from which other bonds may be valued. For example, let us take a provincial bond: the Province of British Columbia 3.70 percent due December 18, 2020. It is valued by the market at 74 basis points above the relevant benchmark, the Canada 3.5 percent due June 1, 2020. (1 percent is divided into 100 pieces, each of which is called a basis point. In this case, the B.C. bonds at 74 basis points higher in yield than the Canadas are 74/100 of 1 percent higher. You will encounter the term “basis points” frequently throughout the book.) To trade these, a trader will observe where the Canadas are trading, add the 74 basis points to the benchmark yield, and then calculate the price for the B.C. bond. Let us say that the Canada 3.5 percent June 1, 2020, is trading at $102.49 to yield 3.1 percent. Now we add the 74 basis point spread and arrive at a yield of 3.84 percent for the B.C.s, which produces a price of $98.87.
Thus, as the liquid, actively traded benchmark issues change in price and yield, so do all the matrixed bonds. The yield spread between the benchmarks and these bonds fluctuates in reaction to supply and demand factors, changes in the yield curve, and changing credit risk perceptions.
The role of investment dealers, then, is to make markets in a wide-ranging list of bonds, bidding for bonds for which there are no apparent buyers or short-selling bonds where they are not sure there are sellers. FIs sell bonds short all the time, either to accommodate demand when they know there will be a seller of the same bond soon, or to hedge long positions (quantities of bonds that they already own). They may also short-sell bonds if they think they have become expensive compared with some other bond. Thus, they are a buffer between the differing needs of a cross-section of bond market participants. These longs and shorts are all held in the dealers’ inventories, which are typically segregated by type (money market, short-term Canadas, mid-term Canadas, long-term Canadas, provincials, strips, and corporates). The dealers hedge these inventories with offsetting transactions in the benchmark issues (or in the futures market) to eliminate or reduce market risk. Bond trading volumes are enormous, averaging approximately five times the daily amount of equity trading (approximately $38.4 billion). Why is this? First of all, the amount of bonds outstanding is huge, exceeding $1.9 trillion in Canada.
Corporations and governments issue bonds all the time for various reasons, such as rolling over maturing debt, paying off bank lines, funding deficits, and building new factories. Investors of all kinds (governments, pension funds, mutual funds, trust companies, life insurance companies, foreign investors, and individual investors) all have varying fixed-income needs, and these needs change over time. Some of these investors trade for speculative reasons; others think they can outsmart their peers by aggressive trading; while still others merely match the term of their assets and liabilities. In addition, new issues come to market that may be more attractive than bonds already owned. As well, bonds mature, making money available for reinvestment, or as they shorten in term over time, investors may wish to sell them in order to buy ones with a longer term to maturity.
What Does the Bond Market Look Like?
The bond market is largely invisible, being decentralized, over-the-counter, and with no post-trade disclosure in Canada yet. The United States has its Trade Reporting and Compliance Engine (TRACE) system and we are studying this approach now. I discuss this in more detail in the section on transparency beginning on page 51. It resembles an onion with a series of layers. At the heart of the Canadian bond market is the Bank of Canada, which is in charge of monetary policy and open-market operations in the foreign exchange, money market, and bond markets.
Next come the money market “jobbers,” whose role is to ensure the orderly maintenance of the money market, including the issuance of Government of Canada treasury bills. The money market is defined as securities issued with a term to maturity of one year or less. Treasury bills are obligations issued by the various governments. They are issued at a discount from their face value and mature at their face value so all the yield is in the amortization from that discounted amount.
Primary Dealers for Bonds
BMO Nesbitt Burns, Inc.
Casgrain and Co., Ltd.
CIBC World Markets Inc.
Desjardins Securities
Deutsche Bank Securities Ltd.
HSBC Securities (Canada)
Merrill Lynch Canada Inc.
Laurentian Bank Securities Inc.
National Bank Financial Inc.
RBC Dominion Securities Inc.
Scotia Capital Inc.
The Toronto Dominion Bank
Then we have the primary dealers, many of whom are also jobbers. Among other things, they are required to bid for the auction of the Government of Canada’s primary bond issues. They do the bulk of the underwriting of new provincial and corporate debt, make markets in the complete array of fixed-income products, and service the fixed-income needs of the various institutional and retail investors by maintaining extensive inven-tories and bidding and offering on all sizes of blocks of bonds. Individual trades can be in the hundreds of millions or as little as $5,000. The lion’s share of the daily $38.42 billion trading volume takes place among the Big Six investment dealers (at the time of writing, they were RBC Dominion Securities, TD Securities, CIBC World Markets, BMO Nesbitt Burns, Scotia Capital, and National Bank Financial) and their institutional and global customers. The market for individual investors is approximately 2 to 3 percent of this total. The other 97 to 98 percent is in the institutional area, where the bank-owned dealers (plus a few non-bank-owned dealers, such as Merrill Lynch Canada, Desjardins Securities, Casgrain and Co., Laurentian Securities, Penson, and HSBC) make wholesale markets in all the various fixed-income products to serve the investment needs of their institutional customers. These customers include life insurance companies, chartered banks, pension funds, mutual funds, investment counsellors, governments, and foreign investors.
It is worth pausing to note that the money that these institutions have for investment represents the aggregate savings of individuals like you! Your money is mixed in with everyone else’s, thus giving the institutions very large sums of money to invest and trade. A large percentage of this money is invested in fixed-income securities to satisfy actuarial requirements, match liabilities, and guarantee fixed returns. With large blocks of money to invest, these institutions command and receive the best prices. The investment dealers vie for this business: competitive tendering for bids and offerings is the norm, and individual trades exceeding $100 million are commonplace.
Naturally, all of the bank-owned dealers serve individual investors, since they all have national sales forces of IAs. There are another 210 members of the self-regulatory body which goes by the unwieldy title of Investment Industry Regulatory Organization of Canada (IIROC), who transact fixed-income securities. There are large, independent firms such as Blackmont Capital (now MacQuarie Private Wealth), Canaccord, and GMP Capital, as well as a host of small- and medium-sized investment dealers such as Odlum Brown, Haywood Securities, and Dundee Securities.
Each of these firms has to find fixed-income products somewhere in order to satisfy their customers’ needs. The bank-owned dealers help to meet these needs. They offer, via electronic delivery, retail quantities and prices of the various fixed-income products. TD Securities, Merrill Lynch, and RBC Dominion Securities are prominent in this area. In addition, Penson, Laurentian Securities, and HSBC also contribute to market making in this space. As well, a company called Perimeter CBID aggregates prices and offerings from a number of contributors and makes them available to all these same small dealers
