Bonds For Canadians: How To Build Wealth And Lower Risk In Your Portfolio [PDF] [u5d8opfc5k80] (2024)

MORE PRAISE FOR BONDS FOR CANADIANS “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 financial press, or an unwillingness on the part of bondmarket professionals to throw back the curtains on their own machinations, 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 financial markets, Mr. Allentuck provides an engaging, entertaining 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 find Andrew Allentuck’s book interesting. He goes beyond the ordinary discussion of bonds and skillfully turns a dull pudding of numbers into a wonderful soufflé 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 covers 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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BONDS FOR CANADIANS

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Andrew Allentuck

BONDS FOR CANADIANS

HOW TO BUILD WEALTH

AND LOWER RISK

IN YOUR PORTFOLIO

Copyright © 2006 by Andrew Allentuck All 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, electronic, 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 enable them to rectify any reference or credit line in subsequent editions. Library and Archives Canada Cataloguing in Publication Data Allentuck, Andrew, 1943Bonds for Canadians : how to build wealth and lower risk in your portfolio / Andrew Allentuck. ISBN-13 ISBN-10

978-0-470-83691-0 0-470-83691-1

1. Bonds—Canada. 2. Bond market—Canada. I. Title. HG5154.A43 2006

332.63’230971

Production Credits: Cover design: Ian Koo Interior text design: Adrian So Printer: Tri-Graphic Printing Limited John Wiley & Sons Canada, Ltd. 6045 Freemont Blvd. Mississauga, Ontario L5R 4J3 Printed in Canada 1 2 3 4 5 TRI 10 09 08 07 06

C2006-901432-9

Contents

Preface

xi

Chapter 1: Bonds—A Matter of Definition Chapter 2: The Seduction of Risk Chapter 3: Taking a Measure of Credit Chapter 4: Alternative Bonds Chapter 5: Global Bonds—A Tale of Promises and Defaults Chapter 6: What’s a Bond Worth? Chapter 7: Bond Funds Chapter 8: Bond Trading Tactics Chapter 9: The Future Environment for Bonds Chapter 10: Bond Strategies—A Summary and a Conclusion

1 31 57 81 103 125 155 183 211 231

Glossary Bibliography Index

251 267 273

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For my children, Adam and Sarah

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Preface

B

onds 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 finance. 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 fiscal 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 interest 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 petrocurrency whose value is linked to the price of oil. The loonie has

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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 investors. 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 inflation 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 navigate in this market. Canadian public finance is in relatively good shape as 2006 begins and this book heads for the printer. The fiscal 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 find 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 fluency in debt finance 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 separates the serious investor from the dilettante. A private investor need

Preface

xiii

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 finance, have inflicted 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 find that this book is free of the inspirational content that fills many personal finance 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 concept of debt finance is almost as old as civilization itself. Before there was deficit finance and government debt, there was regime debt arranged by medieval bankers for their princes. Modern debt finance 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 governments. Bankers loaned money to clients whose titles were variously Royal, Serene, and Imperial. Government finance 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 finance. We end the chapter with an introduction 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 fixed income products. We examine the complex relation of risk to return, of the risks of bonds or other interest-paying

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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 interest 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 convertible bonds that lurk in the shadow of stocks to the substantial but manageable risks in junk bonds, and finally 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 developing world. Business can ruin investors, as Parmalat Finanziaria SpA did when its web of frauds began to unravel in 2003. We examine the problem of defaults of foreign bonds, the role of Brady bonds in facilitating investment in foreign bonds, and the use of inflation-linked bonds in hedging inflation. 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

Preface

xv

bonds and the assistance of credit rating letter scores used by large bond raters. We show that default rates are closely connected to rating 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 discussion 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 prohibitively 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 investment 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 benefit (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 investors can do about it today. We examine alternative asset classes, how bond allocations should shift as one grows older, and the potential role of China becoming manager of global inflation and interest rates. In this environment of uncertainty, the value of the promise of absolutely sure payment by a government is precious.

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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 ultimate question, raised in the first 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 capital markets for whatever deals are being sold. And that, in sum, is the point of Bonds for Canadians.

WHO SHOULD READ THIS BOOK Investors 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 investors who know their way around options and futures, foreign exchange markets, and bond covenants will find this book too elementary. But the stock investor who wants to shift to a different field of risk and the somewhat experienced bond investor who wants to broaden his or her bond skills will, I hope, find this book useful and a good investment in itself.

GIVING CREDIT It is incumbent on an author to give thanks to those who helped build his book. In my case, they include professional bond managers 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

Preface

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experience to what would otherwise have been an academic task. Sal Pellettieri, a quantitative analyst with IGM Financial, was generous in the time he gave to reviewing my work. Alan Brownridge, a masterful manager of government bond portfolios, made valuable comments on the manuscript. Brad Bondy, a shrewd bond analyst and portfolio manager with Genus Capital Management, Derek Moran, a financial advisor with Macdonald Shymko & Co., and Caroline Nalbantoglu, a financial advisor with PWL Advisors, gave me perspectives for assessing fixed income returns. Patrick McKeough, a pundit and portfolio manager, offered counsel. 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, current 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 finance and encouraged me to write about the field. My friends Jim Cristall, Rachel Siemens, Tanis Bridges, Sheila Balasko, Jerry Tutunjian and Mel Rempel were more helpful 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 assessment. 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

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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 possible 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 Definition

I

n a world in which stocks behave like they are in a crack-driven frenzy, soaring and swooping on gusts of rumours, bonds’ promise of payments of specific sums at fixed 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 company. 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, however. 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 relative stability of bonds is a rather static concept. Over long periods,

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common stocks that tend to pay rising dividends and to generate rising earnings do a better job of pacing inflation 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 corporate bond is the flag of its issuer. It is normal for stocks of even fine, secure companies like the Royal Bank of Canada to flourish 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 afflicted corporate executives whose financial 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 flee from rooms where it is taking place. To be associated with an act that would turn a major government into a financial 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 infinite, as it is for perpetual bonds. This quality of certainty puts bonds in the most senior of all classes of corporate and governmental liability. Indeed, in a world in which chance and mayhem fill 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 government or corporation that seeks to borrow from many people. It is

Bonds—A Matter of Definition

3

a loan intended to be widely subscribed. The promise is binding within the terms of the bond agreement, usually called an indenture. 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 financial 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 flexible idea, but all bonds earn the bondholder 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 stockholder). The powers given to lenders make bonds vehicles for producing 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 bondholders 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 security begins with bonds that have no risk of default. Beyond riskless government issues, bonds take on many of the chances of the business cycle and of other influences. When investors move into junk bonds, they are in a casino of bonanzas and hazards.

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

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tribes turned into deals among strangers, credit became formalized in bonds. Bond finance 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 attracted entourages of beautiful people eager to get in on the game. Novelist Tom Wolfe wrote The Bonfire of the Vanities about the immorality of the life of a bond trader in the money-soused atmosphere 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 field of junk bonds, filed for bankruptcy protection in February 1990. Michael Milken, Drexel’s impresario of junk, led a coven of fixed income wizards in the firm’s Los Angeles offices and brought a measure of respect to financial instruments that legendary financier Warren Buffett later called “weeds priced like flowers.” 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 fiddling 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 mathematicians fleeing the wreck of the Soviet Union to understand them. Few did. There is a lesson here and it is this: Bonds have the potential to make investors rich and, as well, the capacity to destroy those who do not understand the risks they take. Building on the foundation of simple, no-frills bonds issued by national governments that are sure to pay their interest and to repay their principal on time, financial 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

Bonds—A Matter of Definition

5

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 rarified and qualified bond bets ever conceived. To no avail, for they saw their formulas fizzle 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, functioning 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 matter how artful its design, the profit 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 financial 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

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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 defined 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 flexible. Most bonds are issued for definite 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 fifth 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 interest 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 inflation does not exist—heroic assumptions indeed—the total return and final value of the bond would be Kronor 6.87 × 1012. The immortal owner would

Bonds—A Matter of Definition

7

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 BOND Credit 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 first uniform commercial code. His laws set maximum interest at 33½% per year for loans of grain repayable in more grain and 20% for loans of silver. Loan agreements had to be written or chiselled, if you like, and witnessed by officials. If a lender extracted a promise for higher interest or took it by trickery, the loan was officially 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 flow into the market, and he did away with personal slavery for non-payment of debts.5 The concept of marketable debt at variable interest rates was growing.

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Solon’s elimination of slavery as a means of guaranteeing repayment 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 specified.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, banished 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 pustules 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 spendthrift 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

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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 difficulty of collection.9 A discount is interest 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 structured, 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 commodities. 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 identified 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 permanently 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,”

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reads an inscription at the Oracle of Delphi. It is the first lesson and perhaps the final lesson as well in the assessment of risk.

WHAT INTEREST MEANS Interest rates are the monetized measure of risk. Over history, rates have varied from 10,000% per year charged in Germany in the peak hyperinflation 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 deflation, such as the Great Depression of the 1930s when the price level declined. The German inflation, which was engineered by a government on a suicide mission to show that reparations imposed by the Treaty of Versailles were unsupportable 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 financial 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 inflation 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 dubious 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 first 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

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11

means of payment, much like cheques that turn into third- or fourth-party instruments that today might be handled by commercial 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 financial 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 deposit accounts for customers, and financing 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 MARKET The growth of Mediterranean trade during and after the 5th century 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 repaid.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 clarification 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

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bond issues are bought by a single lender, but the concept of the bond remains, at its core, a loan financed by many people and repayable on known conditions. A bond is a solemn obligation. In the late 13th century, the Republic of Venice invented prestiti, perpetual bonds with no maturity 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 reflected 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 certificates. Trades were recorded in a central office 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 issue 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 florins worth of 6¼% perpetual bonds issued by the Lekdyk Bovendams Company, a

Bonds—A Matter of Definition

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business chartered in 1323, which was essentially a Crown corporation 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 issue. 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 RETURN The 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 counter at prices that are not displayed on one central board, unlike the stock market, where each exchange maintains a central, definitive 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

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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 first stop for any bond investor is the yield floor, which is set every moment by yields offered on government bonds. That basic yield is the lowest in the market and constitutes the foundation that supports the entire structure of corporate bonds above it. Government bonds are liquid, are frequently traded, are competitively priced by dealers who often sell from their own inventories, and operate as bellwethers for inflation trends. Bonds issued by governments and investment-grade bonds issued 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 flow 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 annual compound returns of 4.9%. In that period of two centuries, inflation averaged 1.4% per year, bringing down the returns to 6.9% and 3.5% respectively.18

Bonds—A Matter of Definition

15

Case closed? Not quite, for the data that support the two categories of returns are flawed. 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 emerging 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 circ*mstances, 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 investor 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

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268 years of inflation, the return slumps into negative territory at minus 0.082% per year compounded annually. Had our investor 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 $42 quadrillion.20 That sum exceeds the money supply of the United States 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 existing bonds with fixed 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 outstanding bonds rises. Summer for stocks tends to be winter for bonds. The five 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 generated 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)

Bonds—A Matter of Definition

17

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 returns to shame. For the five-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, produced an average annual compound return of 7.4%.22 The lesson here is that as risk rises in markets, it is good to find safe haven in investment-grade bonds, which seldom trade with as much emotion as stocks and which, therefore, tend to show less volatility. In the end, one cannot say that bonds are always to be preferred. 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 dominate 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 flowed to U.S. stocks and has been rewarded with increases in profitability beyond expectations. But the U.S. case of bond reliability, a quality 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 reflected not only interest rate expectations, but also an implicit

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

WHEN SOVEREIGN BONDS DEFAULT The 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 refinancing 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 become £10,638,400. Inflation 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

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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 prudent 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 governments 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 defaulters failed to pay bonds in their own eroded currencies. Bonds become newsworthy only when defaults rise and threaten to ruin the reputations of issuers or the lives of the investors who hold them. Yet by sheer quantity of issues and of money involved, bonds are in much the same league as stocks.

VALUING BONDS At the beginning of this millennium, the U.S. bond market, the largest national market in the world, held $18.5 trillion in various 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 compared to C$1.6 trillion of stocks.27 Bonds don’t get the press that stocks do because they are traded over the counter without visible exchanges between bargaining

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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 prices 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 15minute delay. The BMA began posting all corporate bond prices on February 7, 2005, with a 30-minute delay and moved to 15minute 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 whistles. Difficult 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 copied 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

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hold out for retail prices when they sell. That defence is close to claiming virtue for the extortion that comes from lack of information. For now, however, with only moderately good information in U.S. corporate and municipal bonds and rather poor moment-bymoment 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 before 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 determination 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 political 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 decline 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 preceding the invention of the empire by Augustus in 28 b.c. and until

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the empire began to be too large to supply and govern in the late first 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 fifth centuries. With the breakdown of the central government after successive attacks on Rome and the collapse of its authority, lending practices lacked standardization. Substantial trade nevertheless existed in the three centuries preceding Charlemagne, who created the fiction 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 inflation. By the 18th century, banking had spread throughout Europe, resulting again in lower risk, easier settlement of financial 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 hyperinflation from 1919 to 1923 devastated the country’s currency and wrecked several banks, even as annualized interest rates rose to five figures. 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 inflation 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

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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 inflation 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 business 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 financial networks break down, where conquest or disease make repayment 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 FORECASTING At 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 increasing 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 reflects the present view and future expectations. If shortterm 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

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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 postponing 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 periods 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 influential 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 influential but not decisive in pricing the demand for loanable 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 flat, investors are signalling that a period 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 inflationary 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 financial fortunes, and major market indices began to collapse with the recognition that the tech bubble was about to burst. And, duly, it did.

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Normal and Inverted Yield Curves 5

Interest %

Normal 4

3

Inverted 1 month 3 months 6 months

2

3

5

7

10

30

Years to Maturity

There are few economic models or forecasting tools as accurate as the yield curve. While the stock market tends to forecast economic conditions six to nine months ahead, the yield curve does the task for 12 months in advance. It reflects central bank policy, shows what long-term assets should earn in comparison to shortterm assets, and sets the basis for the increased returns expected on stocks.30 Investment managers and bond strategists use what, for many, are baffling constructions in mathematics to squeeze meaning out of the yield curve. But even without math, you can read it and obtain a great deal of information. A very flat curve implies that the market is paying a bond buyer very little premium for holding long bonds rather than short bonds. A flattish 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.

