CSC Volume 1 Chapter 6.pdf

SECTION 3 INVESTMENT PRODUCTS 6 Fixed-Income Securities: Features and Types 7 Fixed-Income Securities: Pricing and Trading 8 Equity Securities: Common and Preferred Shares 9 Equity Securities: Equity Transactions 10 Derivat...

SECTION 3 INVESTMENT PRODUCTS 6 Fixed-Income Securities: Features and Types 7 Fixed-Income Securities: Pricing and Trading 8 Equity Securities: Common and Preferred Shares 9 Equity Securities: Equity Transactions 10 Derivatives © CANADIAN SECURITIES INSTITUTE  Fixed-Income Securities: Features and Types 6 CHAPTER OVERVIEW In this chapter, you will learn about the fixed-income marketplace and the rationale for using fixed-income securities. You will become familiar with the terminology used to discuss bonds, debentures, and other types of fixed-income securities, and you will learn to distinguish among the different types used by governments and corporations. Finally, you will learn how to read bond quotes and ratings. LEARNING OBJECTIVES CONTENT AREAS 1 | Describe the fixed-income marketplace and The Fixed-Income Marketplace the rationale for issuing debt securities. 2 | Define the terminology, main features, and The Basic Features and Terminology characteristics of the various fixed-income of Fixed‑Income Securities securities. 3 | Summarize the features and characteristics Government of Canada Securities of Government of Canada securities. 4 | Summarize the features and characteristics Provincial and Municipal Government of provincial and municipal government Securities securities. 5 | Summarize the features and characteristics Types of Corporate Bonds of corporate bonds. 6 | Summarize the features and characteristics Other Fixed-Income Securities of other fixed-income securities. 7 | Interpret bond quotes and ratings. How to Read Bond Quotes and Ratings © CANADIAN SECURITIES INSTITUTE 6 2 CANADIAN SECURITIES COURSE      VOLUME 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. after-acquired clause extendible bond premium bond face value principal bond residue first mortgage bond protective provisions call protection period fixed-income securities purchase fund callable bond floating-rate securities real return bond collateral trust bond forced conversion redeemable bond commercial paper foreign bond retractable bond conversion price foreign pay bond serial bond conversion privilege guaranteed investment sinking fund certificate convertible bond strip bond index-linked notes coupon rate subordinated debenture instalment debenture debenture term deposit liquid bonds debt security term to maturity market price denominations Treasury bill marketable bonds discount trust deed maturity date domestic bond variable-rate securities mortgage election period yield to maturity negotiable bonds equipment trust certificate zero-coupon bond par value Eurobond © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      FIXED-INCOME SECURITIES: FEATURES AND TYPES 6 3 INTRODUCTION Governments, corporations, and many other entities borrow funds to finance and expand their operations. In addition to bank lending and private loans, these entities also have the option of issuing fixed-income securities in the financial markets. From the investor’s perspective, purchasing a fixed-income security essentially represents the decision to lend money to the issuer. Investors become creditors of the issuing organization. They do not gain ownership rights, as they would with an equity investment. Many investors overlook the fixed-income market. Trading activity on the Toronto Stock Exchange (TSX) and other international stock markets grabs most of the investing public’s attention. Trading in bonds, Treasury bills (T-bills), and other fixed-income securities tends to be less transparent than other investments, such as exchange-traded funds listed on the TSX. Most investors would be surprised to learn the magnitude of the fixed-income market. To put it in perspective, the dollar amount traded on Canada’s bond markets consistently averages about 10 times that of total equity trading in any given year. The significance of the bond and fixed-income markets gives you an appreciation of the importance of having a thorough understanding of the features, characteristics, and terminology of the fixed-income market. This chapter provides a primer on all aspects of fixed-income securities. THE FIXED-INCOME MARKETPLACE 1 | Describe the fixed-income marketplace and the rationale for issuing debt securities. Fixed-income securities represent debt of the entity that issues them. As such, you will often hear the term debt securities to describe them. The terms of a fixed-income security include a promise by the issuer to repay the maturity value, or principal, on the maturity date, and to pay interest either at stated intervals over the life of the security or at maturity. In most cases, if the security is held to maturity, the rate of return is fairly certain. Interest payments paid by issuers are taxed as ordinary income. Fixed-income securities trading in today’s markets come in many varieties, including bonds, debentures, money market instruments, mortgages, and even preferred shares. The various types reflect widely different borrowing needs and investor demands. Issuers of fixed-income securities can modify the terms of a basic security to suit both their needs and costs, and to provide acceptable terms to various lenders. THE RATIONALE FOR