate of interest, will grow to a matured or reference value at a specifi c date.

Prestiti—book-based debt obligations issued during the Italian renaissance as payment for loans.

Prime Bank Note—promissory notes issued by purported banks or other deposit-taking institutions, often at very high rates of in-terest, with little potential for repayment.

Ratings—scales of value or worth of bonds set according to the issuer’s ability to pay sums in stipulated amounts and on time.

Real return bond—a Canadian bond that pays interest in amounts that rise or fall with changes in the Consumer Price Index.

Reinvestment—the concept of putting period interest from a bond or other asset back into the bond in question or into a similar bond or capital asset at prevailing interest rates.

Recession—a period of slow economic growth defi ned as two consecutive quarters of shrinkage of gross domestic product.

Risk Systematic—the exposure of a bond to rising or falling inter-est rates driven by monetary policy and infl ationary expectations.

262 G l o s s a r y

Credit—the risk of nonpayment of interest due or default by the issuer; a special case of counterparty risk in which one side to a trade fails to fulfi l the terms of the trade or to maintain its promises within the terms of the investment. Call—the issuer’s ability, stipulated in the bond indenture and usually found in documents supporting the bond, to demand the bond be turned in for redemption prior to the terminal or due date of the bond. Liquidity—the ability of an investor to turn a bond into cash in the bond market, often regarded as the robustness of the market for the bond. Foreign exchange—the changeable ratio at which a bond is-sued in a currency other than the investor’s base portfolio currency, such as the Canadian dollar, will convert to the base currency. Sovereign—the chance that a foreign government or corpora-tion may default on a debt; when governments default, seizure of foreign assets may be impossible.

Risk shifting—the value of default, nonperformance, or under-performance that can be transferred to a contracting party in exchange for payment of a premium or participation in an offset-ting investment such as an asset swap.

Savings bonds—low-interest bonds issued by the Bank of Canada for the convenience of investors who accept modest returns.

Scripophily—the collecting of stocks, bonds, contracts, and other fi nancial instruments for their worth as antiques, objects of art, or curios.

Securities regulation OSC—the Ontario Securities Commission; the leading regu-lator in Canada.

263G l o s s a r y

SEC—the Securities and Exchange Commission that has the duty to regulate investment markets in the United States.

Share—a unit of ownership of a corporation or of a fund or other asset pool traded on a stock exchange; see also Unit.

Spread—the difference between a security’s price at purchase and at sale; typically, the spread is the price or bond yield difference between the bid and the ask price of a bond.

Stagfl ation—a process by which an economy suffers both from infl ation and low or zero economic growth.

Standard & Poor’s—fi nancial information service that provides credit ratings on bonds.

Step bond—a bond that increases its coupon interest payments over time at defi ned intervals.

Stock Common—units of ownership of a corporation, dividends on which are paid at the discretion of the board of directors. Preferred—ownership units in a corporation with fi xed and specifi ed dividends that must be paid in full before any dividends may be paid on common stock.

Strip bond—a single bond coupon or principal for repayment sold at a discount equal to the present discounted value of the device at the time of trade (see also Zero coupon bond).

Swap—a custom-tailored exchange of obligations customarily for periods of one to twelve years in which the parties exchange risks

264 G l o s s a r y

for known repayment terms; often used in deals linked to forward currency transactions.

Terms Short—generally under 5 years. Medium—generally 5 to 10 years. Long—generally over 10 years.

Timing—the practice of trading bonds and other securities based on market conditions, trends, or events as opposed to a buy-and-hold strategy of doing nothing to a portfolio or, alternatively, following fi xed buy and sell protocols set by time regardless of market moves or trends.

Treasury Infl ation Protected Securities (TIPS)—infl ation-linked bonds issued by the United States Treasury.

Unit—the smallest proportion of an income trust or other divisible asset that can be owned by an investor; similar to a share of stock.

Volatility—the tendency of asset prices to vary visibly on public exchanges and on trading based on investor expectations of return or market conditions.