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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 opportunity cost of not putting money into even better paying bonds should inflation return to double-digit levels. Capital markets don’t expect a return to the inflation levels of the early 1980s, but the wise investor does not ignore any possibility. The present outlook for inflation is that it will average between 2% and 3% per year for the next two to three decades. The forecasting tool is the inflation premium built into bonds that tie interest payments to inflation rather than to interest rates. Such long-term inflation rates imply good conditions for business and tell the investor that the additional return to be had from holding stocks (really a diversified 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

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daily in many newspapers and at many financial websites. When the curve gets steeper, it tends to reflect higher expectations for growth and competition from other markets for funds. Think of the yield curve as a soufflé 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, however, 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 find bonds with more potential profit 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 financial planning firm 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 insurance stocks and a well-diversified 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

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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 vulnerability 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. Endnotes 1. See Mark P. Kritzman, Puzzles of Finance (New York: John Wiley & Sons, 2004), pp. 104–114. 2. Almost all bonds have a fixed 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 clarification of whether a price was payment or loan. Leviticus 25:29. 7. Homer and Sylla, A History of Interest Rates, p. 99. 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. 10. Homer and Sylla, A History of Interest Rates, p. 98. 11. Homer and Sylla, A History of Interest Rates, p. 28. 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 financial 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.

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17. Conventional bonds leave inflation risk with the holder. Inflation-protected bonds such as Canadian Real Return Bonds and U.S. Treasury Inflation Protected Securities shift that risk to the issuer. 18. Jeremy J. Siegel, Stocks for the Long Run: The Definitive 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.

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Chapter 2

THE SEDUCTION OF RISK

A TASTE FOR RISK We are afloat 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 flu or being overcharged by error at a grocery checkout. The first event is improbable but of infinite value while the second is probable but of little value. Random outcomes pervade the future, but risk, as a term in finance, is the deviation of markets or returns from expectation. 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.

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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 lossproducing 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 champagne 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 economics: Your first buck or your first 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 first chapter of most first-year university economics textbooks. Risk aversion is not just a taste—it is the fundament of financial 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 comparison ignores the question of market price and tax consequences, but it makes the point. The bond seems dull and the stock may be

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on an upward roll. Acting on enthusiasm rather than calculation, the investor in this example ponies up for the stock, is then terrified 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 finances his oceangoing 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 financial compensation for a 1-in-10 chance of a $1,000 loss by fire or flood 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 specified 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 behaviour of capuchin monkeys, researchers have found that avoidance of bad bets is innate and not learned.1 The implied conclusion is that hom*o 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

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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 accurate 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 flees one that appears to be destined for disdain.

RISK HAS MANY FACES Stocks and bonds, often paired together as a synonym for capital 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 benefit 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 difficult to predict where interest rates will be a year from today. A forecast of rates five 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

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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 five 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 profit (or loss) at any time prior to maturity of the bond in question. The bond’s profit 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 Market An 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

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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 financial planners. With limited licences, they cannot directly sell anything but bond or other mutual funds and certain deposit instruments such as guaranteed investment certificates 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 first-time investor and provide diversification 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,

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and the bond buyer must shop the market to find 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 financial 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.fitch.com—is important in making decisions about purchase of individual bonds. We will delve further into bond value issues in Chapter 6.

IMAGING RISK What makes the prices of bonds and stocks and other assets vary has intrigued traders and mathematicians for centuries. Measuring the length and repeatability of financial cycles has been the preoccupation 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

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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, according 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 abnormality of financial 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 intrinsic mechanics of financial 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 pilgrimage in Geoffrey Chaucer’s Canterbury Tales, wiped out a third to a half of the population of Europe and wrecked the landholding system and its accompanying system of serfdom. Dynastic and religious wars occupied the next 200 years, shattering the Catholic

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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 surpluses 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, invalidating 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 revolutions 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 investor 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 repay principal in a sound currency three decades from the time of purchase is an optimist. So far, capital markets have rewarded optimism 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

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on the wisdom of those governments in managing the inflationary forces that can trash the value of their bonds. French geophysicist Didier Sornette suggests in his provocative analysis of financial 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 cooling from 2300 b.c. to 2200 b.c. terminated the Akkadian empire in Mesopotamia, the Old Kingdom of Egypt, the Indus Valley civilization 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 dedifferentiation (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 catastrophe would be many years in the making. Governments would be likely to respond by appropriate measures to limit incursions into remaining forests, reduce overfishing, 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 distribution. In a diagram of the bell curve, it means that the tails are very long and that, by implication, odd events will occur more frequently than they would in a more orderly map of the distribution of outcomes. Negative outcomes, which in the case of financial assets are losses, are more likely in capital markets than in wellordered systems that have no psychological feedback mechanisms.

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Feedback can turn a small market decline into a panic and a rumour 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 financial 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 financial assets to tomatoes. If the price of tomatoes falls, shoppers rush to buy the bargain. If the price of a financial asset falls, investors may abandon it for fear that others may also flee. If tomatoes rise in price to some absurd level, few will be sold. If a financial asset soars in price, many investors 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 financial 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 financial asset in the midst of a price rise maintain its momentum? The diligent investor changes the issue to a question of risk, assuming, quite correctly, that if risk is well shepherded, profit and wealth will grow. In an effort to find new ways of managing risks in capital markets, 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 sacrifice 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

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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 occurrence of events derives from a proposition in statistics called the Central Limit Theorem. The normal bell curve is fine for mapping variance from the size of an average pea in a collection of pods, but it does not deal well with characteristics of financial 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 RISK The difficulty 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 profitable—though very different—outcomes in either. Put bonds and stocks in a portfolio and, quite predictably, the portfolio’s volatility 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

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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 unevenness 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 markets 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 consequences of off-the-map catastrophes, you’ll need more than a clutch of financial 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 reflection 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 uncertainty. Even if some terrorist events could have been anticipated, the targeting of the World Trade Center was not known to the investing 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 reaction 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

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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 during periods of high inflation. 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 flavours of bonds, ranked by seniority of government issuer, status of corporate issuer, availability 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 principal. 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 reflect 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 RISK Government 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 flow or coupon payment, current yield will rise if the bond

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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 volatile in price than 90-day treasury bills. Clearly, over three decades interest rates may fluctuate more than they can in three months. And a very short-term, government or investment-grade bond is almost as good as cash and thus deviates little from the face value it pays at maturity. Let’s look further into how time influences bond prices. More time to change means more opportunity for price change in reflection 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 equation, 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 fixed income to compensate for any bond price decline driven by rising interest rates. The periodic payments 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

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bond’s value depends less on the repayment of principal as interest 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 every 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 reflects reduced selling pressure and holds its price much better than the lower interest 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 principal, 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 fixed 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 below investment grade, then to bonds almost in default and, finally, 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

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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’ inflation 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 deflation. Government bonds march to the drummer of monetary policy and inflation 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 profitable 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

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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 defined assets, restitution is even easier. Over periods of five or fewer years, a diversified 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 RISK Before 1960, bonds were simple promises to repay principal at a specified date and interest on fixed 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 flavours. New bonds in major nations tend to be issued in book-based form and exist in certificate form only in special circ*mstances 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 beneficial 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

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• 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 government corporations are difficult 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 managers 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, reflecting 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 reflect ever-changing monetary policy and fluctuating expectations of inflation 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 portfolio risk. Because bond prices move opposite to stock prices, bonds will reduce portfolio risk. One could say that risk embodies volatility, but risk is more than volatility. After all, as Peter Bernstein

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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 definition, 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 flee 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 unknowable hazards, that they face? Risk as a concept is a fragile thing. If risk is defined as fluctuation in the abstract, it becomes a truism, for negotiable assets vary in price almost by definition. After all, they are negotiable. By adjusting the measuring period, one can predetermine the amount of fluctuation 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 define 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 concept, 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 defined 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, inflation-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

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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 benchmark. 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 EXPECTATION The 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 confidence within a range of years. Life insurance companies make a nice living doing just that. But how one will die—what illness or what event—can only be predicted with reduced confidence. 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 influenza 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 corollary 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

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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 bankruptcy 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 inflation 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 inflation 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 substantial periods of time. It is all a question of managing risk. In a well-managed portfolio, bond returns can be handsome 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 annual 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 RETURNS When are bonds appropriate for investment? The simple answer is when interest rates are declining, driving up the prices of

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outstanding bonds. But that answer is too pat. Rates tend to decline as central banks ease up on lending and drive down interest rates, often in periods of economic contraction. Predicting macroeconomic trends is difficult 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 extra component of exchange fluctuation. 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 profits 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 exchange 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

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in short bonds and some yield advantage in long bonds. Holding to maturity eliminates market risk no matter how it is defined. 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 RISK Risk, defined as asset price volatility, is inherently difficult to quantify. But risk exposure is manageable by controlling the amounts of money in play, its concentration or diversification, 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, commodities, 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, burning 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. Endnotes 1. M. Keith Chen et al., “The Evolution of Our Preferences: Evidence from CapuchinMonkey Trading Behaviour,” Yale School of Management, available at www.som.yale. edu/Faculty/keith.chen.

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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 profitably. 3. Sornette, Why Stock Markets Crash, p. 51. 4. Sornette, Why Stock Markets Crash, p. 385. 5. Sornette, Why Stock Markets Crash, p. 384. 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-financial 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 financial microscopy adds little to return or to the efficient 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 efficiently and frequently priced and that their inclusion in any process to move toward the efficient 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. 9. Homer and Liebowitz, Inside the Yield Curve, p. 47. 10. Homer and Liebowitz, Inside the Yield Curve, p. 55. 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.

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here 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 investment-grade corporate bonds into convertible bonds, hybrid stock/bond instruments, junk bonds, and structured products so dubious that they are called “toxic waste,” the investor travels from low

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to mid-single-digit annual returns into what may potentially be annual 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 fulfilment as a lame horse winning at Woodbine. There are wonders of financial engineering so complex that they defy understanding. And there are markets in the bonds of bankrupt companies in which speculators fight, often successfully, 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 default 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

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classes such as cash, commodities, and real estate to produce an efficient portfolio that has enhanced return and reduced risk. Both are properties of diversification, 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 needed. High-risk bond investments tend to be indefinite 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 longer 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 individual investor is probably best to do what is easy, safe, and natural. Managerial acrobatics are best left to professionals.

STEP BONDS The bond investor who wants the benefit of higher rates has a dilemma. Should he wait, staying short on the yield curve and sacrificing 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 defined 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 first 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 final 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

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rising rates. While conventional bonds drop in market price as interest rates rise, the Osbies don’t. Corporations are seldom so generous. Steppers issued by corporate borrowers often have call features that allow the issuer to pay off holders under specified conditions or dates. For example, a Royal Bank five-year stepper due July 22, 2010, was sold in mid-July 2005 with a 3.10% coupon for the first year, 3.30% for the second, 3.75% for the third, 4.15% for the fourth, and 4.60% for the final 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 offers 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 interest 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

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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 float 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 find that spread a roadblock to trade or swap strategies, say professional bond investors. Step bonds tend to be a retail product for the private investor, explains Peter Kotsopoulos, executive vice president for fixed income at McLean Budden Limited in Toronto. “The retail investor 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 elaborate 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 final 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 inflation has more choices than steppers. Variable rate bonds that adjust payouts according to a formula that accompanies the bond, real return bonds that pace inflation, and convertible bonds that turn into common stock that can rise with inflation if the issuer does well all can do what step bonds do—pay more money on a nominal or real basis.

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This leaves the question of which sort of bond is best for the investor who wants some inflation 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 higher 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 purchasing 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 threedecade-long, inflation-proof bond is costly. In the end, Steppers do offer the retail investor limited protection 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 fights and games that go on in the real world of finance.

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CONVERTIBLES Convertible 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 debentures, that is, bonds that have no collateral beyond the promise of the issuer to pay. Unlike asset-backed bonds and mortgage bonds, which have specific collateral that bondholders may seize for nonpayment, debentures are backed by no more than the good faith and credit of the issuer. Convertibles come in many flavours, but the essence of the concept is that the bond can change character under defined conditions. The most common variety is the bond convertible into common stock of the issuer. Some convertibles have been issued by large companies eager 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 companies 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 defined terms of conversion to common stock. The conversion 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 common shares produce a lower yield, reflecting the investor’s cost of having purchased a stock warrant (time-limited option to buy) that is intrinsic in convertibility.

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Other attributes of convertibles make them potentially appealing 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 satisfied, convertible bondholders 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 secure 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 floor 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 first sight, these qualities make convertibles look like the ideal security. The operation of a convertible bond is simple at first 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 first five years, $120 for the next five, and so on. Convertibles may also have what are called antidilution 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

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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 issues 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 financial 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 complicate 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 flop 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 convertible 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 difficult 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 conversion 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

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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 value. 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 floating conversion rate in these deals is not comfort for the investor, but potential poison. The phenomenon works in young companies 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 compensation. Infamous Internet flops 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 fixed 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 benefits 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.

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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, thereby pushing up the bond price, with concurrent increases in the price of the company’s stock. In good times, these conditions prevail, 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 fixed-income portfolios for the firm: “Don’t buy crap just because it is convertible.”

PACKAGED LINKERS Creative minds in financial 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 winner. The company has packaged a stack of inflation-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 Inflation 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 inflation. The fund, to be managed by Western Asset Management of Pasadena, California (which got the Morningstar award for fixed 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-efficient because it converts annually taxable income from the bonds into capital gains. The downside of the offering is the fees: 120 basis points for management, 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 inflation-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 longshort 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 leverage, 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 reflects 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 exchange risk and converts it to a Canadian-dollar asset. The fund will be able to do well if inflation rates or even if stagflation breaks out, though deflation would drive the fund’s return toward zero after fees,” Murdoch says. “But sustained deflation, 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 inflationary, as is the probable continuing decline of the U.S. dollar and its effect of pushing up U.S. consumer prices,” he notes.

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COMMODITY-LINKED BONDS In 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 onekilogram 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 float. 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 finance 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 TeckCominco Ltd. in 2001 in a merger). Bonds with a commodity valuation mechanism appeal to investors 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.