ISSUING FIXED-INCOME SECURITIES Corporations and governments regularly raise money to finance their operations by issuing fixed-income securities. Governments fund their programs and other obligations largely through tax revenue. However, when a government spends more on those obligations than it receives in tax revenue, it must make up the difference by borrowing money. Most governments borrow by issuing fixed-income securities. Unlike governments, companies have various choices available when their expenses outweigh their revenue; issuing fixed-income securities is one option. They can also raise cash by selling assets, borrowing from a bank, or issuing equity securities. The choice of financing method depends on the cost, given that companies generally prefer to raise money by the cheapest means possible. Although companies issue fixed-income securities for various purposes, two particular reasons are commonly cited: To finance operations or growth To take advantage of financial leverage © CANADIAN SECURITIES INSTITUTE 6 4 CANADIAN SECURITIES COURSE      VOLUME 1 EXAMPLES Two examples of financing operations or growth: A company wants to invest and expand its current operations so that it can meet the increasing demand for its product lines. The company decides to announce a new bond issue for “general corporate purposes”. A corporation is interested in purchasing a company that specializes in making paper bags for grocery store chains. The cost of the purchase is $3 million. The corporation does not want to spend any of its available cash on the purchase, so instead it issues $3 million in bonds. The proceeds from the bond issue are used to complete the purchase, and the borrowing costs are paid out from the corporation’s revenue stream. An example that takes advantage of financial leverage: Financial leverage refers to using borrowed funds to seek magnified percentage returns on an investment. Consider a company that wants to open a new plant to increase its production capacity. The company issues $1 million in bonds at 10% interest, at a cost of $50,000 a year after tax. The expanded capacity is expected to increase after-tax profits by more than $100,000 a year. The company proceeds with the project because it can increase the return on shareholders’ equity by borrowing the money. In other words, the expected return from investing the borrowed funds is greater than the cost of borrowing. When the return from borrowing is higher than the borrowing cost, the result is the successful use of financial leverage. THE BASIC FEATURES AND TERMINOLOGY OF FIXED-INCOME SECURITIES 2 | Define the terminology, main features, and characteristics of the various fixed-income securities. In most cases, when people speak of fixed-income securities, they are referring to bonds. However, other types of fixed-income securities also exist, which we will discuss later in this chapter. A bond is a long-term, fixed-obligation debt security that is secured by physical assets—such as a building or a railway car—owned by the issuing company. Bonds are considered fixed-income securities because they impose fixed financial obligations on issuers—that is, the payment of regular interest payments and the return of principal on the date of maturity. The details of a bond issue are outlined in a legal document called the trust deed and written into a bond contract. If the issuer can no longer meet the fixed obligations, the bond goes into default. When that happens, the provisions of the trust deed allow the bondholders to seize specified physical assets and sell them to recover their investment. A debenture is a type of bond that is secured by something other than a specified physical asset, typically by a general claim on residual assets. Therefore, the debenture is backed by the general creditworthiness of the issuer. For this reason, debentures are also referred to as unsecured bonds. Aside from this difference, debentures are similar to bonds, and as such, they promise the payment of regular interest and the repayment of principal at maturity. In this chapter, we follow the industry practice of referring to both bonds and debentures as bonds, unless the difference is important. For example, government bonds are never secured by physical assets, and so technically they are debentures; in practice, however, they are always referred to as bonds. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      FIXED-INCOME SECURITIES: FEATURES AND TYPES 6 5 BOND TERMINOLOGY Table 6.1 defines the important characteristics of a bond. Table 6.1 | Characteristics of a Bond Par value The par value of a bond (also called face value) is the principal amount the bond issuer contracts to pay at maturity to the bondholder. A bond is issued and matures at its par value. Coupon rate The coupon rate, or simply the coupon, is the interest or rate paid by the bond issuer relative to the bond’s par or face value over the term of the bond. The coupon represents the regular interest the bond issuer is obliged to pay to the bondholders. Most bonds are coupon bonds, paying fixed coupon rates. Most bonds make semi-annual coupon payments; some bonds pay coupons on an annual basis. The coupon rate is set at the time of issue and typically does not change over the term of the bond. The bondholders receive a fixed-income stream of payments based on that coupon rate. As you will learn in the chapter on bond pricing, changes