Yield—the annualized return of a bond or of stock dividends di-vided by price at time of issue or at time of measurement. Running or current yield—interest divided by price at a rel-evant time. Yield to maturity—the interest an investor will earn if a bond or other time-defi ned instrument is held to its term. Yield to ma-turity takes into account the bond or other instrument’s purchase

265G l o s s a r y

price, current market price, the coupon rate of interest, and the time remaining until the bond or other instrument reaches matu-rity and reverts to cash.

Yield curve—the map of interest rates for deposits of successive periods of 1 day to 30 years. Normal—the time-defi ned rates of interest on debt, usually higher as time lengthens to compensate for risk and deferral of consumption of the money value of the bond. Inverted—a condition in which short-term interest rates ex-ceed long-term rates.

Yield to worst—the lesser of yield to maturity and yield to call when the yield typically falls due to the termination of coupon payments.

Zero coupon bond—a bond term used in the United States to refer to a bond principal or single coupon that bears no interest until its designated maturity date.

Bib l iography

STRATEGIES AND THE BOND MARKET

Michael V. Brandes, Naked Guide to Bonds. New York: John Wiley & Sons, 2003. Introductory manual with emphasis on U.S. markets.

Moorad Choudhry, Analysing and Interpreting the Yield Curve. New York: John Wiley & Sons, 2004. An advanced and mathematical treatment of the yield curve via predictive models and with substantial reference to U.K. data.

Marilyn Cohen, The Bond Bible. New York: New York Institute of Finance, 2000. American bond trading situations in a clear format.

*Anthony Crescenzi, The Strategic Bond Investor. New York: McGraw-Hill, 2002.An illuminating guide to bond management by a very successful bond analyst and manager.

Geoffrey A. Hirt and Staley B. Block, Managing Investments. New York: McGraw-Hill, 2003. Chapters 11 to 14 cover bonds, duration, and convertible securi-ties; clear lessons, but only for the motivated.

* Selections marked with an asterisk are especially recommended.

268 B i b l i o g r a p h y

*Sidney Homer and Martin L. Leibowitz, Inside the Yield Book. New York: Bloomberg Press, 2004. Reprints the 1972 Prentice-Hall classic with an update.A classic examination of bond math with emphasis on the compo-nents of duration.

Michael D. Sheimo, Bond Market Rules. New York: McGraw-Hill, 2000.Introductory rules in an easy-to-read format.

*Annette Thau, The Bond Book, 2nd ed. New York: McGraw-Hill, 2001.A valuable, detailed look at bond and fi xed income markets with insights into global bonds. An essential desk reference.

Sharon Saltzgiver Wright, Getting Started in Bonds. New York: John Wiley & Sons, 2003.

MARKET ANALYSIS*Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk. New York: John Wiley & Sons, 1996.A history of statistics written with great style by a master of fi nan-cial analysis.

*Aswath Damodaran, Investment Valuation, 2nd ed. New York: John Wiley & Sons, 2002.Encyclopedic manual on valuating fi nancial assets.

Edgar E. Peters, Chaos and Order in Capital Markets, 2nd ed. New York: John Wiley & Sons, 1996.An intriguing look at the noise and ambiguity of price change in stocks. The bond applications are evident to the diligent reader.

269B i b l i o g r a p h y

Steven A. Schoenfeld, ed. Active Index Investing. New York: Wiley Finance, 2004.Chapters on bond index construction are useful in understanding exchange-traded funds.

*Didier Sornette, Why Stock Markets Crash: Critical Events in Complex Financial Systems. Princeton, N.J.: Princeton University Press, 2003.A major work on large-scale fl uctuations in fi nancial assets with implications for bonds. A mathematical analysis with immensely insightful comment on why events that should be rare are rela-tively common in fi nancial markets.

ACCOUNTING AND DECEITStephen F. Jablonsky and Noah P. Barsky, The Manager’s Guide to Financial Statement Analysis, 2nd ed. New York: John Wiley & Sons, 2001. Comprehensive but rather dull.