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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 submarket 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 engineering 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 customcrafted 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 financial 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 floor, the commoditylinked bond has a predetermined value at maturity. Commodity-linked bonds offer advantages absent from conventional bonds that just pay interest in cash. Commodities are an asset class separate from stocks and bonds. During periods of very high inflation, such as the early 1980s, commodities outperformed equities, bonds, and cash. What’s more, commodities tend to do well during catastrophes while stocks wobble and inflationary expectations decline. We are in such a period now with the Goldman Sachs Commodity Index (GSCI), a widely used reference 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.

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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 five years, notes John Brynjolfsson, a portfolio manager with California-based Pacific 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 commodity-linked returns. Is it time to buy into a commodity-linked bond, especially after energy and certain materials have had a long and profitable 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 reflects a combination 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 inflation characteristic of the early 1980s. “Inflation 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

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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 already creating commodity-linked, bond-like products. In October 2005, Toronto-based Sentry Select Capital Corp. launched its Sentry Select Rogers International Commodity Index PrincipalProtected Notes with a fixed 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 BONDS The 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 Dangerfield, “don’t get respect.” The reason that bonds which rating 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 question, however, is whether the returns are sufficient 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 deflate 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 companies 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 profits for 2005 would be 80% lower than the US$5 per share it had previously estimated, General Motors Corp.’s US$116 billion of

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outstanding bonds was soon downgraded. GM, once the best industrial 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 announcement, 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 finance unit, the prospect of a dunk into junk is nothing less than horrific. 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 coming due and reborrowing the money it needs at what are likely to be higher interest rates, thus putting additional pressure on its profits. 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 [interest] spreads (what GM must pay over benchmark federal bond interest rates) set to widen?”3 As we go to press, GMAC Canada, the finance unit of the U.S. parent, is seen as troubled. GMAC Canada 5.9% bonds due October 9, 2007, yield 9.53% to maturity. 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 finance 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

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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 financial 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 diversified 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 finance 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 dubious 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 finances, 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 first coupon due November 1999 and filed 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 fined 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

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finances were fictitious. Needless to say, investors in the company 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 marketing them and, what’s more, of creating them specifically 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$30million loan for Texas International. Mike Milken, soon to become the Rasputin of junk, figured that there would be a market for the great majority of American companies that did not have the financial muscle to issue investment-grade debt. In the next ten years, Milken raised money for perhaps a thousand companies, including Warner Communications, McCaw Cellular, and MCI. He financed 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 refinanced the stuff when it was about to default, juggling mountains of debt during what were said to have been 15-hour days. In 1988, the U.S. Securities and Exchange Commission filed complaints against Milken and Drexel. Milken was indicted on 98 counts of stock manipulation, insider trading, and racketeering. Drexel filed for bankruptcy protection in February 1990. Milken was sentenced to ten years in prison and agreed to pay US$600 million in fines 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.

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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 flops. While in any brief period, junk bond defaults are modest, over extended periods they are terrifyingly common. Over five years, 39% of issuers rated B minus will default. Those with the dubious CCC rating will have a 53% failure rate over five 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 government 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 meltdown that began in 2000, junk traded down to 200 points over the benchmark Treasury.7 At that level, junk bonds were efficiently 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 required to appraise companies is demanding, the cost of error is high, and the need for diversification is huge. Given the need for serious research and the need to diversify into many issues, it is

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

CREDIT DEFAULT SWAPS An alternative to trying to squeeze yield out of doubtful bonds is insuring investment-grade bonds against default. It is a huge international market. Recently, credit default swaps (CDS) finance 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 attractive. 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 recovery rate of 49.1% was found in a study by Ed Altman, professor of finance 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 five-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 income from the scheme. If more than 11 companies were to default,

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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 financing 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 financial 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 sufficient homework to determine how well bond

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

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Chapter 4

ALTERNATIVE BONDS

A

s 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 flows. 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, fixed income devices that are all promise and no performance. At a distance, one can wonder why investors would even consider 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 outright frauds that look like bonds but that have no prospects for

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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 outperformance 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 suspend 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 proposed 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 confidence. The following list of investments are mostly potentially reasonable, if increasingly risky, plays in debt finance. 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 fine line. In debt investment, it’s often the scholar who winds up with the spoils of those who did not read the fine print.

PAY IN KIND BONDS PIKs, short for pay in kind bonds, are issued by companies that are pressed for cash and would rather not have to pony up when coupons 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 resort.1 They tend to be rated as junk and offer stratospheric interest rates for greedy or courageous investors.2 The theory behind PIKs

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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 figured 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 finance, 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 office building developer who had been called “a blood sport enthusiast who is most alive when killing 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-moneydown dealing. The debt financing 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 retailing, his empire was in tatters, facing 50,000 creditors in bankruptcy who had filed 29 volumes of documents each 2,020 pages long. Total claims of US$8.2 billion had produced their own

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adjudication industry with lawyers as the initial beneficiaries of a process that saw accountants and securities companies billing almost a million dollars a month and other charges, including such things as $52,189 for photocopying by just one law firm, sucking the blood out of creditors’ claims. With poetic justice, First Boston, the securities firm 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 marital property, including their Austrian villa.5 The financial schemes that impoverished the credulous investors in Campeau’s dreams finally came home to roost. PIKs are still being created and used as a way of paying interest 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 effectively subsidizing the enterprise by foregoing current payment on his bond. He might be better off as a stockholder, for the “earnings 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 investor is asked to finance 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.

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PREFERRED SECURITIES There 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 profits. 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 benefit is the basis of Canadian tax law. If and when the investors do get postponed 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 refinance at currently lower rates. See the following table. Preferred Securities: A Menu of Choices Name of Issuer Coupon Brascan Corp.

8.35%

Term

Call Date

Price Current Yield Symbol

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

9 30 46

12 31 06 $26.57

7.27%

TA.Pr.C

7.75%

Preferred securities expose the holder to a huge risk, for if interest 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 companies issue debt that is, as one wag has said, “at the end of the food chain.”

COLLATERALIZED DEBT OBLIGATIONS Eager to free up their balance sheets of loans and the capital required to back them, banks and other lenders like major automobile finance 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 industry 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 first, 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 shortterm 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 Investment 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 highest 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 better odds with straight common stock.

INTELLECTUAL PROPERTY BONDS Bonds are about security and, not surprisingly, investors have tended to prefer bonds backed with specific assets or debentures backed by the full faith and credit of large, well-known issuers. The security preference of the market has made it difficult 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 physical assets have been very difficult 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 specialpurpose 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 company, 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$55million 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 investment 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 finance railroad freight cars and office buildings and such prosaic financial instruments as credit card receivables, is growing as a means of financing the growth of small to medium-sized firms, 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 firm has done most of the deals of IP-backed bonds since 1999, he says. In each case, the assets backing the bonds are royalties 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 institutions 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 market for the bonds exists. The potential buyers in the resale market could be individuals whose interest is piqued by the potential association 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 floating rate IP bonds in average offerings of US$500 million based variously on the U.S. prime rate and commercial 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 better for the issuer than paying 12% on junk, or as much as 22% per year on a hybrid stock and debt financing deal in which the borrower 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 insolvent, the special-purpose corporation receiving the royalty stream would not be affected. The process separates the valuable intellectual 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 characteristics of the assets and the history of the issuer. “The more stable the cash flow, the better off you are,” says bond manager Chris Kresic, senior vice president for Mackenzie Financial Corporation in Toronto.

FIXED INCOME DERIVATIVES The riskiest of all plays in the formerly humdrum world of fixed 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 fixed income derivatives market is relatively recent. In the mid-1980s, as takeover artists were positioning themselves to capture companies like Revlon and RJR Nabisco, investment banks began to market a lexicon of fixed income products that included Dollarized Yield Curve Notes and Prime-LIBOR Floating Rate Notes. Some involved renting companies’ 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 fixed 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 companies 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 trading 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 properly quantified. 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 financial manager of Galway United, an Irish football club, has written a book about his adventures, and lectures on his life.12 The diversification 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 financial history does not always predict the financial future. The bottom line on derivatives is this: With borrowed money and fancy derivatives, you can blow your brains out. With conventional 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 BONDS The shabbiest of all bonds are those that are in default; paradoxically, they are also among the most profitable. Investors can buy defaulted bonds at pennies on the dollar and then wait for payoffs as receivers 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 specialized 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 companies 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 fleet 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 investors 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 specified assets in the case of collateralized bonds, it should be relatively easy to find 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 conflict with other creditors. Wars, even when won by bondholders, can wind up as pyrrhic victories. The idea, after all, is to make money, not just to win. As well, not all workouts of distressed debt are profitable. 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 finalized, 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 money. 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 notorious 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 BONDS Old bonds have remarkable powers to return to life and profit. 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 find 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 profitable. Cheryl Anderson, president of America West Archives Inc. of Cedar City, Utah ([emailprotected]), says she finds 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 affinity for old documents. Bob Kerstein, president of Old Company Research (www.oldcompany.com), one of the leading firms in the field, was chief information officer in the mid-1990s for Orca Bay Sports and Entertainment, owner of the Vancouver Canucks. His company,

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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 attributable 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 five 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 [emailprotected]. 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 affiliate of the National Post. A company called Stock Search International Inc. in Tucson, Arizona, handles old financial instruments. The firm, which was started in Montreal in 1969 by Micheline Massé, moved south of the border in 1988. “Our main business is to research corporate histories and to find residual values in old instruments,” says Pierre Bonneau, Stock Search CEO. “There is no statute of limitations on finding value. If there is someone responsible for payment, the bond can be redeemed.” The company maintains a database of 40,000 companies that are defunct or that have dropped out of sight or that have been privatized. “Our regular research work takes six to eight weeks per company and we charge a flat fee of US$85; however, if the research has already

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been done, it is online for US$40,” Bonneau adds. Check www. stocksearchintl.com. In New York, R.M. Smythe & Co., an auction house specializing in numismatics and old stock and bond certificates, researches old bonds and stocks. “We do a few thousand issues a year and find 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 information directly,” he notes. “Each bond is case-specific 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 Plainfield, New Jersey (www.fiinet.com). A list of resources for finding 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.independent.co.uk/personal_finance/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 automatically 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 financier 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 field is filled with bonds that are traded at the customarily 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 find 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 issued 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, fish, and eagles, it is better as wallpaper than as a fixed income instrument. The regime 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 registration systems include that data, of course, but the option to sell an elaborately engraved bond or stock certificate in the scripophily market will decline. As that happens, the dwindling supply of old paper bonds will presumably become more valuable. Therein lies the best chance old securities have for regaining some of their worth. No security certificate 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 NOTES In the files 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 systematic 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 assigned Treasury securities,” they all have official-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 financial 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 financial 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 solicit 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 tripledigit annualized return. For some reason, perhaps lack of bond education by investors, perhaps because of sheer greed, even institutions have been suckered. 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 Benefit 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 profits that fixed income derivatives players 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 efficient 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 efficiency, it is not possible for any investment-grade bond to pay four times the base rate for sovereign bonds. If those deals exist, they involve dubious bonds that

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

Endnotes 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.

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

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Chapter 5

GLOBAL BONDS A Tale of Promises and Defaults

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here is good reason to diversify a portfolio by adding foreign 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 sector, 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 inflation. 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 investments in French telecoms or British banks, he may want to

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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 liquidity 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 difficult 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.

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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 currency 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 regimes have made only the slimmest of redemptions, leaving holders with essentially worthless paper. Bonds issued during the German hyperinflation that culminated in October 1923, other than those collateralized against fixed assets, have remained worthless. A survey 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 briefly 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 challenged 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-finance 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 profits 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 effect 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 fiscal characteristics that would better befit 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 levels 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 influential 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 charges as a fraction of government spending, could emerge as the best credit in North America.

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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, bulletin. One would think that sensible governments would raise taxes, postpone retirement ages, or define health benefits more carefully in order to preserve the integrity of their public finances. 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 difficulty. A nation is a much harder case.

THE ARGENTINE FIASCO What 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 legacy 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 trading 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, subsequently did not, pay interest due. The bonds, rated a dismal Caa3 by Moody’s, reflected the country’s inability to service public debt that totalled US$132 billion.8 The Argentine dilemma was in many ways typical of emerging 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 first. 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 capital. 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 creditors tried seizing La Libertad, a training ship of the country’s navy. Both efforts were of no avail, reported the Wall Street Journal.14

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By the end of February 2005, Argentina had worked out a deal with creditors that was all but legalized theft. Up to 80% of holders 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 value 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 defaulted 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 eventually 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 maturity 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 first world financial stature. Mexico, for example, has moved from being a casualty of bad economic management and kleptocratic government 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 promise 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 first to announce it.”19

PARMALAT: A CASE OF BONDS GONE SOUR Some 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 comparable 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 financial condition 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 fictitious 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 flush 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 confirmed 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

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created a global consumer brand, but it was a leading producer of such things as shelf-stable milk that needed no refrigeration. Tanzi, fingered 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 financial statements that were fat with fictitious sales. Outside auditors are accused of having been complicit in the brewing of the financial statements, and a company lawyer, Gian Paolo Zini, chief partner in New Yorkbased Zini & Associates, was jailed in Parma, Italy—the company’s global base. Other company officials were fingered 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 finances. The deals booked fictitious sales, charged imaginary costs for them, and produced receivables that banks were happy to monetize into real cash. The actual liabilities 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 fill 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 finances global. By the time of the collapse eight years later, it owed its investors €14 billion.”22 The deeper scandal of the Parmalat fiasco may not be in its financial misdeeds. Rather, it is in the blindness of financial 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 company called Buconero was used to put new clothes on debt. Buconero, which means “black hole” in Italian, was just that. Parmalat’s receiver, Enrico Bondi, has pointed to the entity as evidence of the guilt of the company officers 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 securities 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, fired by

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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 officials 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 pacified them by filling 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, officially 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 financial 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 financial 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 finalized by May 2006. The concept appears to be to force banks and investment 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 financial statistics of the borrowing countries and by attention to news from corporate borrowers. G-7 nations’ finances 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 puss*cat soon to be a tiger—Turkey. But the investor who plunges into highyield 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 CINDERELLAS If 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 correlate 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

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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 first year of issue, 6.58% in the second and following years. Speculative-grade bonds below CC default consistently from 2.68% in the first 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 finally 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 investments. 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 company 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 investor 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 strategy in this niche of fixed income arbitrage is to play the linked phenomena of financial 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 fixed 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 fixed income arbitrage index did not recover until April 2001.32

BRADY BONDS An 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, provided 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 creditors 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 emerging 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

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are intricate, difficult to value, and tend to trade in a narrow market 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 first 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 collateralized 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 floating 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. Treasuryguaranteed 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 specific

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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 BONDS Investors 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 techniques, but all reflect the issues of the dependability of payment and the effect of inflation on the future value of the cash flowing 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 reflects a zero level of worry that bonds from G-7 nations or from the senior governments of Australia and Sweden will be dishonoured. The risk to holders of these top-level government bonds is inflation. It is a valid worry. In 2005, soaring oil prices have renewed the spectre of inflation 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 stifle economic growth and a good deal of Chinese expansion. But the smell of inflation is in the air and the prospects for long bonds are dimmed by what could be rapidly rising inflation rates.34 Inflation-linked bonds are the antidote to inflation fears, for they are structured to push their payouts upward as inflation rises. Faced with rising inflation, these bonds, often called “linkers,” gain value, even as conventional bonds drop in price.