in market interest rates impact the value and price of a bond. As interest rates rise and fall, relative to the coupon rate, the price or value of a bond will also rise and fall accordingly. However, the coupon payments are not impacted by changes in interest rates. Maturity date The maturity date is the date at which a bond matures, when the principal amount of the loan is paid back to the investor holding the bond. Upon maturity, the final interest payment is also made. Term to maturity The term to maturity is the time that remains before a bond matures. Bond price The bond price is the present discounted value of all the future payments that the bond issuer is obligated to pay the investor. Specifically, the bond price is the sum of the present value of all future interest payments plus the present value of the future repayment of the loan upon maturity. Alternatively, you can think of it as the price you would pay today to earn interest every six months and receive the principal repayment upon maturity. Once a bond is issued, it can trade at a value that is equal to, above, or below its par value depending on the direction of market interest rates. The price of a bond is quoted using an index with a base value of 100. For example, $1,000 par value with a price quoted at 97 refers to a price of $97 for each $100 of face value. Since there are 10 units of $100 face value in a $1,000 bond, the price of a bond with a $1,000 face value and a price quote of 97 would be $970. Yield to maturity The yield to maturity is the annual return on a bond that is held to maturity. You will learn more about this concept in the chapter on bond pricing and trading. © CANADIAN SECURITIES INSTITUTE 6 6 CANADIAN SECURITIES COURSE      VOLUME 1 EXAMPLE A $1,000, 6%, semi-annual coupon bond due January 10, 2037 will pay $30 to the bondholder on January 10 and on July 10 of each year until maturity. The semi-annual payment of $30 represents the fixed obligation that the issuer is required to make for the life of the bond. The yield to maturity on the bond on January 10, 2024 is 5.2% and trades at a price of 107.491 for a total cost of $1,074.91. The characteristics of this bond are summarized as follows: $1,000 Upon maturity, the issuer will pay back to the bondholder the principal amount of $1,000, which represents par value, or the face value, of the bond. 6% The issuer pays the bondholder a coupon rate of 6%, which is paid in amounts of $30 twice a year. January 10, 2037 The maturity date of the bond is January 10, 2037. 13 years The term to maturity of the bond is 13 years (January 10, 2024 to January 10, 2037). 107.491 The bond price is 107.491, which means each $100 of face value will cost $107.491 to purchase. Based on the quoted price of 107.491, the price of a $1,000 face value bond is currently 107.491% of its face value, or $1,074.91 (calculated as 107.491 / 100 × $1,000). In other words, the $1,000 face value bond has 10 units of $100 face value and therefore costs 10 × $107.491. 5.2% The yield to maturity on the bond (the annual return if purchased on January 10, 2024, and held to maturity) is 5.2%. BOND FEATURES Bonds come in many varieties, but most bonds have certain features in common, including those described below. INTEREST ON BONDS A bond’s coupon indicates the income the bondholder will receive. Therefore, the coupon is also referred to as interest income, bond income, or coupon income. Most bonds pay a fixed coupon rate, although some bonds have variable rates (referred to as floating-rate securities). Interest payments can take the following forms: Coupon rates can change over time, according to a specific schedule, as with step-up bonds, and most types of savings bonds. Interest can be compounded over time and paid at maturity, rather than periodically, as with strip bonds (coupons and residuals). A rate of interest does not have to be applied; the loan can be compensated in the form of a return based on future factors, such as the change in the level of an equity index. These types of securities are called index- linked notes. In North America, the majority of bonds pay interest twice a year, at six-month intervals. Other bonds may pay interest monthly or yearly. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      FIXED-INCOME SECURITIES: FEATURES AND TYPES 6 7 DID YOU KNOW? The majority of bonds pay interest semi-annually. For the purposes of this course, you can assume that bonds pay interest twice yearly unless stated otherwise. In all cases, the amount of interest at each payment date is equal to the coupon rate divided by the number of payments per year. DENOMINATIONS Bonds can be purchased only in specific denominations. Normally, an issue designed for a broad retail market is issued in smaller denominations, the most common being $1,000 and $10,000. Larger denominations may be issued to suit the preference of investing institutions, such as banks and life insurance companies. These denominations may be worth millions of dollars. BOND PRICING A bond trading at a quoted price of 100 is said to be trading at par (i.e., at face value). A bond trading below par—at a price of 98, for example—is said to be trading at a discount (i.e., based on the index of 100, the bond is trading at 98% of face value). A bond trading above par—at a price of 104, for example—is said to be trading at a premium. Market interest rates, relative to the coupon on a bond, are