Christopher Byron, Testosterone Inc.: Tales of CEOs Gone Wild. New York: John Wiley & Sons, 2004. Stories of how various CEOs fooled credit analysts and investors.

Paul B.W. Miller and Paul R. Bahnson, Quality Financial Reporting. New York: McGraw-Hill, 2002. Sleep-inducing but thorough.

Charles W. Mulford and Eugene E. Comiskey, The Financial Numbers Game. New York: John Wiley & Sons, 2002. A valuable guide to understanding balance sheets.

270 B i b l i o g r a p h y

*Howard Schilit, Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports, 2nd ed. New York: McGraw-Hill, 2002.The most intriguing guide to fi nancial fl im-fl am in decades. Highly readable and very useful.

HISTORIES AND STORIES OF BONDS AND MARKETS*Nicholas Dunbar, Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It. London: John Wiley & Sons, 1998.A valuable analysis by a British mathematician.

Loren Fox, Enron: The Rise and Fall. New York: John Wiley & Sons, 2003.Scandal told with style.

*Sidney Homer and Richard Sylla, A History of Interest Rates, 3rd ed. New Brunswick, N.J.: Rutgers University Press, 1996.A diligent bond investor can learn much of the craft from this book.

Charles P. Kindelberger, Manias, Panics, and Crashes, 4th ed. New York: John Wiley & Sons, 2000.Perspective on market volatility.

Michael Lewis, Liar’s Poker: Rising through the Wreckage on Wall Street. New York: Norton, 1989.A bond trading tale of egos, huge sums gambled, and careers wrecked.

271B i b l i o g r a p h y

James B. Stewart, Den of Thieves. New York: Simon & Schuster, 1991.Ivan Boesky and his pals unmasked.

*Frank Partenoy, F.I.A.S.C.O. New York; Norton, 1997.A tale of derivatives and how they were built and used to ruin suckers who did not understand them.

Frank Partenoy, Infectious Greed. New York: Times Books, 2003.A complaint by a one-time bond trader about fi ckle regulation.

Index

Aberdeen Asia-Pacifi c Income Investment Company Ltd 177

Acuity Funds Ltd. 161Acuity Pooled Fixed Income Fund 161

Africa 224AGF Global Government Bond Fund 161

A.H. Robins 150AIC Global Bond Fund 161-162, 206

AIC Ltd. 206 see also LeClair, Randyallocation model 234-235, 251Altamira Bond Fund 162 Alternatives to actual bonds 160-178

closed-end bond funds 174- 176 closed-end Canadian bonds 176 closed-end global bonds 177 closed-end junk bonds 177- 178 dividend and income funds

172-174 exchange-traded funds 167-170 money market funds 170-171 mutual bond funds 160-167 specialty bond funds 172Altman, Edward 77, 100nA.M. Best 145America West Archives Inc. 94Andersen LLP, Arthur 143Anderson, Cheryl 94Angola 19, 105antidilution provisions 64arbitrage 93, 115-116,188, 194Argentina xii, 18, 69, 93-94, 107-109, 113

Arrow High Yield Bond Fund 172asset-backed debt 86-87, 252asset class, as determinant of return 214

Australia 118, 119, 120

baby boom 186 see also elder bombBank of America,

274 I n d e x

Parmalat scandal 110, 112-113Bank of Canada 124n, 199, 232-233, 242

Bank of Canada Working Paper #20 69

Bankruptcies see insolvenciesbarbell 240-241Barber, Tony 123nBarclay’s Global Investors 168Barings Bank 91, 136 see also Leeson, NickBarrick Gold Corp. 69bearer bonds 48, 192bear market, bond 217bell curve 38, 40, 42, 215bellwether 251benchmark 50-51, 109, 158, 162, 163, 167

Berkshire Hathaway 213 see also Buffett, WarrenBerman, David 79nBernstein, Peter 49-50, 55nBerra, Yogi 189Beta 50, 128-129Beutel Goodman 162Beutel Goodman Private Bond Fund 162