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The concept of inflation-linked bonds is venerable. In 1780, the Massachusetts Bay Company sold a kind of inflation-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% inflation rate then raging in the North Atlantic island state.35 The idea of connecting bond payments to inflation rates came back into fashion in 1981 as consumer price indices in the United States, Canada, and several European countries showed doubledigit 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 Inflation Protected Securities to market. In 2003, Greece and Italy sold linkers and, finally, 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 similar principles no matter where issued. Sold as long bonds, they have a fixed coupon and reset their cash payments by adjusting the value of the bonds’ principal. The inflation link concept gives comfort to investors who no longer need worry that their assets will fizzle in value. For example, a $1,000 10-year linker with a 2.0% annual real coupon purchased in 2005 with a 3% annual inflation 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% inflation. The bond would then be redeemed at $1,344. The concept is irresistible to investors worried about inflation, but it works only if inflation 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 inflation-linked bond is priced to yield 2% to maturity, then the inflation rate implicit in the 2% nominal coupon of the linker assumes 4% inflation on average for the next three decades. If inflation exceeds 4% on average for the period, then the linker will turn out to have been a better bet than the conventional bond. If inflation 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 inflation 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 inflation rates. That confidence has set break-even inflation rates above which the linkers have recently paid a return over conventional 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 inflation protection, a premium so high that it will take inflation 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 difficult to determine in comparison to conventional bonds. Linkers, after all, guarantee only a post-inflation return, not a known or agreed cash return. Yet linkers are wildly popular with institutions and individuals. In Canada, for example, the $1.7billion TD Real Return Bond Fund posted an 11.84% average annual return for the three years ended December 31, 2005, compared 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% management 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

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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 inflation. So far, owners of linkers have suffered very little, for the market has kept rising even as the prospects for long-term global inflation have been modest. Inflation-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 appetite for inflation insurance, the bonds have sold well with relatively low nominal coupons. Insurance companies have used linkers to provide inflation-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 deflation, the Ministry of Finance sold ¥100 billion (equivalent to US$920 million at the time) of inflation-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 deflation, 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 inflation it would like to generate. As inflation returns, the conventional, fixed-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 floor 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 ratings 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, especially on trades below $1 million, may require giving up substantial return. Nevertheless, the global market for inflation-linked bonds is significant. 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 outstanding federal bonds.40

IN SUM Global 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 minefields of additional risk from foreign currency variation and default by foreign governments to systematic risk such as unforeseen increases in foreign interest rates that drive down prices of foreign conventional bonds. The wise bond investor should sort out the advantage of having 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 jurisdiction 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 centuries, but for almost all bonds, time is finite. The wise bond investor

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should therefore realize that money put into the bonds of companies and governments of faraway places can present risks that make a problem like the insolvency of a domestic airline seem hardly a difficulty at all. Global bonds trade in markets in which rules either do not exist or are determined only after costly international litigation and workout that can take years. May the global bond investor beware of the problems of managing assets far from home. Endnotes 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. 13. Wall Street Journal, January 14, 2004, p. A-1. 14. 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.

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21. Peter Gumbel, “How It All Went So Sour,” Time Europe, December 13, 2004. 22. Peter Gumbel, “How It All Went So Sour,” Time Europe, December 13, 2004. 23. Peter Gumbel, “How It All Went So Sour,” Time Europe, December 13, 2004. 24. 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 Inflation-Linked Bonds,” PIMCO, January 2005. 36. “A Guide to Global Inflation-Linked Bonds.” 37. One should note that inflation has indeed returned to the land of the rising sun. In November 2005, Japanese prices rose for the first time in two years, heralding the nation’s long-awaited reflation. See TimeNet News, December 27, 2005. 38. Barclay’s Capital Inflation-Linked Bond Indices January, 2004, p. 9. 39. “A Guide to Global Inflation-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?

B

onds 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 income streams. Two major factors influence 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 BONDS A 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.

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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 first 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 quality, 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 flows 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 eventual recovery.

DURATION Government 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 fixed interest payments becomes more appealing when new bond issues are more stingy. Conversely, if interest rates rise, existing bonds with fixed coupons are less desirable. The prices of old bonds must then fall to let their current yields match what the market offers.

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Unfortunately, bond prices do not work on this perfect teetertotter principle. Long bonds, those with maturities of 10 or more years, tend to rise and fall more than short bonds, those with maturities of less than 5 or 10 years (the definition varies, depending on application), for any interest rate change, and high-coupon bonds fluctuate less in price than low-coupon bonds when interest 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 defining moment in the history of finance.1 Macaulay created an equation that for the first time allowed bonds with no default risk to be priced accurately. Using the formula, both sellers and buyers 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 duration, 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 flow.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 implications. With that understanding, the bond investor achieves a level of sophistication that was rare until a few decades ago.

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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 flow 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 flow before maturity. The average time to cash for the coupon bond is much shorter than that of the strip. This understanding is insufficient to put an accurate value on the two bonds, however. Macaulay’s innovation was to measure the average time to receipt of a cash flow in which each cash flow’s time to receipt is weighted by its present value as a percentage of the total present value of all the cash flows. The sum of the present values of all the cash flows 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 financial services and many handheld financial calculators and programmable scientific 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 final 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

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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 duration 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 flows rise. Thus a high-coupon bond will produce more of the total cash flow 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 flow 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.

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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 implications. 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 government 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. Inflation generated by the way the United States financed 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 inflation, high interest rates, and stagnating economic growth. Bond managers, confronted with shattered portfolio values, needed to find ways to immunize their holdings from further damage. An academic cottage 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 financial engineers use to defer financing costs. A step bond may start at 3% annual interest, then rise

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to 5% and 8% at specified 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 REINVESTMENT A bond that falls in price as a result of an increase in market interest rates can have some of its value restored if the coupon interest it produces is reinvested at what have become higher market interest 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, convexity 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 first 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

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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 investor 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 investor 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 flow 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 portfolio 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

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constructed bond indices that show the entire bond market’s sensitivity 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 incorporated 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 limited to buys, for bonds are held until paid at redemption. The ladder will tend to have positive convexity as well. In sum, the bond ladder is a simple solution to the complex problem of how to optimize bond returns under conditions of varying interest rates.

NOT ALL BONDS ARE EQUAL It 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 refinance 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

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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 issuer will call in the bonds if it is beneficial 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 minimum yield is the lower figure. 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 influence selection of specific 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 fluctuations should select a high-coupon bond, since its duration will be lower 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.

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• 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 BONDS Bonds 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 governments 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 enthusiasm or what a newspaper or market guru has said, corporate bonds trade on closely analyzed credit quality. Much of the risk evaluation is taken care of by rating agencies.8 But the diligent bond investor will examine companies’ financial statements and each bond offering circular or contract to ensure that the risk is properly categorized by the raters. There is always a chance that books have been manipulated to increase apparent sales, to decrease apparent 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 resurrected, some turned into criminal prosecutions, and some simply gutted their investors.

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Top Dozen U.S. Bankruptcies: A Selected List Insolvent Filed for Total assets Outcome company bankruptcy U.S.$ Worldcom Inc. Enron Corp. Texaco Inc. Global Crossing Ltd. Pacific Gas & Elec. Co. UAL Corp. Delta Air Lines Inc. Adelphia Communications Delphi Corp. First Executive Corp. Kmart Corp. Northwest Airlines

2002 2001 1987 2002 2001 2002 2005

$103.9 billion $ 63.4 billion $ 35.9 billion $ 30.2 billion $ 29.8 billion $ 25.2 billion $ 21.8 billion

Execs to jail Execs to jail Reorganized Chief kept wealth Reorganized Reorganized Reorganized

2002 2005 1991 2002 2005

$ 21.5 billion $ 16.6 billion $ 15.2 billion $ 14.6 billion $ 14.0 billion

Execs to jail Pending Int’l scandal Now glamorous 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 reorganized 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 fixed income investor has an advantage over the stock investor, for the debt holder is interested only in having his bonds paid on time and the principal redeemed on schedule.

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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 companies 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 confidence (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 increase confidence 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 RISK Bond duration, which shows how bonds behave when interest rates change, and bond credit analysis, which reflects the borrower’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 equity, market penetration, role of macroeconomic forces, and even the popularity of a stock into the future. The bondholder is almost 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.

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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 financial application, it is the difference between what one expects to make from an investment compared to what one actually realizes from the investment. It is not an expression of the unknown, only of potential financial outcomes that tend to be within known boundaries. Investments in government bonds can be structured to anticipate 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 profitable common stocks, is worth it depends on events and the investor’s own need for security. If the rate of inflation 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 inflation erosion. However, if the economy goes into deflation, then a government bond, especially a long bond, will increase in value and produce paper profits before maturity. At maturity, the bond will have enhanced purchasing power. Prolonged deflation is not regarded as likely, but the chance that it could happen creates at least a theoretical justification for holding a small part of any portfolio in long bonds. Corporate bonds usually are rated below government issues. Some companies have sounder finances than governments, but companies cannot print money. Risk climbs with impediments to payment. Bond analysts regard risk as rising over time, for more

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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 example, 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 investments 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 flow 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 proportional 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.

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THERE’S BAD, AND THEN THERE’S AWFUL Credit rating agencies like to boast of their meticulous workmanship 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 diversified line of kitchen appliances and other household goods, hired Al Dunlap, an executive who had turned Scott Paper Company from a money-losing disaster into a stock market darling by firing 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 field offices, 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 firing 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.

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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 financial officer were fired, and the company 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 settle a securities fraud suit filed by investors who thought they had been deceived by Sunbeam’s handiwork.13 Sunbeam’s debt holders were not immune to Chainsaw’s wizardry 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 investment banker Morgan Stanley helped Sunbeam falsely inflate its finances 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 coming 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 nonrecurring items that allegedly are not part of a company’s regular

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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 fine in theory, 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 financial 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, compared 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 flow from operations. Sunbeam showed plummeting cash flow 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.

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Credit rating agencies tend to be prescient in their appraisals 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 flaw 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 decision 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 securities. They can no longer rely on the opinions of auditors, and such opinions are no longer a bar to recovery for fraud in securities 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 profits 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 distinguished counsel, the New York law firm of Cravath Swaine & Moore. The implication of the WorldCom decision is that underwriters, auditors, lawyers, and investors should take an active role in meetings and be alert to representations that the company is performing to industry standards. If it appears to be doing far better than competitors, all parties should find 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

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than in the United States, investors would have been lucky to see a fraction of the award. It is significant 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 Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 B1 B2 B3 Caa

S&P AAA AA+ AA AAA+ A ABBB+ BB B+ B BCCC

Fitch AAA AA+ AA AAA+ A ABBB+ BB B+ B BCCC

DBRS AAA AA (high) AA AA (low) A (high) A A (low) BBB (high) BBB B (high) B B (low) CCC

Interpretation exceptional security, lowest risk excellent security almost AAA superior, small long-term risk presently secure, more risk satisfactory security above average security good credit standing average rated security questionable security speculative very speculative highly speculative high risk and could default

Sources: Moody’s Investor Service, Fitch Ratings, Standard & Poor’s, Dominion Bond Rating Service

Investors tend to give the rating agencies the benefit 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 longrun 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

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The most common criticism of the raters is that they work not for the investor or even for financial intermediaries like investment 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 observation 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

Rating AAA AA A BBB BB B CCC

1 year US CAN 0.00 0.00 0.01 0.00 0.04 0.11 0.29 0.35 1.20 1.50 5.71 11.67 28.83 26.67

Default Rate in % 5 years 10 years 15 years US CAN US CAN US CAN 0.10 0.00 0.45 0.00 0.61 0.00 0.30 0.56 0.85 0.63 1.35 0.63 0.61 1.11 1.94 1.60 2.98 2.10 2.99 2.34 6.10 3.82 8.72 4.60 11.25 6.37 19.20 8.99 22.59 10.11 25.40 28.33 33.75 28.33 38.63 28.33 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.

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The work of the raters is vital to making correct bond investment 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 Canadian Commercial Bank Northland Bank Campeau Corporation Algoma Steel Corporation Limited Central Guaranty Trustco General Trustco of Canada Confederation Treasury Services Loewen Group Inc. Canadian Airlines Corporation Laidlaw Inc. Algoma Steel Inc. Teleglobe Inc. Air Canada Saskatchewan Wheat Pool Hollinger Inc. Stelco Inc.

