of the larger independents, such as MacQuarie, Dundee, Canaccord, and Odlum Brown, have their own specific fixed-income trading departments staffed by experienced personnel. They have sufficient capital and technology resources to assemble, maintain, and offer a wide range of fixed-income securities to meet the needs of their IAs’ customers.
My former firm, Blackmont Capital, for example, has a department of four professionals who have enough capital to maintain inventories of sufficient size to adequately serve the needs of their entire sales force. They manage these aggregates on a fully hedged basis to eliminate market risk for the firm and to offer competitive prices at all times. With an online, real-time trading system at their disposal, they can offer their own inventory plus fixed-income securities that they do not own. This is possible owing to the presence of actively traded, large bond issues for which there exists a known market.
Knowing what spread they trade at in relation to one of the benchmark issues makes it easy to offer a security without owning it. In fact, the benchmark prices are fed electronically into this system as they change, ensuring that the IAs’ customers are always seeing live prices. Also, in a typical sales force, some clients are selling securities that others will be buying. Knowing this, the trading department will keep and hedge the sold securities for later resale to its own sales force rather than to “the street,” the large market-making investment dealers mentioned earlier. This is an efficient way to do business, and customers benefit through better prices. Running to and from the wholesale market for every small transaction is very expensive. Yet, that is what the smaller dealers must do, as they do not have the personnel, capital, or the inclination to keep an inventory themselves.
It is also worthwhile pointing out the different philosophies of the various investment dealers with respect to how they treat individual fixed-income investors. Most of the bank-owned dealers treat their retail customer base as a captive audience and therefore charge more for individual bonds than the smaller, more focused firms. What you need to know is whether the FI you are dealing with treats the retail fixed-income market as a profit centre or not. The best ones work at growing the business through value-added service and competitive prices. Make a point of ascertaining what approach your FI uses.
Also, there are interdealer brokers (IDBs) whose role is to act as middlemen, facilitating anonymous trades among the jobbers, primary dealers, and investment dealers. The most prominent ones in Canada are Shorcan (owned by the TMX) and Freedom (owned by Cantor Fitzgerald and the Canadian banks). The trades are done anonymously so that the dealer in question does not give up any trade secrets to his counterparties (read competitors). Also, it means that each dealer does not have to make multiple phone calls to attempt a transaction. The IDB displays everyone’s bids and offerings electronically and pockets a brokerage fee on each transaction. These parties trade among themselves to offset transactions done with clients.
Last, we come to the individual investor whose needs are served by the different FIs. Individuals have their own specific reasons for purchasing fixed-income products directly: to generate income, to plan for retirement, and to provide safety of principal. They may need income in a foreign currency, they may wish to speculate on the price movement of bonds, or they might want to invest some money for future educational needs. Direct investment by individuals in the bond market, including GICs and ETFs, totals several hundred billion dollars.
The Case for Bonds
Why go through the bother of purchasing individual fixed-income securities? Why not take the easy route and invest in a nice bond mutual fund or ETF? The answer to the second question is that it is not in your best interest to do so! Mutual bond funds and ETFs simply do not offer the certainty required in retirement planning; their performance is erratic, and the management fees are too high. I speak from experience. For five years I managed what is now the largest mutual bond fund in Canada.
Sadly, there are too few IAs with sound enough working knowledge of fixed-income markets. The line of least resistance for them is to recommend bond mutual funds because they are an easier sell and the fees are attractive. However, they are not the ideal choice for the individual investor. Here are five reasons to choose individual fixed-income products.
Planning. Fixed-income products have specific maturity dates. That is, you know the exact date at which your principal will be returned to you and what your yield will be for the term that you hold this security. Contrast this with bond mutual funds: They do not have a specific maturity date, nor do they have a specified income level. Investors do not know what their investment will be worth at any moment or what it will be worth when they actually need their money back. Bond fund managers are constantly tinkering with their portfolios, shortening term, extending term, and trading for capital gains. This is not conducive to effective planning.
Fees. Bond funds charge management fees averaging approximately 1.66 percent per annum! ETFs offer lower management expense ratios (MERs). This takes a serious bite out of an investor’s income and return. Contrast that with individual products, where there is a one-time fee at the time of purchase (averaging 1/2 to 1 percent) with no further fees until they mature and the money is reinvested or if they are sold before maturity.
Performance. The long-term results of “professional” bond fund managers are not impressive, for a couple of reasons. First, it is a well-documented fact that no one is 100 percent sure of where interest rates are going. All forecasters, traders, and market commentators are right some of the time, but nobody is right all of the time. However, this does not stop portfolio managers from guessing using a technique with the more elegant name of “rate anticipation trading.” It only takes a couple of bad guesses for performance to suffer. Second, there is indexing in the bond fund management business, too, as brave portfolio managers huddle around the different bond indices in order to look good in the performance game and earn those bonuses for their professional management. They strive to beat the index as well as more than half of their peers so they will be able to market above-average performance. Also, consider that bond funds are required to calculate an annual return since they do not have a fixed maturity date. Investors owning individual bonds do not have to worry about annual returns since their yield and maturity date are known at the time of purchase. A good analogy is a baseball game. Individual investors in specific fixed-income securities know the outcome of the game before it starts even though the score (the annual return) may vary by inning. Bond fund holders have to worry every inning since they may have to leave the stadium before the end of the game without knowing the outcome.
It is difficult to have negative performance in the bond market.
Here are the annual performance results from 2002 for the broad Canadian Government Index and the Canadian Corporate Index as provided by Merrill Lynch Canada.
Corporate bonds just barely turned in a positive return in 2008 while the only negative performance came from government bonds in 2009. The principal reason for bonds to return positive returns on a consistent basis is the interest paid on bonds and the reinvestment of that interest. Granted that bond yields fell on a net basis since 2002, nevertheless there were lots of negative months. The bond market is one market where investors are advised not to sell into weakness.
Following is a table showing a group of Canada and corporate bonds with three-, five-, seven-, and ten-year maturities. Using current market yields, I increased the yield by 100 basis points or one full percent for a one- and two-year period. For good measure, I increased the yield by 200 basis points for the two-year period.
A few things stand out. For one, the lower the starting yield, the more negative the return for a given increase in yield. This makes sense as the income to be reinvested is less than that of higher yielding bonds. Thus, the corporate bonds would outperform all the government bonds for these