Bierwag, Gerald 153 nbill of exchange 10-11Blackmont Capital 74BlackRock High Yield Trust (BHY-N) 177

Block, Stanley 28nBloomberg European Pharmaceuticals Index (IBEP) 167

BMO Nesbitt Burns 75bond derivatives 4, 27, 77-78, 90-92 , 256

bond fund 252 see also Chapter 7Bondi, Enrico 112bond ladder 53,132-133, 240bond selection 134-135, 191-192bond vs. bond fund 171-172Bondy, Brad 163Bonneau, Pierre 95-96Bouey, Gerald x, 22Bourgeois, Bruno 162Bowie bonds 252Bowie, David 88Brady bond xii, 116-118 emerging markets 116 estimating value of 117 issuing nations 117 Brazil 176, 179, 224Bre-X Minerals 136 see also insolvencies Brynjolfsson, John 71bubble 252Buconero 112Buffett, Warren xiv, 4, 213Bulgaria 117“bullet portfolio” 240-241Byron, Christopher 154n

call premium 133-135Cameroon 94, 105Campeau, Robert 74, 83-84Canada bond vs. Canadian bond 26, 253

275I n d e x

Canada Real Return Bond 62, 119

Canada Savings Bond 35, 197-198

Canada Treasury Bills 170Canada Trust Income Investments Fund (CNN.UN) 176

Canadian Depository for Securities 192, 193

Canadian Originated Preferred Securities (COPrS) 85

CanDeal 195-196Canwest Global Communications Corp. 83

Carnegie, Andrew 96CARS see synthetic bonds cash fl ow 253Cayman Islands 111Ceausescu, Nicolae 97Central Limit Thereom 42, 253Chainsaw Al see Dunlap, AlChomisky, Eugene 154nCIBC Canadian Bond Fund 159-160

CIBC Monthly Income Fund 163 CIBC Wood Gundy 36Chambers, John 123nCharlemagne 22Chili 115China xiii, 118, 225-227, 243Chomiskey, Eugene 154nCitigroup tech boom 227Citigroup World Government Bond Index 104, 162

closed end 253

closed-end bond funds 174-178closed-end junk bonds 177-178Colbourne, Scott 161collateralized debt obligations (CDOs) 86-87

Comeau, Janet 209nCominco Ltd. see Teck-Cominco Ltd.

commercial code 7, 253commodities 211, 220-221commodity-linked bond 70-72, 254

during catastrophes and infl ation 70Congo 94Connor Clark & Lunn Group 67, 68, 77-78

see also Murdoch, NeilConnor Clark & Lunn Real Return Income Fund 67-68

consols 6, 254Consumer Price Index 195, 211, 227

convertibles 63-67 as interest-paying bonds 64, 65 antidilution provisions 64 conversion to stock 65-66 death spiral 65-66convexity 131-132, 166, 254 see also reinvestmentcorporate bonds 132-153, 254 see also insolvencies considering yield to call in 133-134 cost manipulation in 141-142 credit analysis of 137-140

276 I n d e x

fraud in 140-141 guidelines to buy 134-135 ladder of rates 132-133 life plans and 151-152, 153 rating agencies of 144-148 shelf registration in 143-144 vs. government 138-139Costa Rica 117cost-manipulation see corporate bonds

Cote, Judge Denise 143coupon 44-45, 48,126, 129-130, 166, 192, 254

covenant 255 see also indentureCravath Swaine & Moore 143credit analysis 136-139, 140, 146-148

credit default swaps (CDS) 58, 77-79, 255

credit ratings and defaults 114-115 listed 144Credit Suisse First Boston 92Crescenzi, Anthony 29ncurrency crisis, Asian 104-105, 115

custody 192-194cycles, bond price 235-236cycle theory 189-91Czitron, Tom 87, 149, 165, 175-176, 178, 196, 216