Date of Insolvency 1985 1985 1990 1991 1991 1993 1994 1999 2000 2000 2001 2002 2003 2003 2004 2004

Ratings morph from sublime to suspicious to downright dubious, 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 investment-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

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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 appreciation 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 difficulty include the following:23 Indicator Cash and equivalents declining relative to total assets Receivables are growing faster than sales

Potential problem The company may be running out of cash and have to borrow Aggressive revenue recognition, excessive vendor finance, problems with returns Inventory grows faster than sales Inventory may be obsolete and need write-off Prepaid expenses increase in Operating expenses may be comparison to total assets improperly capitalized Accounts payable grow faster Slow payment may indicate lack than revenue of cash or earnings management Cost of goods sold rises faster Pricing pressure compresses than sales margins Continued on next page

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Indicator Major portion of income comes from one- time gains

Potential problem Core business may be weakening

Change of accounting principles

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

Auditor changes Chief financial officer resigns

CEO flees the country

RISK AND STRATEGY A 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 investment grade to sub-investment-grade debt by ensuring that the debt at risk is well diversified. 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 diversification process, a portfolio can contain high levels of junk debt. There is a cost to such diversification. 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

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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 unsecured 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 find 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 company 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 accounting exercise. A good deal of intelligence comes from what can be called “shoeleather economics.” That’s the sensibility one gets from reading the financial 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 happened 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 embargoes may block the sale of products of designated companies or companies in certain nations whose goods are blocked. Drug companies face immense difficulty 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

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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 profit. There is peril in such concepts, however, for bond desks at major financial 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 find hard to understand, may trade with spreads sufficient to boost yield by as much as 40 to 50 basis points. The market distinguishes 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 finance 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

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to sell the bonds, he would find the spread working against him. Thus investing in illiquid or obscure bonds, even those with superb 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 principal, 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 misfires. The worst leave the investor caught in a trap with no escape.

BONDS AND LIFE PLANS For the investor seeking to retire in a defined 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 equity 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

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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 period. 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 prospects, 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 institution or company and if the investor can find 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 acquisition, 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

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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 different from what one might tell a tailor. Strategies work when they fit 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 insurance 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 first and last step in defining a bond strategy.

Endnotes 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 flow, 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 flows 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 first derivative of duration, per footnote 2 above. 6. A fine 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.

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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 redflagged 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 first quarter,” National Post, April 20, 2005, p. FP4.

Chapter 7

BOND FUNDS

B

uying 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 shadows of each other’s moves. Not surprisingly, many investors who want the security of bonds choose to have managers do the selection 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

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with yield spreads between wholesale and retail of just a few basis points compared to the 25 to even 50 point yield spreads that investment 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 perhaps sales fees, the investor gets such advantages as the following: 1. Professional management 2. Low trading costs 3. Easy reinvestment of income and trading profits 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 accounts 5. Hands-off ease, for once the decision is made, the investor need never do more than follow the fund’s progress 6. Diversification in many bonds in the fund

FEES AND RETURNS Sad to say, data fail to show that this wonderful model of mutual fund convenience and performance works. That’s because fees devastate 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 exchangetraded funds that package well-defined fixed 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 effects 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 significantly less than the 7.7% average annual compound return of the SC Universe Bond Total Return Index

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in the period. The difference of 1.6% reflects 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 correlation is negative. And it gets worse. Bond funds, like stock mutual funds, are sold by two basic distribution models. The most common is the financial 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 flat fees that do not vary with the amount the investor has on account or invested, though high net worth individuals and smart investors can usually 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 fixed advisory fee formula in which the advisor is paid a flat 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

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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 financial 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 management 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 difference between the bid and ask prices for bonds. The more liquid the bond, the narrower the spread. Government bond funds must

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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 profit 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 investor, 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 taxable 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 managers who do earn their fees and several low-fee funds that allow for even mediocre management to shine, the average manager appears 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 firm. “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 $794million portfolio with an average annual compound return for the

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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 relationship of fees and performance. In an asset category as narrowly defined as Canada bonds, dominated by government issues, managers 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 managed by the same company.

EXCEPTIONS TO THE RULE: BOND FUNDS WITH STRONG PERFORMANCE A few managers are able to add substantial returns to their benchmarks 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 manoeuvre, 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

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peers appears in those funds that have relatively low fees. The following funds fall into that category.

Acuity Pooled Fixed Income Acuity Funds Ltd. is a Toronto boutique manager with an exceptional record of brilliant stock and bond picking. The company’s $99-million bond fund, technically classified as a Canadian income 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 Fund Scott 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 five years ended December 31, 2005, invests only in sovereign debt or debt guaranteed by or issued 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 Fund Picking global bonds is a tough business, for the manager has to contend with the yield curves in foreign markets and currency moves.

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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 aboveaverage returns for five out of the six years of the fund’s existence. For the five years ended December 31, 2005, the $26-million portfolio 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 currency 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 Fund Altamira 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 fine 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 Fund Toronto-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.

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CIBC Monthly Income Fund CIBC Monthly Income Fund runs $4.9 billion in a blend of government and corporate bonds and income trusts. It produced a handsome 11.62% average annual compound return for the five years ended December 31, 2005, far above the 4.55% average annual compound return of the median fund in the Canadian income balanced 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 Fund Vancouver’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 provincial 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 return 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 first quartile returns. The goal of the fund is to beat the benchmarks and to provide currency-hedged diversification to investors, says Brad Bondy, director of research at Genus. “It’s our finding that global bond returns have been negatively correlated with returns from Canadian equities,” he explains.

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

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

Northwest Specialty High Yield Bond Fund In the business of buying junk bonds, there are few managers better 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% average 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-flavoured bond fund or a first step into the bond market.

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

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products chief, Tom Czitron, the portfolio of Canadian federal and provincial bonds turned in above-average performance for each calendar 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 Fund Real 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 inflation adjustment. For the 10 years ended December 31, 2005, the fund, which requires $1,000 as a minimum investment, produced an 8.77% average annual 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 field of RRBs that consists of four federal issues and a couple of Quebec issues with a few U.S. Treasury Inflation Protected Securities tossed in to

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add some foreign flavour. Investors should beware the effect of this fund on taxable accounts: Annual inflation 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 FUNDS Mortgage funds are included in this discussion of bond-like investments and investment funds because, for the most part, they behave like bonds, though with a crucial difference. Conventional bonds with fixed coupons and defined 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 buffers 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 duration. 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 refinance 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 compensation 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

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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 Ecflx Mortgages portfolio with a 3.59% average annual compound return for the five 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 Funds Mutual funds would have stronger returns but for the fees that transfer performance from investors to managers. What’s more, in the narrowly defined 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 first 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 financial advisors. The buy and sell commissions

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are the only fees. Some RRSPs have custodial fees that are not covered 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 under 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 investment 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%.

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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 Inflation 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

Symbol* Asset Type and Portfolio Content

MER

iUnits Cdn. Bond Broad XBB-TSX Emulates Scotia Capital 0.30% Market Index Fund Universe iUnits Short Bond Index XSB-TSX Fund

Emulates Scotia Capital 0.25% Short Bond Index with maturities of 1–5 years

iUnits Real Return Bond XRB-TSX Emulates Scotia Capital 0.35% Index Fund Real Return Bond Index iShares Lehman Aggregate Bond Fund

AGG-A

Emulates the total 0.20% investment-grade U.S. bond market defined by the Lehman Brothers U.S. Aggregate Index

iShares Lehman 1-3 Year Treasury Bond Fund

SHY-A

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

0.15%

iShares Lehman 7-10 Year Treasury Bond Fund

IEF-A

Emulates Lehman Brothers 7-10 Year US Treasury Index

0.15%

Continued on next page

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ETF Name

Symbol* Asset Type and Portfolio Content

iShares Lehman 20+ Year Treasury Bond Fund

TLT-A

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

GS $ InvestTop™ Corporate Bond Fund

LQD-A

Emulates U.S. corp. bonds defined 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 FUNDS The 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 chartered 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

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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 fixed income funds happens only because investors do not know what is happening or know but fail to take their money elsewhere. 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 DIFFERENCES There are vital differences between bond funds, ETFs, and actual bonds. Managed products tend to be self-perpetuating. They retain 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 postponement, the choice of taking coupon interest and capital gains as cash or reinvesting can be very important. Reinvestment of coupons provides automatic value hedging if interest rates are rising. For a large bond position, that reinvestment can mean the difference 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.

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Investors with, say, six-figure investments in bonds or funds can reinvest from time to time. It may not be as often as managed 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 outperform 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 FUNDS Some funds provide bond investing strategies that the retail investor would be hard pressed to imitate. For example, the Arrow High Yield Bond Fund, a $101-million portfolio, produced a 1.61% return for the 12 months ended December 31, 2005. For three years ended December 31, 2005, the fund returned 5.78% per year compounded annually. Arrow Hedge Partners Inc. is a firm known for alterative strategies, but complexity of play does not necessarily produce a proportionately larger return. For the respective periods, the S&P/TSX Total Return Index produced returns of 1.61% and 21.66%

DIVIDEND AND INCOME FUNDS This 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 five years would appear to be reasons to divert investments from bonds into these alternatives.

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

Superficially, there would appear to be no reason at all to buy bonds. But the data need to be refined. First, Canadian bond funds are heavily weighted with government bonds and investmentgrade corporate bonds. The default rates in hard times on these vehicles is exceptionally low. The income has a high level of certainty. Income trusts are companies packed in a tax wrapper. They have equity risk built on the fortunes of businesses as narrowly defined as mattresses, peat moss, oil, gas, cold storage, and single newspapers. Income trusts’ yield includes return of capital in a difficult-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 fluctuation 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

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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 assets. 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 flourished 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 period and has been a strong performer in the sector since the fund’s inception in February 2002. Sentry Select has diversified 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 FUNDS Closed-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 office 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 outstanding. 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

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else below the net asset value if investors are pessimistic about its holdings. The number of units of the closed-end fund is fixed and they therefore sell in an auction process not much different than the market for stocks. And that market can add volatility and uncertainty 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 exceptions, 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 possible 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 liquidation 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 field of investing. As we have noted before, there are no minimum investment sums that are required to enter closed-end funds. Investment dealers prefer to trade lots of 100 shares and multiples thereof, but an investor can buy five or ten shares if he wishes. It should be noted, however, that commissions on such small trades may take the form of fixed minimums that are large enough to be effective penalties on small trades. Closed-end equity funds are common in Canada, for conventional 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 flow into new investments, effectively cut down any advantage that a closed-end fund would offer, says Tom Czitron. “Equities and other assets are more volatile than

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investment-grade bonds and can support conventional underwriting fees, but most bonds cannot,” he explains. Internationally, the closed-end style supports specialized geographic 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 municipal 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 initial 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 firm, notes that it’s opportune 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 flattens 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 Bonds The Canada Trust Income Investments Fund (symbol CNN.UN) is a blend of fixed 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.

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Closed-End Global Bonds The Aberdeen Asia-Pacific 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 efficient. It paid out 421% of NAV since inception in June 1986. The MER is a modest 1.04%.

Closed-End Junk Bonds Junk 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 find the DDJ Canadian High Yield Fund (symbol 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 first 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

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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 underlying 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, speculators may pour in and drive up the price. When the underlying assets go down, the players may flee and drive the price down.” Some closed-end funds have price-support programs. A management 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 discount 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 efficient though complex way to buy into credit markets.

THE LIMITS OF BOND RETURNS The 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 specified date. Perpetual bonds, once called consols, have no

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specific repayment date, but the idea is still that the stream of income 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, ultimately, 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 inflation 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 hyperinflation of 1919–1923 left the Reichsmark at one six-billionth of its 1914 value. The inflation 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 inflation. The wise bond investor should estimate the future conservatively and seek to minimize risk in diversification 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.

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THE FUTURE OF PACKAGED PRODUCTS Canadian mutual fund companies like to point out that they have a smaller customer base over which to distribute fund costs. That, they say, justifies 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, including 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 rapidly 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 underway, the fund industry will find 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-classified 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 defined 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 management 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

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

Endnotes 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).

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Chapter 8

BOND TRADING TACTICS

I

f 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-bymoment 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 significant 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 middleman 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

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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 issue. 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 profit of US$150 million, which was pretty good when you consider that Merrill Lynch made just US$391 million in profits in 1987. The lesson was that supposedly riskless bond arbitrage—selling one issue and buying a similar bond when they were trading at prices supporting different returns—would be hugely profitable. And it was until the fall of 1998 when events conspired to destroy 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 economists 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 interestrate-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 derivatives 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 financial community, the U.S. Federal Reserve organized a rescue plan that brought

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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 overconfidence, a Russian debt default a month before the September crisis, the Asian currency meltdown, and, finally, 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 financial markets this is not true. The more people write financial insurance, the more likely it is that a disaster will happen, 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 increase. It is surprisingly easy to move the market by fiddling 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

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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 FASHION It is an arguable proposition that bonds will soon move from the obscurity of the ledgers of insurance companies to co*cktail party banter. The kids of the post-World War II baby boom are coming into their bond years. co*cktail party talk that used to dwell on mergers and takeovers, tech stocks and laments for the losses triggered 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 management 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 finish 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 TRENDS Managing 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 flow, return on equity, and news pertinent to what amounts to the popularity of the stock in the present and perhaps even in the future.

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The owner of investment-grade bonds should study interest rate trends. The holder of credit-sensitive bonds needs to look into the issuer’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 future. 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 fine 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 investment 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 approximate 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 actually 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, finding 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 professional forecasters seldom get their numbers right, what chance has a player on the sidelines? The answer, oddly enough, is that the individual investor with an absolutely clear understanding of why he is

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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 defined 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 reduction 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 satisfied 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 inflation, 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 sector 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.

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A degree of disbelief can pay a healthy return. That’s not because 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, especially 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 flummoxes 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 managers, but just to survive the 20-year period, generate a return above inflation, 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 nonfinancial indicators 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 five years and three months. The

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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 succeeding months of recovery. A bond investor can buy bonds with terms of less than five 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 benefit of interest 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 variability 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 five 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 shortterm 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 five or six years—which is a full average economic cycle—the

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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 substantial 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 specific time-framed goal, the business cycle matters less than efficient 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 during 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 SELECTION Stocks 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 available 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 esoteric for institutional managers that want to push performance by a hundredth of a percent, is actually fairly simple for a private investor. For the individual investor, one Government of Canada bond due in 2015 is as good as another. There may be small variances

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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 investmentgrade bonds, the private investor with a need for cash at a certain date can shop with confidence 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.

CUSTODY Bonds 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 corporations continue to issue fully registered bonds that show the name of the beneficial 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 confidentiality 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 government 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

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Exchange and related businesses), is at the core of the securities transfer business in Canada. CDS has over $2.3 trillion of securities on deposit and takes part in more than 62 million securities 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 certificate form and registered in the name of CDS & Co., a nominee 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 beneficial 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 fully 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 excellent. 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 figure out what safe custody arrangements they can make. Investors who prefer to

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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 efficiency of holding virtual bonds.