a key determinant of the price of a bond. You will learn more about this concept in the chapter on bond pricing and trading. BOND YIELDS A bond yield, also referred to as what a bond is yielding, represents the amount of return on the bond. There are several types of yields, including yield to maturity which we mentioned above. The interest income that you earn on a bond divided by its face value is another type of yield. We can also determine the current yield on a bond by dividing the coupon income by the current market price. As you will learn in the chapter on bond pricing and trading, while the coupon income on a bond stays constant over its term, yield and price fluctuate day to day. TERM TO MATURITY Bonds can be grouped into three categories according to their term to maturity: Short-term bonds have more than one year but less than five years remaining in their term. Medium-term bonds have terms of five to 10 years. Long-term bonds have terms greater than 10 years. Certain bonds that have a term to maturity of up to one year trade as money market securities. Money market securities are a special type of short-term, fixed-income security, generally with a term of one year or less. These securities include T-bills and commercial paper, but some high-grade bonds also qualify when their terms are reduced below the one-year mark. DID YOU KNOW? A bond that was issued eight years ago with an original term of 15 years is no longer a 15-year bond. Because eight years have passed, and only seven remain in the life of the bond, it is now a seven-year bond. In other words, providing that it is not called before its maturity date, a bond classified as a long-term bond when first issued becomes, over time, a medium-term bond, a short-term bond, and, eventually, a money market security. © CANADIAN SECURITIES INSTITUTE 6 8 CANADIAN SECURITIES COURSE      VOLUME 1 LIQUIDITY, NEGOTIABILITY, AND MARKETABILITY Liquidity, negotiability, and marketability all refer to the ease with which bonds can be traded. Liquid bonds trade in significant volumes. Medium and large trades can be made quickly without a significant sacrifice on the price. For example, Government of Canada bonds have very good liquidity given that there is an active market for these bonds, i.e., they are generally in high demand by both domestic and international investors. Negotiable bonds can be transferred because they are in good delivery form. Among other things, good delivery generally refers to a time when actual paper copies of bonds and fixed-income securities were delivered between investment dealers. Today, a bond’s negotiability is not really an issue because most bonds are electronically recorded by depositories that keep track of ownership. Marketable bonds have a ready market. For example, a private placement or other new issue may have clients willing to buy it because its price and features are attractive. However, marketable bonds are not necessarily liquid because most private placements do not have an active secondary market. STRIP BONDS A strip bond (also called a zero-coupon bond) is created when a dealer acquires a block of high-quality bonds and separates the individual, future-dated interest coupons from the rest of the bond (known as the underlying bond residue). The dealer then sells each coupon, as well as the residue, separately at significant discounts to their face value. Holders of strip bonds receive no interest payments. Instead, the strips are purchased at a price that provides a certain compounded rate of return when they mature at par. Strip bonds typically trade at a discount to their par value. The income on strip bonds is considered interest income rather than a capital gain. Tax must be paid annually on the interest income, even though that income is not received until the bond matures. Therefore, it is often recommended that strip bonds be held in a tax-deferred plan such as a registered retirement savings plan. DID YOU KNOW? A capital gain occurs when property such as stocks or bonds is sold at a price that is higher than the purchase price. Conversely, a capital loss occurs when such property is sold at a lower price than the purchase price. EXAMPLE An investment dealer buys $10 million face value of a five-year, semi-annual pay Government of Canada bond with a coupon of 5.50%, intending to strip the bond for sale to clients. With this bond, the dealer can create 10 different strip coupons, each with a face value of $275,000 (calculated as $10 million × 0.055 × 0.5). Each coupon will have its own maturity date. The face value of each strip coupon is equal to the dollar value of each interest payment on the regular bond. The bond’s principal repayment can be sold as a residual with a face value of $10 million. The strip coupons are then sold at a discount to the $275,000 face value. For this example, let’s assume that the coupon payable in three years sells today for $233,690. If you were buying this strip bond today and holding it until the coupon’s payment date, you would receive $275,000 in three years. The strip bond does not generate any other regular income for the investor during the three-year period. Note that bond price calculations are covered in Chapter 7. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      FIXED-INCOME SECURITIES: FEATURES AND TYPES 6 9 CALLABLE BONDS Bond issuers often reserve the right, but not the obligation, to pay off the bond before maturity, either to take advantage of lower interest rates or simply to reduce their debt when they have the excess cash to do so. This privilege is known as a call or redemption feature. A bond bearing this clause is known as a callable bond or redeemable bond. As a rule, the issuer agrees to give notice of 10 to 30 days that the bond is being called or redeemed. In Canada, most corporate and provincial bond issues are callable. However, Government of Canada bonds and municipal debentures are usually non-callable. STANDARD CALL FEATURES A standard call feature allows the issuer to call bonds for redemption at a specified price on either specific dates or specific intervals over the life of the bond. The call price is usually set higher than the par value of the bond, which provides a premium payment for the holder. The premium is a compensation to the investor, who no longer has an investment that was expected to receive a stated income for a certain number of years. The closer the bond is to its maturity date before it is redeemed, the less the hardship for the investor. Therefore, the redemption price is often set on a graduated scale, with the premium payment becoming lower as the bond approaches its maturity date. Provincial bonds are usually callable at 100 plus accrued interest (i.e., interest that has accumulated since the last interest payment date). Accrued interest belongs to the holder of the bond. The period before the first possible call date (during which a callable bond cannot be called) is known as the call protection period. EXAMPLE DEF Corporation’s 7.375% debentures are due May 1, 2029. They are not redeemable before May 1, 2025. Starting May 1, 2025, they are redeemable according to the following payment schedule on 30 days’ notice, up to the 12 months ending April 30 of each year: From May 1, 2025 to April 30, 2026 at 103.68 From May 1, 2026 to April 30, 2027 at 102.46 From May 1, 2027 to April 30, 2028 at 101.23 From May 1, 2028 and thereafter at 100.00 (at par to maturity) Suppose you own a $1,000 debenture of this issue and the debenture is called. The following are examples of payment received, depending on what date it is called: Called on January 31, 2026: $1,036.80 plus accrued interest. Called on August 15, 2026: $1,024.60 plus accrued interest. Called on March 20, 2028: $1,012.30 plus accrued interest. Called on December 1, 2028: $1,000.00 plus accrued interest. EXTENDIBLE AND RETRACTABLE BONDS Some corporate bonds are issued with extendible or retractable features. Extendible bonds and debentures are usually issued with a short maturity term (typically five years), but with an option to extend the investment. This option means that the investor can exchange the debt for an identical amount of longer-term debt (typically 10 years) at the same rate or a slightly higher rate of interest. In effect, the maturity date of the bond can be extended so that the bond changes from a short-term bond to a long-term bond. © CANADIAN SECURITIES INSTITUTE 6 10 CANADIAN SECURITIES COURSE      VOLUME 1 EXAMPLE GHI International Inc. 7% Extendible Junior Bonds, Series B2.1, due July 26, 2025, are extendible to July 26, 2030 from July 26, 2025 at a rate of 7.125%. Retractable bonds are the opposite of extendible bonds. They are issued with a long maturity term but with the option to redeem early. The maturity date is usually at least 10 years, but investors have the right to redeem the bonds at par by a retraction date (which is typically five years earlier than the maturity date). EXAMPLE JKL Inc. 4% bonds are due on June 30, 2030 and are retractable at par on June 30, 2025. With both extendible and retractable bonds, the decision to exercise the maturity option must be made during a specific time called the election period. In the case of an extendible bond, the election period may last from a few days to six months, or more, before the short maturity date. During the election period, the holder must notify the appropriate trustee or an agent of the debt issuer to either extend the term of the bond or allow it to mature on the earlier date. If the holder takes no action, the bond automatically matures on the earlier date and interest payments cease. In the case of a retractable bond, if the holder does not notify the trustee or agent before the retraction date of his or her decision to shorten the term of the bond, the debt remains a longer-term issue. CONVERTIBLE BONDS AND DEBENTURES Convertible bonds and convertible debentures (often called convertibles) combine certain advantages of a bond with the option of exchanging the bond for common shares. In effect, a convertible security allows an investor to lock in a specific price (called the conversion price) for the common shares of the company. The right to exchange a bond for common shares on specifically determined terms is called the conversion privilege. Convertible bonds are like regular bonds; they have a fixed interest rate and a definite date on which the principal must be repaid. However, they offer the possibility of capital appreciation through the right to convert the bonds into common shares at the holder’s option, at stated prices over stated periods. Convertible bonds therefore offer the investor the potential to share in the company’s growth. The conversion privilege makes a bond more attractive to investors, and thus more saleable. It not only tends to lower the cost of