Dalkon Shield 150Dangerfi eld, Rodney 72

Dan Hallett & Associates see Hallett, Dan

Dansk Olie og Naturgas A/S 6Davies, Robertson 110day trading of bonds 194-195DDJ Capital Management LLC 177

dealers, investment types of 35-36Dean Knights Capital Management Ltd.

see Knight, Deandeath spiral 65-66, 255 see also convertiblesdebenture 63, 87, 93, 256debt to capital ratio 137 debt to equity ratio 137 defaults 256 and corporate bonds 207 and credit ratings 115 rating categories 145defaulted bonds see dishonoured bonds

defaulting nations 18, 19 see also Argentina, Brady bonds emerging markets and 108 nations listed 104-105, 117 small investors affected by 109defunct bonds 94-97demographics 186 see also elder bombdepression 233, 256de Roover, Raymond 28nd’Estaing, Valéry Giscard 69direct distribution see no loaddirect sales 198-201

277I n d e x

dishonoured bonds 92-94dividend funds 172-174, 256 see also income fundsDizard, John 100nD’Loren, Robert 88, 89-90Dominion Bond Rating Service (DBRS) 144, 256

dot-coms 66, 92-93, 247 Dow Jones Industrial Average (DIA) 38, 167

Dreamworks 89Drexel Burnham Lambert 4, 75Drkoop.com 66Duff & Phelps Capital Partners 89

Duncan, Richard 225-226, 229nDunlap, Al 140-141 see also Sunbeam Corp. duration xii, 35, 45, 126-131, 137ff, 153n, 207, 221-222, 226, 239-241, 257

as beta stock equivalent 128- 129 as interest rate sensitivity measure 129 as hedge against chaos 221- 222 rising interest rates 226 step bonds 130-131 synthetic bonds 207Dynamic FocusPlus Energy Income Trust 174

EAFE 257Ebbers, Bernie 144

Echo Bay Mines Ltd. 86Ecuador 117 see also Brady bondsEinstein, Albert 67 concepts of randomness 5elder bomb 217-220emerging markets 108, 116Enron Corp. 110, 143equity risk 47, 208, 227, 236Esterline, Caleb 96Ethiopia 94Euroclear 193exchange-traded funds (ETFs) 36, 167-170, 180, 228, 257

Fabozzi, Frank 100nFederal Reserve Bank of Chicago 201

Federal Reserve, U.S. 5, 11, 22, 24, 184-185

Fed Model see allocation modelfees 156-167, 181, 185, 197, 228Fibonacci 37-38, 257Finland 185First Boston 84Fisher, Irving 187Fisher, Lawrence 131Fitch Ratings 144-146, 257foreign currency 49, 104-105, 205

see also yuan, the Asian currency crisis 104-105France 121, 122 see also G-7French tresors 69, 258

278 I n d e x

see also commodity-linked bonds

G-7 ix, 22-23, 104, 105-106, 114, 118, 135, 22, 218, 258, 260

G-8 258, 260Galloni, Alessandra 124nGalveston, Houston and Henderson Railroads 98-99

Gampel, Aron 71Garzarelli, Elaine 187Gates, Bill 213General Motors Acceptance Corp. 73, 152, 246

General Motors Corp. xiii, 72-73, 148-149, 236, 246

Genus Canadian Bond Fund 163Genus Capital Management 163Germany 105, 176, 179 see also G-7Giscards see French tresorsGlobal Association of Risk Professionals (GARP) 107

global bonds see Chapter 5, 258global funds 103-123,168, 176, 242-244

see also AIC Global Bond Fund and Argentina 107-110 and Brady bonds 116-118 and currency hedges 104-105 and Parmalat Finanziaria SpA 110-114

and Real Return Bonds 118- 122 as ETF package 168-169 as insurance against domestic loss 242-243 defaults 105 during economic tailspins 104global real return bonds 118-122Globe High Yield Peer Index 164Gluck, Richard 61, 66Goldman Sachs Commodity Index 70-71

Goldman Sachs Group Inc. 18, 200

Gondor, Cecelia 176, 178Goodman, Laurie 100ngovernment debt increasing in the future 105- 106Grant Thornton LLP 111 Greece 119Green, Jeff 154nGreenspan, Alan 11Grenada 105Gumbel, Peter 111-112, 124nGuyana 94