VIGILANCE As the 21st century opened, the spread of computers and of highspeed 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 investors. It is harder than it looks. Day trading bonds is even tougher, for the intrepid investor has to find a counterparty with a bond, buy it, and find 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 theories into fixed income trading. Pricing models are installed on supercomputer networks that are the envy of the world. Big institutions 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 Prizewinning 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 gossip about what central bank governors may or may not want to do.

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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 finds 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 firm 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 reference 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 unemployment 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 SMART A careful bond trader will watch the market for trends that can offer profitable 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

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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 conventional 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 sometimes less ethical too, say experienced bond dealers, for when a dealer quotes a price, he could be fishing for business, low-balling the client, protecting his inventory for a bigger deal, or just trying to flush 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 investor, 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 wholesale (what the dealer pays) and retail (what the investor pays). The spreads are made up of actual price or yield differences and commissions tacked on by the investment dealer, usually one’s broker.

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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 financial websites, the bond prices in the Globe and Mail’s Report on Business and other financial 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 fiveyear 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 market rates. All impose restrictions or disincentives on sale such as limiting cashouts to one day or one month a year, or offer floating rates that lack a clear definition of the standard against which interest 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 conventional 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 investors 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

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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 fixed rate of 4.0% that is non-redeemable until maturity is crummy compared to a five-year Canada with semi-annual coupon that pays 3.73% with no restrictions on sale. Ontario also has a seven-year floating-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 find 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 fixed 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 SALES Bond 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 customers, 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 field of investing in which portfolio managers and investors sweat to get an extra 25 basis points of yield, trading

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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 often. 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 statement 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 advantage 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 specification 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

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$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 government 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/markets_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.

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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 transfers 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, according 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 justification 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 profits. The value of participating in auctions and arranging settlement 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 first 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 benefit of direct trading.

BOND TIMING In the stock market, it is said that “that there are no famous market timers.” Translation: Figuring out the patterns of market ups and

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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 commodities. 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 reflection of macroeconomic 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, find correlations between past and future price behaviour. Indeed, those correlations do exist. Data mining can produce numerous correlations that work in the past but that vanish in the future. Critics of technical analysis say that there is more in a commodity’s behaviour 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 minutes 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 speculation. Financial analysts have invested a great deal of brain power in trying to find 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.

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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, additional 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 collection 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 SMART Buying 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 variance 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 onethousandths 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.

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If you want to trade bonds actively, you can use a standard reference bond such as a Canada five-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 $1million 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 experienced go the spoils.

TRADING TIPS Bond 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 figure that retail investors lack experience and so widen their spreads, figuring 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 reduction 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.

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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 financial pages 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 government 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 currency 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 investor might pay and what a retail investor might pay could be as much as 200 basis points.

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In practice, a dealer’s inventory influences 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 DEAL A 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 supranational 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 account 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 five 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 profit centres and try to squeeze the best profits out of small, relatively defenceless accounts. “In the old days, which is ten years ago in the bond business, 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 find out from their advisors what commissions are tacked on

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and buried in the price, they are much farther ahead,” LeClair recommends. 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 similar 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 buyand-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 obscure 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, confident that mortality will match the bond’s term. If you, as the buyer, become the entirety of the secondary market, you’ll have to find 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

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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 basics. The investor who wants yield can switch to junk bonds or to income trusts. Or go to the common stock of the issuer, which usually gets boosted in value by increasing dividends or earnings to keep up with inflation. Know the beast before you buy it. Simplicity is the key. The temptation is to raise yield by moving 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 acquires by looking at the multiples of price to earnings, price to sales, cash flow, 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 significant 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 acquisition of a stock buyer. Buying risky bonds for enhanced yield makes sense in the context 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 compromise one’s initial purpose. All investment strategies and certainly

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all trades have to be anchored in the investor’s purpose, not on the deal of the day.

Endnotes 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).

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Chapter 9

THE FUTURE ENVIRONMENT FOR BONDS

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long-term investor who wants to reduce portfolio risk has to contend with the changing environment for different asset classes. At times, such as periods of recovery from recessions, stocks tend to outperform bonds. When economies go into recession 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 inflation, for rising commodity prices are part of the definition of inflation. The early 1980s, when the Consumer Price Index rose at double-digit rates each year, drove people to gold, the definitive monetary commodity. 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 single asset, such as shares of Royal Bank, it is nearly impossible to

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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 first three finishers 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, financial markets offer plenty of the latter.

THE TRENDS The first 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 beginning 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 senior 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

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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 BONDS If 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 billionaire 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 nuclear 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 involved 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 government bonds would tend to thrive, as they do when capital flees to havens of safety. There are other risks, hard to quantify, but still huge in their potential impacts on capital markets. A flu pandemic that would kill a third or a half of all people on earth, worse than the Spanish flu 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

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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 investors. 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 position to buy others’ assets at deeply discounted prices.2 The wise investor can buy bonds at least in amounts that provide 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:

Stocks held Bonds held

Bonds as Portfolio Insurance $ 400,000 50% Potential Loss $200,000 $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 perpetual 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 specific date, perhaps for retirement, perhaps just for trading purposes. Asset allocators are investors who know that the most influential determinant of return is the asset class (stocks, bonds, cash, real estate, commodities) in which one invests. Unfortunately,

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these investors have relatively little profit to show for their insight, but the concept of timing has to be given its due. After stocks rise to excessively high valuations, they eventually fall. At the time of writing, the S&P 500 Composite index is selling at about 27 times earnings. Other methods of setting the ratio (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 efficiency. 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 defined 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 defined by probability. In the October 19 disaster, markets 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 find a median drop of 15.9%. Portfolio insurance via bonds or some other form of protection is therefore not the financial 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

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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 fixed 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 inflation or deflation),” 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 fire, 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 trifling cost for the protection obtained. So is a financial meltdown in the offing? Chaos happened in senior capital markets every few generations in the 20th century. Yet capital markets recover quickly, perhaps because technological 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 inflation. 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

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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 conflict, which was financed by the Johnson administration’s policy of letting consumers pay for the war by inflation, and culminating in 1981 when prices posted annual double-digit gains. Bonds in each period were devastated, particularly in the episode from 1973 to 1981, when American war finance 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 ELDERBOMB We 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 members 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% compared 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:

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Elderly (65+) as a part of the total populations G-7 nations Country U.S. Canada U.K. France Germany Italy Japan

% 65+ in 2005 % 65+ in 2030 19 31 20 40 25 33 25 40 28 47 30 48 30 52

% 65+ in 2050 32 44 38 46 50 68 72

Source: 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 population 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 financial afterthought to a fiscal nightmare because of advances in medicine. For most of history, the elderly, which Jackson and Howe define 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.

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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 benefits for the elderly 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 benefits, 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 inflation. Transfers out of current income taxes would impoverish and perhaps 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 government 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.

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The most democratic way to finance public spending is, in a sense, through inflation. If governments generate spending in excess of what the economy produces or obtains through trade, prices will rise. Inflation 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 inflation driven by their own demographic weight relatively severely. Governments, which have to choose between keeping taxes reasonably low to stimulate production and high enough to finance spending, may tend to favour inflation. If not well managed, benefits financed by inflation could turn economies into the abyss of stagflation, 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 efficient in generating goods and services, especially for the elderly, inflation is part of the scenario of mid-21st century public finance.

BEYOND GOVERNMENT BONDS In 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, bullets, and gold? Real assets have their day, usually in periods of high inflation when stocks and bonds are devastated by high interest rates. Commodity prices were high in 2005 without high inflation because 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 particular, marches to a band of drummers with substantial knowledge

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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 financial assets and commodities and real estate. Most financial assets pay a periodic return in the form of interest or dividends 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 apartments and offices, shopping centres, and parking lots built on land can generate periodic returns through rent. Bonds, however, are the ultimate life jacket in collapsing economies. 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 traffic 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 PROTECTION All 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 issues. The worst damage when inflation drives up interest rates will be in long duration issues too. We need to balance the price sensitivity 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 benefit. 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

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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 inflation or even deflation. 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 inflation. 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 inflation and deflation for which neither stocks nor bonds are particularly well suited. Stagflation, defined as a combination of high inflation and high unemployment, 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 inflation would be the triggers. If we did return to stagflation, short bonds and high coupon bonds could generate rising returns through the rising interest rates available on reinvestment. On balance, stagflation 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 finance at York University in Toronto, suggests that a good financial 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

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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 finds he lacks growth in comparison to stocks and may not even have much inflation 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

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last 50 years that is not repeatable in the next 50 years. The longer period, however, includes the crumbling of Japanese military power 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 elimination of earlier occupants, and numerous scientific 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 deficits and war, Europe is immobilized in recession, 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 customarily exports its deficits to its bond customers abroad. Yet at some

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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 SYNDROME As 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 deficits are ultimately financed by foreign central banks that accept 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 country to do—then a part of the deficit might be adjusted. Chinese exports to the United States would rise in price, reducing demand 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 find other suppliers 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 disinflation (a sharply reduced rate of inflation) or outright deflation (a period of declining real prices).

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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 deficit…. If it corrects at the same time that falling consumption sharply curtails America’s imports, 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 refinance 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 inflationary. Funds would flow 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 deflation 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 deflation 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 interest rates maintained by China’s willingness to hold U.S. debt would have to rise. Rising interest rates would take the largest toll

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on high duration bonds. A strategy of staying with five-year bonds to capture some of the yield boost over Treasury bills that midterm bonds offer and of being ready to roll into higher interest rates would appear to be prudent. For now, Chinese central bankers 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 official Chinese government view is that a full float cannot happen until 2010.18

THE IMPLICATIONS The China syndrome and the elderbomb suggest a return to a climate of inflation. 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. Inflation will tend to drive up bond yields and to take money out of the stock market. Equity markets will tend to fall in this inflationary environment. For the investor, a return to inflation implies a need to be nimble. You don’t want to be holding long bonds and interest-sensitive stocks as inflation quickens. Short to intermediate bonds and defensive stocks look better in an inflationary 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 investments. Corporate bonds bear substantial equity risk, as the bankruptcies of Kmart Corp., Global Crossing and WorldCom, Pacific 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 government bonds, though it is wise for the cautious investor to spread bond investments among several major bond-issuing nations.

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Trends are called that because they change. The risk-averting investor can buy an assortment of bonds through an exchangetraded fund holding debt from nations in Europe, Australasia, and the Far East. At the minimum, the careful investor can buy supranational 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 highfee 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 probably 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 specific bond strategies.

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Endnotes 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 certificates are relics, though they continue to exist in Europe and in old issues. Holders of physical certificates 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. 8. Jackson and Howe, “The 2003 Aging Vulnerability Index,” p. 1. 9. Jackson and Howe, “The 2003 Aging Vulnerability Index,” p. 3. 10. Jackson and Howe, “The 2003 Aging Vulnerability Index,” p. 9. 11. Jackson and Howe, “The 2003 Aging Vulnerability Index,” p. 10. 12. Jackson and Howe, “The 2003 Aging Vulnerability Index,” p. 12. 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.

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he 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 government 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

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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 inflation 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 investor will already be in place to profit 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 offsetting 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 estimate the relative weights of bonds to stocks, we need meaningful benchmarks. One’s remaining life expectancy is a reasonable period. 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

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of bonds, after all, is to stabilize a diversified portfolio. Putting 60% bonds into a portfolio that has a complementary balance of 40% financial 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 certainty. 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 decades 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 inflation, 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 reduce interest rates. Even at what amounted to 0% interest on short bonds, consumer spending would not rise. But bond investors made money hand over fist 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.

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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 deposit in a guaranteed investment certificate or treasury bills. If bond prices rise, the investor can book a profit. 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 10year 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 earnings, so, implies the model, one should buy stocks and dump bonds

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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 trading 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 CYCLES Stock prices move in cycles driven by a cacophony of expectations 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 fluctuations of daily stock prices over periods of 20, 30, or 40 years, using moving 10-year averages and the flutters disappear. U.S. stocks’ real returns from 1802 to 2001 compounded at an average 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 afflicts 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’ inflation expectations. Government policy is a tenuous thing that varies from brilliant to abysmal. Inflation varies with world events, the business trends of major trading partners, and government fiscal 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 insurance 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 profitable 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 ALLOCATION Now 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 beginning at age 60 and you are 50 today, allow, say, 2% inflation for the

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next ten years or 20% in all. Inflation compounding will push this up a little, so make it a 22% boost in income to compensate for inflation. 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 income stability, reduced the effect of stock market fluctuations on your portfolio, and created a balance in which there is potential 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 parallel 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 decade. But when stock markets became overheated in the dot-com frenzy and then cracked, bonds performed strongly. In 2000, during 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 retain value in periods of massive stock market meltdowns is widely understood in financial 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 significant level of bonds in a conservative, balanced portfolio. What is significant 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 allocation have been unspectacular. For the five years ended December 31, 2005, Canadian tactical asset allocation funds produced a 4.2% average annual return compared to the 6.3% average annual return 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 sufficient to hold a target level of bonds, adding to bonds when one’s stocks have done well and adding to stocks when bonds have done well. Do this at a fixed 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 lower 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.

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THE OPPORTUNITY COST OF BONDS It 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 fluctuations in the stock market. McKeough notes that stocks, trading at about 20 times earnings on the TSX, have an earnings “yield” of 5%. Add 3% average dividend on senior large caps in financial 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 holding 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 METRICS Given a portfolio structure that calls for a certain weight of bonds that mature in various time periods, the investor is left with selection 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 financial 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 fluctuations in the market value of a bond portfolio will select issues with high coupons and short terms. Short terms sacrifice 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 first year of a child’s university education, a single maturity will be sufficient. A portfolio that has only one term is called a “bullet portfolio” for the obvious reason that it can hit a perfectly defined target. An investor can buy a five-year bond for an obligation due in five years and be done. In the absence of the simplicity of targeting a single term, investors 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.

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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 distributions, depends on timing and risk control. Bond and term selection are flexible 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 INSURANCE Bonds 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 payment 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 university 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 beneficiary 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 coupons 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 average out interest rate fluctuations. 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 flawless provided that the bonds used are immune to default. The plan guarantees return of capital, though it provides no inflation 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 guarantee 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 inflation protection through rising equity values and rising dividends.