Haghani, Victor 185Hallet, Dan 159, 180-181Hammurabi 21 commercial code 7Harley-Davidson Inc. 73 Hedge Fund Research Fixed Income Arbitrage Index 115

279I n d e x

hedge funds 91, 94 see also Leeson, Nickhedging of global bonds 104-105Herpolsheimer’s 83high-yield bonds 4, 27, 49, 58, 72-77, 82-84, 88, 106-107,148-149, 151, 164, 173, 177, 259

historical events and the economy 8, 38-40, 43-44, 51, 130, 212, 213, 216-217, 223-224

effect on stocks 223-224 infl ation 216-217 Viet Nam 130Homer and Liebowitz 153n Homer and Sylla 7, 21, 28n, 29n, 229n

Homer, Sidney 7, 55n, 153n, see also Homer and SyllaHowe, Neil 218-219, 229bHulbert Financial Digest 187Hulbert, Mark 187Hungary 115hybrid bonds collateralized debt obligations 86-87 commodity-linked bonds 69- 72 convertibles 63-67 credit default swaps 77-79 fi xed income derivatives 90-92 packaged linkers 67-68 preferred securities 85-86

Iceland 119income funds 172-174

income trusts 247indenture 3, 134, 258India 69, 176Indonesia 105 see also Asian currency crisis, defaulting nationsIneichen, Alexander 16, 29n, 100n, 124n

infl ation and the elder bomb 219-220 chances of return to 216-217 present outlook of 26 probable future of 227infl ation-linked bonds 67-68, 258insolvencies 136, 146, 227intellectual property bonds 87-90interest coverage ratios 136-137interest rate forecasting see yield curve

interest rates history of 21-23 trends in, 212International Monetary Fund (IMF) 69, 98, 108, 109

investment grade 144, 259investor age in allocating portfolios 236-237

Israel 119, 122Italy 105, 106, 113, 119, 122 see also G-7, Parmalat Finanziaria SpA

Ivory Coast 94

Jackson, Richard 218-219, 229nJapan 119, 121, 124n, 223

280 I n d e x

see also G-7Jorisdochter, Elsken 12-13JP Morgan 89, 96, 143junk bonds see high-yield bondsJust For Feet 74-75

Kapner, Fred 124nKerstein, Bob 94-95Knight Capital Management see Knight, Doug

Knight, Doug 76, 164Knights Templar, Order of 8 Kotsopoulos, Peter 61Koza, Harry 71-72, 74, 79nKraemer, Moritz 106, 107, 123nKresic, Chris 78, 90, 149, 152Kritzman, Mark 28n, 153n kurtosis 40

Lac Minerals Ltd. see Barrick Gold Corp.

LeClair, Randy 162, 206-207Leeson, Nick 91, 136Lekdyk Bovendams Company 12-13

Leonardo of Pisa 37-38 Levy, Don G. 95Lewis, Kenneth 112Lewis, Michael 183, 185LIBOR 90, 259Liebowitz, Martin 55n, 153life plans 151-153linkers see global real return bonds and real return bonds

Long-Term Capital Management xiii, 5, 38, 183-186, 194, 259

loss aversion, capuchin monkeys 33

Lucchetti, Aaron 79n

Maas, Florida Circuit Court Judge Elizabeth 141

Macaulay Duration 127-131 see also durationMacaulay, Frederick R. 127Macdonald Shymko & Co. 27Mackenzie Financial Corp. 78, 14 see also Kresick, ChrisMajorica Asset Management see Marcus, Robert

Malackowski, James 89Malaysia 104managed bond funds 246management expense ratio (MER) 157-161, 181n, 199, 259-260

Mandate National Mortgage Corp. Fund 166-167

Marcus, Robert 162Massé, Micheline 95mathematics, fractal 43Mauldin, John 229nMB Fixed Income Fund 163-164McClatchy, Will 181nMcLean Budden Ltd. 61, 163-164