GLOBAL BONDS At times, bonds issued in foreign jurisdictions can provide far stronger performance than domestic bonds. As the Bank of Canada or the Federal Reserve raises rates, central banks in Europe and Japan

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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 investments in the European Union or in Japan. The investor can lock in buying power in the foreign jurisdiction, fix 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 relationships. One cannot say how long the cycles may be, but economic forces such as unit labour costs that define 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 global currency markets.5 Even a misphrased article written in early May 2005 by a rookie reporter for a Chinese news service, later mistranslated 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 figured 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, fluctuations in foreign currency values are an important driver of global bond returns. The investor in a foreign 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 difficulties of obtaining timely information on financial and political events affecting 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 sufficient to say that they provide heightened levels of risk and challenging management requirements.

REAL RETURN BONDS Inflation-linked bonds that compensate for changes in the purchasing power of a basket of goods used to measure the Consumer Price Index have been immensely successful as both asset plays and income 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 inflation compensation adjustment. The investor who buys Canadian RRBs is accepting what may be

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an inferior short-term return below the Treasury bill rate. In addition, the bonds, which are adjusted by means of increases in the underlying principal to generate inflation-equivalent income, create 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 investor planning to use RRBs outside an RRSP for a retirement fund with the idea that inflation 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 efficiently 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 inflation risk to the potential money pit of paying too much for inflation that may not materialize. In inflationprotection as in every other investment decision, it pays to diversify.

QUALITY: A LONG-RUN VIEW Investors in search of yield are often tempted to go below investment-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 10year 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 corporate bond for a five-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 investmentgrade 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 FUNDS An 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% average 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 investors. 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 using 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 difficult if not impossible to anticipate. As well, bond trading in relatively complex debt instruments is more difficult than buying straight government or investment-grade corporate bonds. In the area of relatively elaborate products, bond managers can shine.

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RISK MANAGEMENT The 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 flourished 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 defined products such as canned fish. 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 diversification. 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 Diversified Income Trust. Each structure adds fees, but if management adds to return through apt asset selection, it may be an efficient 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

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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 corporate 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 cannot match. Those investors who seek to engineer bond portfolios to emulate equity levels of performance are deviating from the essence of the bond: time-bounded certainty of return. In buying bonds and their substitutes, simplicity is its own reward.

CONCLUSION: THE VIRTUES OF BONDS We have seen that bonds and stocks are very different in their behaviour. Stocks have an upward trend over time if only because company management seeks to increase earnings and usually succeeds. Bonds, on the other hand, fluctuate in value with interest rates and inflation expectations without a clear upward path. But, paradoxically, the prices of investment-grade bonds are knowable with perfect accuracy 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 volatility that goes with them and the predictability of bond returns will tend to improve investment returns overall, to lower portfolio 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 cornerstone 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

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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 absolutely have a place in a portfolio, as may real estate and commodities and, who knows, art and collectibles. But bonds function as a cornerstone 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 potentially 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, government 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. Endnotes 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.

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Glossary

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 financial 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 financial 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 bellwethers for their respective markets.

252

Glossary

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 market 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 inflation driven by investor enthusiasm by which the market value rises far in excess of replacement value or reasonably

Glossary

253

predictable cash flow or profits; bubbles occurred in the 17th century in Holland when tulip bulb prices soared, in England in the 18th century 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 flow—the money generated by a business from its operations 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 frequency 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 fixed 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 structure with bond attributes that assembles such things as credit card

254

Glossary

receivables with the understanding and design that such payments will flow 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 influenced 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 floating rate of interest. Corporate bond—a promissory note of payment issued by an entity 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 convertible bond are transformed into shares. Convexity—in bonds, the property of the weighted average return of cash flow to the time of receipt of that cash flow that increases return as interest rates rise, reflecting higher returns from reinvestment, or that falls when interest rates decline, reflecting lower returns from reinvestment; mathematically, the first derivative of duration. Coupon—the periodic commitment to pay interest, usually in fixed currency amounts. Once represented by paper tags appended to

Glossary

255

bonds, coupons now are time-defined commitments to pay interest in fixed currency amounts, in other forms of consideration—such as additional shares (see Pay in Kind) or in inflation-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 financial 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 interest 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 financial instrument is held by a third party, typically a trust company or other trustee, for a beneficial owner. Death spiral—the process by which a convertible bond that allows the holder to transform his bond into a sufficient 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

Glossary

Debenture—a debt or bond not secured by specific 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 historical significance. Depression—a period and condition of an economy marked by declining gross domestic product, falling prices, rising unemployment, 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 financial instrument whose value is derived at least in part from the value or condition or performance of an underlying 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.

Glossary

257

Duration—the average time to receipt of a bond’s cash flow in which each element of the cash flow (coupon and principal) is weighted by its present value as a part of the total present value of all the cash flows. Also called Macaulay duration. EAFE—Europe, Australasia, and the Far East. Earnings—the income of a business. Exchange traded fund (ETF) iUnits—defined asset portfolios that replicate major bond or stock indices that are managed by Barclays Global Investors in Canada. iShares—defined 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 first two, is the sum of the preceding pair, e.g., 1, 1, 2, 3, 5, 8, 13, 21. The sequence is regarded by some financial 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 finance that involves sale of assets with obligations to pay defined sums of money in the form of preferred stock dividends or bond coupons.

258

Glossary

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 corporations 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 consisting 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 portfolio of assets established by the mandate of the portfolio manager to track a given market or market segment. Inflation—the process by which prices of goods rise over defined time periods. Inflation-linked bonds—debt issues that pay interest based on changes in a referent such as the consumer price index; typically inflation-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.

Glossary

259

Insurance—a financial 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 patents, 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 agencies 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 significant risk of default; often called high-yield or speculative bonds. LIBOR—the London Interbank Offered Rate employed by international banks as the price for short-term bank-to-bank loans. Long-Term Capital Management—a hedge fund based in Connecticut 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 management, usually expressed as an annualized fee; in Canada, the MER is inclusive of office and selling expenses and can be calculated by

260

Glossary

dividing total fund operating expenses by the number of units of the fund outstanding. Money market fund—a mutual fund that holds short-term obligations that have low volatility and that are readily converted to cash. Money supply—the amount of money in an economy, a flexible measure that moves from the narrow base of currency plus chequing account balances to the inclusion of time deposits and on to readily saleable financial assets. Moody’s Investor Services—an agency that provides credit ratings on bonds. Mortgage fund—an investment fund the assets of which are invested 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.

Glossary

261

Preferred securities—hybrid bond/stock instruments that pay interest but that allow extended periods of non-payment of interest 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 specific 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 interest, 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 defined as two consecutive quarters of shrinkage of gross domestic product. Risk Systematic—the exposure of a bond to rising or falling interest rates driven by monetary policy and inflationary expectations.

262

Glossary

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 fulfil 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 issued 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 corporation may default on a debt; when governments default, seizure of foreign assets may be impossible. Risk shifting—the value of default, nonperformance, or underperformance that can be transferred to a contracting party in exchange for payment of a premium or participation in an offsetting 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 financial instruments for their worth as antiques, objects of art, or curios. Securities regulation OSC—the Ontario Securities Commission; the leading regulator in Canada.

Glossary

263

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. Stagflation—a process by which an economy suffers both from inflation and low or zero economic growth. Standard & Poor’s—financial information service that provides credit ratings on bonds. Step bond—a bond that increases its coupon interest payments over time at defined 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 fixed and specified 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

Glossary

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-andhold strategy of doing nothing to a portfolio or, alternatively, following fixed buy and sell protocols set by time regardless of market moves or trends. Treasury Inflation Protected Securities (TIPS)—inflationlinked 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 divided by price at time of issue or at time of measurement. Running or current yield—interest divided by price at a relevant time. Yield to maturity—the interest an investor will earn if a bond or other time-defined instrument is held to its term. Yield to maturity takes into account the bond or other instrument’s purchase

Glossary

265

price, current market price, the coupon rate of interest, and the time remaining until the bond or other instrument reaches maturity 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-defined 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 exceed 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.

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Bibliography * Selections marked with an asterisk are especially recommended.

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 securities; clear lessons, but only for the motivated.

268

Bibliography

*Sidney Homer and Martin L. Leibowitz, Inside the Yield Book. New York: Bloomberg Press, 2004. Reprints the 1972 PrenticeHall classic with an update. A classic examination of bond math with emphasis on the components 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 fixed 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 financial analysis. *Aswath Damodaran, Investment Valuation, 2nd ed. New York: John Wiley & Sons, 2002. Encyclopedic manual on valuating financial 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.

Bibliography

269

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 fluctuations in financial assets with implications for bonds. A mathematical analysis with immensely insightful comment on why events that should be rare are relatively common in financial markets.

ACCOUNTING AND DECEIT Stephen 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

Bibliography

*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 financial flim-flam 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.

Bibliography

271

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 fickle regulation.

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Index

Aberdeen Asia-Pacific Income Investment Company Ltd 177 Acuity Funds Ltd. 161 Acuity Pooled Fixed Income Fund 161 Africa 224 AGF Global Government Bond Fund 161 A.H. Robins 150 AIC Global Bond Fund 161-162, 206 AIC Ltd. 206 see also LeClair, Randy allocation model 234-235, 251 Altamira Bond Fund 162 Alternatives to actual bonds 160178 closed-end bond funds 174176 closed-end Canadian bonds 176 closed-end global bonds 177 closed-end junk bonds 177178 dividend and income funds

172-174 exchange-traded funds 167-170 money market funds 170-171 mutual bond funds 160-167 specialty bond funds 172 Altman, Edward 77, 100n A.M. Best 145 America West Archives Inc. 94 Andersen LLP, Arthur 143 Anderson, Cheryl 94 Angola 19, 105 antidilution provisions 64 arbitrage 93, 115-116,188, 194 Argentina xii, 18, 69, 93-94, 107109, 113 Arrow High Yield Bond Fund 172 asset-backed debt 86-87, 252 asset class, as determinant of return 214 Australia 118, 119, 120

baby boom 186 see also elder bomb Bank of America,

274

Index

Parmalat scandal 110, 112-113 Bank of Canada 124n, 199, 232233, 242 Bank of Canada Working Paper #20 69 Bankruptcies see insolvencies barbell 240-241 Barber, Tony 123n Barclay’s Global Investors 168 Barings Bank 91, 136 see also Leeson, Nick Barrick Gold Corp. 69 bearer bonds 48, 192 bear market, bond 217 bell curve 38, 40, 42, 215 bellwether 251 benchmark 50-51, 109, 158, 162, 163, 167 Berkshire Hathaway 213 see also Buffett, Warren Berman, David 79n Bernstein, Peter 49-50, 55n Berra, Yogi 189 Beta 50, 128-129 Beutel Goodman 162 Beutel Goodman Private Bond Fund 162 Bierwag, Gerald 153 n bill of exchange 10-11 Blackmont Capital 74 BlackRock High Yield Trust (BHY-N) 177 Block, Stanley 28n Bloomberg European Pharmaceuticals Index (IBEP) 167

BMO Nesbitt Burns 75 bond derivatives 4, 27, 77-78, 9092 , 256 bond fund 252 see also Chapter 7 Bondi, Enrico 112 bond ladder 53,132-133, 240 bond selection 134-135, 191-192 bond vs. bond fund 171-172 Bondy, Brad 163 Bonneau, Pierre 95-96 Bouey, Gerald x, 22 Bourgeois, Bruno 162 Bowie bonds 252 Bowie, David 88 Brady bond xii, 116-118 emerging markets 116 estimating value of 117 issuing nations 117 Brazil 176, 179, 224 Bre-X Minerals 136 see also insolvencies Brynjolfsson, John 71 bubble 252 Buconero 112 Buffett, Warren xiv, 4, 213 Bulgaria 117 “bullet portfolio” 240-241 Byron, Christopher 154n

call premium 133-135 Cameroon 94, 105 Campeau, Robert 74, 83-84 Canada bond vs. Canadian bond 26, 253

Index

Canada Real Return Bond 62, 119 Canada Savings Bond 35, 197198 Canada Treasury Bills 170 Canada Trust Income Investments Fund (CNN.UN) 176 Canadian Depository for Securities 192, 193 Canadian Originated Preferred Securities (COPrS) 85 CanDeal 195-196 Canwest Global Communications Corp. 83 Carnegie, Andrew 96 CARS see synthetic bonds cash flow 253 Cayman Islands 111 Ceausescu, Nicolae 97 Central Limit Thereom 42, 253 Chainsaw Al see Dunlap, Al Chomisky, Eugene 154n CIBC Canadian Bond Fund 159160 CIBC Monthly Income Fund 163 CIBC Wood Gundy 36 Chambers, John 123n Charlemagne 22 Chili 115 China xiii, 118, 225-227, 243 Chomiskey, Eugene 154n Citigroup tech boom 227 Citigroup World Government Bond Index 104, 162 closed end 253

275

closed-end bond funds 174-178 closed-end junk bonds 177-178 Colbourne, Scott 161 collateralized debt obligations (CDOs) 86-87 Comeau, Janet 209n Cominco Ltd. see Teck-Cominco Ltd. commercial code 7, 253 commodities 211, 220-221 commodity-linked bond 70-72, 254 during catastrophes and inflation 70 Congo 94 Connor Clark & Lunn Group 67, 68, 77-78 see also Murdoch, Neil Connor Clark & Lunn Real Return Income Fund 67-68 consols 6, 254 Consumer Price Index 195, 211, 227 convertibles 63-67 as interest-paying bonds 64, 65 antidilution provisions 64 conversion to stock 65-66 death spiral 65-66 convexity 131-132, 166, 254 see also reinvestment corporate 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

Index

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 138-139 Costa Rica 117 cost-manipulation see corporate bonds Cote, Judge Denise 143 coupon 44-45, 48,126, 129-130, 166, 192, 254 covenant 255 see also indenture Cravath Swaine & Moore 143 credit analysis 136-139, 140, 146148 credit default swaps (CDS) 58, 77-79, 255 credit ratings and defaults 114-115 listed 144 Credit Suisse First Boston 92 Crescenzi, Anthony 29n currency crisis, Asian 104-105, 115 custody 192-194 cycles, bond price 235-236 cycle theory 189-91 Czitron, Tom 87, 149, 165, 175176, 178, 196, 216