McLoughlin, David 101nMcKeough, Pat 239McNamara, Robert 213Medici 8

281I n d e x

Meriwether, John and LTCM 183-186

Merrill Lynch 85, 112, 184, 245Merton, Robert 184Mexico 109, 115, 117, 119, 121Microsoft Corp. 82Milevsky, Moshe 222-223Milken, Michael xi, 4, 75 see also high-yield fundsMinder, Ralph 124nmoney market fund 170-171, 260Moody’s Investor Services 108, 144, 260

Moran, Derek 27-28Morgan Stanley 89, 141Morningstar Inc. 50, 67, 116mortgage fund 166-167, 260Mulford, Charles 143nmunicipal bonds 20munis see municipal bondsMurdoch, Neil 68, 78mutual bond fund 160-167 Acuity Pooled Fixed Income Fund 161 AGF Global Government Bond Fund 161 AIC Global Bond Fund 161- 162 Altamira Bond Fund 162 Beutel Goodman Private Bond Fund 162 CIBC Monthly Income Fund 163 Genus Canadian Bond Fund 163

management expenses of 156- 158 MB Fixed Income Fund 163- 164 Northwest Specialty High Yield Bond Fund 164 open end fund 260 Sceptre Bond Fund 164-165 TD Real Return Bond Fund 165-166 trading costs for 158-160

NASDAQ Composite Index 167, 237

National Bank Money Market Fund 170

National Council of Churches of Christ 99

NAV 175-178 passimnegotiable bonds 203Netherlands, the 12-13Nicaragua 94Nicholas II 51 no-load 157Nortel Networks 42Northwest Specialty High-Yield Bond Fund 164

number theories 37-38

“off the run” 205Old Company Research 94 see also Kerstein, Bob“on the run” 205

282 I n d e x

Ontario Savings Bonds 59-60, 198

Ontario Securities Commission 98, 263

Oppenheimer Real Asset A Fund 71

Organization of Petroleum Exporting Countries (OPEC) 16-17

Osbies see Ontario Savings BondOwen, James 100n

Pacifi c Investment Management Co. (PIMCO) 71

packaged linkers see infl ation-linked bonds

Paraguay 105 Parmalat Finanziaria SpA xii, 110-114 ,115, 143

PARS see synthetic bonds Partenoy, Frank 100nPay in Kind (PIKs) 74, 82-84, 260-261

Perelman, Ron 141perpetual preferred stock 38, 214 perpetuals 6, 12, 18-19, 46, 97, 178-179, 214

Peru 117Peters, Edgar 55nPhillipines, the 117 Phillips, Don 50-51, 55nPhillips Hagar & North U.S. Money Market Fund 171

Phogue, Thomas 154nPIMCO Commodity Real Return

Strategy Fund 71Poland 117Ponzi schemes 98portfolio insurance 214-217, 241-242

portfolio protection, long-term 221-225

preferred securities 85-86, 261 present discounted value 26prestiti 12, 261Prime Bank Notes (PBNs) 98-100

Probability of Regret (PoR) 222-223

public pricing 21-22

Quebec 121

Rai, Satish 165rating agencies 144-146 see also Moody’s, Standard & Poor’sRBC Dominion Securities 36 real return bonds 62,119, 222, 244-245, 261

see also global real return fundsrecession 261 see also global recession 225- 226Registered Education Savings Plan (RESP) 242

Registered Retirement Savings Plan (RRSP) 159, 166, 168, 171, 242, 245

283I n d e x

reinvestment 131-132, 133-135, 171-17

R.M. Smythe & Co. 96Robinson, Allan 100nRothschild, John 100nRoyal Bank of Canada 2, 34, 60, 78