Dalkon Shield 150 Dangerfield, Rodney 72

Dan Hallett & Associates see Hallett, Dan Dansk Olie og Naturgas A/S 6 Davies, Robertson 110 day trading of bonds 194-195 DDJ Capital Management LLC 177 dealers, investment types of 35-36 Dean Knights Capital Management Ltd. see Knight, Dean death spiral 65-66, 255 see also convertibles debenture 63, 87, 93, 256 debt to capital ratio 137 debt to equity ratio 137 defaults 256 and corporate bonds 207 and credit ratings 115 rating categories 145 defaulted 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 109 defunct bonds 94-97 demographics 186 see also elder bomb depression 233, 256 de Roover, Raymond 28n d’Estaing, Valéry Giscard 69 direct distribution see no load direct sales 198-201

Index

dishonoured bonds 92-94 dividend funds 172-174, 256 see also income funds Dizard, John 100n D’Loren, Robert 88, 89-90 Dominion Bond Rating Service (DBRS) 144, 256 dot-coms 66, 92-93, 247 Dow Jones Industrial Average (DIA) 38, 167 Dreamworks 89 Drexel Burnham Lambert 4, 75 Drkoop.com 66 Duff & Phelps Capital Partners 89 Duncan, Richard 225-226, 229n Dunlap, 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 128129 as interest rate sensitivity measure 129 as hedge against chaos 221222 rising interest rates 226 step bonds 130-131 synthetic bonds 207 Dynamic FocusPlus Energy Income Trust 174

EAFE 257 Ebbers, Bernie 144

277

Echo Bay Mines Ltd. 86 Ecuador 117 see also Brady bonds Einstein, Albert 67 concepts of randomness 5 elder bomb 217-220 emerging markets 108, 116 Enron Corp. 110, 143 equity risk 47, 208, 227, 236 Esterline, Caleb 96 Ethiopia 94 Euroclear 193 exchange-traded funds (ETFs) 36, 167-170, 180, 228, 257

Fabozzi, Frank 100n Federal Reserve Bank of Chicago 201 Federal Reserve, U.S. 5, 11, 22, 24, 184-185 Fed Model see allocation model fees 156-167, 181, 185, 197, 228 Fibonacci 37-38, 257 Finland 185 First Boston 84 Fisher, Irving 187 Fisher, Lawrence 131 Fitch Ratings 144-146, 257 foreign currency 49, 104-105, 205 see also yuan, the Asian currency crisis 104-105 France 121, 122 see also G-7 French tresors 69, 258

278

Index

see also commodity-linked bonds

G-7 ix, 22-23, 104, 105-106, 114, 118, 135, 22, 218, 258, 260 G-8 258, 260 Galloni, Alessandra 124n Galveston, Houston and Henderson Railroads 98-99 Gampel, Aron 71 Garzarelli, Elaine 187 Gates, Bill 213 General Motors Acceptance Corp. 73, 152, 246 General Motors Corp. xiii, 72-73, 148-149, 236, 246 Genus Canadian Bond Fund 163 Genus Capital Management 163 Germany 105, 176, 179 see also G-7 Giscards see French tresors Global Association of Risk Professionals (GARP) 107 global bonds see Chapter 5, 258 global 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 118122 as ETF package 168-169 as insurance against domestic loss 242-243 defaults 105 during economic tailspins 104 global real return bonds 118-122 Globe High Yield Peer Index 164 Gluck, Richard 61, 66 Goldman Sachs Commodity Index 70-71 Goldman Sachs Group Inc. 18, 200 Gondor, Cecelia 176, 178 Goodman, Laurie 100n government debt increasing in the future 105106 Grant Thornton LLP 111 Greece 119 Green, Jeff 154n Greenspan, Alan 11 Grenada 105 Gumbel, Peter 111-112, 124n Guyana 94

Haghani, Victor 185 Hallet, Dan 159, 180-181 Hammurabi 21 commercial code 7 Harley-Davidson Inc. 73 Hedge Fund Research Fixed Income Arbitrage Index 115

Index

279

hedge funds 91, 94 see also Leeson, Nick hedging of global bonds 104-105 Herpolsheimer’s 83 high-yield bonds 4, 27, 49, 58, 72-77, 82-84, 88, 106-107,148149, 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 inflation 216-217 Viet Nam 130 Homer and Liebowitz 153n Homer and Sylla 7, 21, 28n, 29n, 229n Homer, Sidney 7, 55n, 153n, see also Homer and Sylla Howe, Neil 218-219, 229b Hulbert Financial Digest 187 Hulbert, Mark 187 Hungary 115 hybrid bonds collateralized debt obligations 86-87 commodity-linked bonds 6972 convertibles 63-67 credit default swaps 77-79 fixed income derivatives 90-92 packaged linkers 67-68 preferred securities 85-86

income trusts 247 indenture 3, 134, 258 India 69, 176 Indonesia 105 see also Asian currency crisis, defaulting nations Ineichen, Alexander 16, 29n, 100n, 124n inflation and the elder bomb 219-220 chances of return to 216-217 present outlook of 26 probable future of 227 inflation-linked bonds 67-68, 258 insolvencies 136, 146, 227 intellectual property bonds 87-90 interest coverage ratios 136-137 interest rate forecasting see yield curve interest rates history of 21-23 trends in, 212 International Monetary Fund (IMF) 69, 98, 108, 109 investment grade 144, 259 investor age in allocating portfolios 236-237 Israel 119, 122 Italy 105, 106, 113, 119, 122 see also G-7, Parmalat Finanziaria SpA Ivory Coast 94

Iceland 119 income funds 172-174

Jackson, Richard 218-219, 229n Japan 119, 121, 124n, 223

280

Index

see also G-7 Jorisdochter, Elsken 12-13 JP Morgan 89, 96, 143 junk bonds see high-yield bonds Just For Feet 74-75

Long-Term Capital Management xiii, 5, 38, 183-186, 194, 259 loss aversion, capuchin monkeys 33 Lucchetti, Aaron 79n

Kapner, Fred 124n Kerstein, Bob 94-95 Knight Capital Management see Knight, Doug Knight, Doug 76, 164 Knights Templar, Order of 8 Kotsopoulos, Peter 61 Koza, Harry 71-72, 74, 79n Kraemer, Moritz 106, 107, 123n Kresic, Chris 78, 90, 149, 152 Kritzman, Mark 28n, 153n kurtosis 40

Maas, Florida Circuit Court Judge Elizabeth 141 Macaulay Duration 127-131 see also duration Macaulay, Frederick R. 127 Macdonald Shymko & Co. 27 Mackenzie Financial Corp. 78, 14 see also Kresick, Chris Majorica Asset Management see Marcus, Robert Malackowski, James 89 Malaysia 104 managed bond funds 246 management expense ratio (MER) 157-161, 181n, 199, 259-260 Mandate National Mortgage Corp. Fund 166-167 Marcus, Robert 162 Massé, Micheline 95 mathematics, fractal 43 Mauldin, John 229n MB Fixed Income Fund 163-164 McClatchy, Will 181n McLean Budden Ltd. 61, 163164 McLoughlin, David 101n McKeough, Pat 239 McNamara, Robert 213 Medici 8

Lac Minerals Ltd. see Barrick Gold Corp. LeClair, Randy 162, 206-207 Leeson, Nick 91, 136 Lekdyk Bovendams Company 12-13 Leonardo of Pisa 37-38 Levy, Don G. 95 Lewis, Kenneth 112 Lewis, Michael 183, 185 LIBOR 90, 259 Liebowitz, Martin 55n, 153 life plans 151-153 linkers see global real return bonds and real return bonds

Index

Meriwether, John and LTCM 183-186 Merrill Lynch 85, 112, 184, 245 Merton, Robert 184 Mexico 109, 115, 117, 119, 121 Microsoft Corp. 82 Milevsky, Moshe 222-223 Milken, Michael xi, 4, 75 see also high-yield funds Minder, Ralph 124n money market fund 170-171, 260 Moody’s Investor Services 108, 144, 260 Moran, Derek 27-28 Morgan Stanley 89, 141 Morningstar Inc. 50, 67, 116 mortgage fund 166-167, 260 Mulford, Charles 143n municipal bonds 20 munis see municipal bonds Murdoch, Neil 68, 78 mutual bond fund 160-167 Acuity Pooled Fixed Income Fund 161 AGF Global Government Bond Fund 161 AIC Global Bond Fund 161162 Altamira Bond Fund 162 Beutel Goodman Private Bond Fund 162 CIBC Monthly Income Fund 163 Genus Canadian Bond Fund 163

281

management expenses of 156158 MB Fixed Income Fund 163164 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 passim negotiable bonds 203 Netherlands, the 12-13 Nicaragua 94 Nicholas II 51 no-load 157 Nortel Networks 42 Northwest Specialty High-Yield Bond Fund 164 number theories 37-38

“off the run” 205 Old Company Research 94 see also Kerstein, Bob “on the run” 205

282

Index

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 Bond Owen, James 100n

Pacific Investment Management Co. (PIMCO) 71 packaged linkers see inflationlinked bonds Paraguay 105 Parmalat Finanziaria SpA xii, 110-114 ,115, 143 PARS see synthetic bonds Partenoy, Frank 100n Pay in Kind (PIKs) 74, 82-84, 260-261 Perelman, Ron 141 perpetual preferred stock 38, 214 perpetuals 6, 12, 18-19, 46, 97, 178-179, 214 Peru 117 Peters, Edgar 55n Phillipines, the 117 Phillips, Don 50-51, 55n Phillips Hagar & North U.S. Money Market Fund 171 Phogue, Thomas 154n PIMCO Commodity Real Return

Strategy Fund 71 Poland 117 Ponzi schemes 98 portfolio insurance 214-217, 241242 portfolio protection, long-term 221-225 preferred securities 85-86, 261 present discounted value 26 prestiti 12, 261 Prime Bank Notes (PBNs) 98100 Probability of Regret (PoR) 222223 public pricing 21-22

Quebec 121

Rai, Satish 165 rating agencies 144-146 see also Moody’s, Standard & Poor’s RBC Dominion Securities 36 real return bonds 62,119, 222, 244-245, 261 see also global real return funds recession 261 see also global recession 225226 Registered Education Savings Plan (RESP) 242 Registered Retirement Savings Plan (RRSP) 159, 166, 168, 171, 242, 245

Index

reinvestment 131-132, 133-135, 171-17 R.M. Smythe & Co. 96 Robinson, Allan 100n Rothschild, John 100n Royal Bank of Canada 2, 34, 60, 78 Rubin, Sandra 154n Russia 18, 38, 51, 94, 115-116, 104-105, 185

Sala, Luca 113 Salomon Bros. 183 Salomon Smith, Barney 143 Salzgiver, Sharon xiv Sargent, Carolyn 100n Scandinavia 135 see also Finland, Sweden Sceptre Bond Fund 164-165 Sceptre Investment Council Ltd. 164-165, 196 see also Czitron, Tom Schilit, Howard 142, 154n Scholes, Myron 184 Scism, Leslie 79n Scott Paper Company 140 scripophily 97, 262 SC 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

283

Sentry Select Canadian Income Fund 174 Sentry Select Corp. 72 September 11, 2001 213 and arbitrage 116 effect on bond markets 43 shelf registration 143 Shemilt, Heather 70 Siegel, Jeremy 29n Singh, Manmohan 100n, 123n Slovakia 115 small cap 159 Soldofsky, Robert 154n Solon 7-8, 21 Sornette, Didier 40, 55n, 229n South Africa 119 South Sea Bubble 15-17, 176 sovereign bonds 18-19, 94 see also global bonds sovereign debt 93, 106 sovereign immunity risk 49, 262 sovereign loans 93 S&P 500 Composite Index, U.S. 215, 233-234 Spain 217 specialty bond funds 172 Speed, Joanna 112 stagflation 22, 263 standard deviation (SD) 50, 173 Standard & Poor’s 19, 77, 100n, 105-106, 114, 144, 263 Standard & Poor’s Composite (SPY) 167 Steen-Knudsen, Michael 6 step bonds 59-62, 130-131, 198, 263

284

Index

steppers see step bonds stock market crashes 38, 57 1929 crash 38, 187 1987 crash 38, 183-185, 187, 215 Stock Search International 95 stocks 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. 140-141 Sweden 118-120, 122 Switzerland 135, 185 Sylla, Richard 7 see also Homer and Sylla synthetic bonds 207, 248

Tanzi, Calisto 110-113 TD M.S. Money Market Fund 171 TD Real Return Bond Fund 165166 tech boom 227 tech bubble 16, 42, 76, 190 Teck-Cominco Ltd. 69 Texas International 75 Thailand 104 Thau, Annette 29n, 123n, 234, 249n Thomas IFR 71 see also Koza, Harry Thomas J. Herzfeld Advisors, Inc. 176 timing 201-203

see also cycles, duration Tonna, Fausto 111, 113 Toronto Index Participation Units (TIPs) 167 toxic waste, in bond market 87 TradeWeb 196 tranche, equity 86-87, 231 Treasury bonds, U.S. 89, 184, 225, 245 Treasury Direct 198, 199, 200 Treasury Inflation Protected Securities (TIPS) 67-68, 119, 169 trends, forecasting and analyzing 186-191 Trilogy Advisors LLC 61 see also Gluck, Richard Turkey 179

UCC Capital 88 see also D’Loren, Robert Uganda 94 Ugolottti, Angelo 113 United Kingdom 106, 119-122, 121-122 see also consols Uruguay 105 U.S. Bond Market Association (BMA) 20 U.S. Depository Trust & Clearing Corporation 193 U.S. Securities and Exchange Commission 74 usury 8, 22

Index

Venice, Republic of 9 see also prestiti Viet Nam 130, 217 Volcker, Paul x, 22 volatility see beta

Waldie, Paul 100n Wall Street, the movie 9 Weil, Roman 131 Western Asset Management 67 Wiandt, Jim 181n Wolfe, Tom 4 WorldCom 110, 143-144

285

Yemen 94 yield curve 21, 23-28, 25 (graph), 35, 46-47, 134, 189, 265 yield to call 134 see also yield to worst yield to worst 134, 265 see also step bonds yuan 225-227

Zambia 94 zero coupon bonds see strip bonds Zimbabwe 19 Zini, Gian Paolo 111