Rubin, Sandra 154nRussia 18, 38, 51, 94, 115-116, 104-105, 185

Sala, Luca 113Salomon Bros. 183Salomon Smith, Barney 143 Salzgiver, Sharon xivSargent, Carolyn 100nScandinavia 135 see also Finland, SwedenSceptre Bond Fund 164-165Sceptre Investment Council Ltd. 164-165, 196

see also Czitron, TomSchilit, Howard 142, 154nScholes, Myron 184Scism, Leslie 79nScott Paper Company 140scripophily 97, 262SC Universe Bond Total Return Index 17, 36, 52, 120, 156-157, 160, 163-165, 167, 186, 237, 246

Securities and Exchange Commission, U.S. (SEC) 74, 98, 263

selling bonds 203-204“senior credits” 135

Sentry Select Canadian Income Fund 174

Sentry Select Corp. 72September 11, 2001 213 and arbitrage 116 effect on bond markets 43shelf registration 143Shemilt, Heather 70Siegel, Jeremy 29nSingh, Manmohan 100n, 123nSlovakia 115small cap 159Soldofsky, Robert 154nSolon 7-8, 21Sornette, Didier 40, 55n, 229nSouth Africa 119South Sea Bubble 15-17, 176sovereign bonds 18-19, 94 see also global bondssovereign debt 93, 106sovereign immunity risk 49, 262sovereign loans 93S&P 500 Composite Index, U.S. 215, 233-234

Spain 217specialty bond funds 172Speed, Joanna 112stagfl ation 22, 263standard deviation (SD) 50, 173Standard & Poor’s 19, 77, 100n, 105-106, 114, 144, 263

Standard & Poor’s Composite (SPY) 167

Steen-Knudsen, Michael 6step bonds 59-62, 130-131, 198, 263

284 I n d e x

steppers see step bonds stock market crashes 38, 57 1929 crash 38, 187 1987 crash 38, 183-185, 187, 215Stock Search International 95stocks vs. bonds 3, 5-7, 13-19, 34-35, 43-44, 135, 191, 194, 208, 212-213, 248

strip bonds 46, 84, 117, 128-129, 132, 135, 241-242, 265

Sunbeam Corp. 140-141Sweden 118-120, 122Switzerland 135, 185 Sylla, Richard 7 see also Homer and Syllasynthetic bonds 207, 248

Tanzi, Calisto 110-113TD M.S. Money Market Fund 171

TD Real Return Bond Fund 165-166

tech boom 227 tech bubble 16, 42, 76, 190Teck-Cominco Ltd. 69Texas International 75Thailand 104Thau, Annette 29n, 123n, 234, 249n

Thomas IFR 71 see also Koza, HarryThomas J. Herzfeld Advisors, Inc. 176

timing 201-203

see also cycles, durationTonna, Fausto 111, 113Toronto Index Participation Units (TIPs) 167

toxic waste, in bond market 87TradeWeb 196tranche, equity 86-87, 231Treasury bonds, U.S. 89, 184, 225, 245

Treasury Direct 198, 199, 200Treasury Infl ation Protected Securities (TIPS) 67-68, 119, 169

trends, forecasting and analyzing 186-191

Trilogy Advisors LLC 61 see also Gluck, RichardTurkey 179

UCC Capital 88 see also D’Loren, RobertUganda 94Ugolottti, Angelo 113United Kingdom 106, 119-122, 121-122

see also consolsUruguay 105U.S. Bond Market Association (BMA) 20

U.S. Depository Trust & Clearing Corporation 193

U.S. Securities and Exchange Commission 74

usury 8, 22

285I n d e x

Venice, Republic of 9 see also prestitiViet Nam 130, 217Volcker, Paul x, 22volatility see beta

Waldie, Paul 100nWall Street, the movie 9Weil, Roman 131Western Asset Management 67Wiandt, Jim 181nWolfe, Tom 4WorldCom 110, 143-144

Yemen 94yield curve 21, 23-28, 25 (graph), 35, 46-47, 134, 189, 265

yield to call 134 see also yield to worstyield to worst 134, 265 see also step bondsyuan 225-227

Zambia 94zero coupon bonds see strip bondsZimbabwe 19Zini, Gian Paolo 111

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