the money borrowed; it may also enable a company to raise equity capital indirectly on terms that are more favourable than the terms for the sale of common shares. CHARACTERISTICS OF CONVERTIBLE BONDS The conversion price of most convertible bonds goes up gradually over time to encourage early conversion. Convertible bonds may normally be converted into stock at any time before the conversion privilege expires. However, some convertible debenture issues have a clause in their trust deeds that stipulates “no adjustment for interest or dividends”. This clause excuses the issuing company from having to pay any accrued interest on the convertible bond that has built up since the last designated interest payment date. Similarly, any common stock received by the bondholder from the conversion normally entitles the holder only to those dividends declared and paid after the conversion takes place. Some convertibles will also have a protection against dilution clause, where if the common shares of the company are split the conversion privilege will be adjusted accordingly. (A stock split occurs when the issuing company decides to increase the number of shares outstanding. You will learn more about stock splits in the chapter on common shares.) Convertibles are normally callable, usually at a small premium and after reasonable notice. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      FIXED-INCOME SECURITIES: FEATURES AND TYPES 6 11 FORCED CONVERSION Forced conversion is an innovation built into certain convertible debt issues to give the issuing company more control in calling in the debt for redemption. The conversion forces bondholders to convert the company’s bonds into a predetermined number of common shares. The issuing company will typically be interested in forcing a conversion when market interest rates fall below the bond’s coupon rate, or if the price of the underlying common shares begins to trade above the conversion price. This redemption provision usually states that, once the market price of the common stock involved in the conversion rises above a specified level and trades at or above this level for a specific number of consecutive trading days, the company can call the bonds for redemption at a stipulated price. The price at which the company calls the bonds back is much lower than the level at which the convertible debt would otherwise be trading because of the rise in the price of the common stock. A forced conversion is an advantage to the issuing company, rather than to the debt holder, for several reasons: It relieves the issuer of the obligation to make interest payments on debt once investors convert their debt into equities. It can free up room for new debt financing if needed. However, a forced conversion is not so disadvantageous to the bondholder that it detracts from an issue when it is first sold. Once the price of the convertible debt rises above par, subsequent prospective buyers should check the spread between the prevailing purchase price and the possible forced conversion level. EXAMPLE Assume that you own 7% convertible bonds of RFC Inc. that are due February 1, 2029. Before February 1, 2026, the bonds are convertible into 44.033 common shares for each $1,000 of face value. Each common share under this arrangement has a conversion price of $22.71 (calculated as $1,000 ÷ 44.033). The bonds are not redeemable by the company before February 1, 2024. The company has the option to pay you the principal amount on redemption or maturity, or to pay you in common shares. The number of common shares is obtained by dividing $1,000 by 95% of the weighted average trading price for 20 consecutive trading days on the TSX, ending five days before maturity or the date fixed for redemption. This provision is considered to be a forced conversion clause because you must choose whether to convert the bond into common shares at $22.71 a share or accept the company’s redemption offer. The second option could force you to pay a considerably higher price per share. For example, if the weighted average price was $27, the company would divide $1,000 by $25.64 (calculated as 95% × $27) to arrive at 39 shares. You would receive 39 shares, compared to 44.033 shares if you had chosen to convert before the forced conversion was imposed by the issuer. MARKET BEHAVIOUR OF CONVERTIBLES The market price of convertible bonds and debentures is influenced by their investment value as a fixed-income security and by the price of the common shares into which they can be converted. When the stock price of the issuing company is below the conversion price, the convertible behaves like any other straight fixed-income security with the same features. However, because these bonds can be converted into common shares, their price behaves differently than comparable straight fixed-income securities. When the price of the underlying stock rises above the conversion price (the bond price divided by the number of shares that the bond can be converted into), the bond price rises accordingly. Conversely, even if interest rates rise sharply, the bond price will not drop below the conversion price. © CANADIAN SECURITIES INSTITUTE 6 12 CANADIAN SECURITIES COURSE      VOLUME 1 EXAMPLE Assume you own an ABC 6% convertible bond that trades at $980 and can be converted into 40 ABC common shares that currently trade at $22 a share. Even if interest rates rise sharply and comparable bonds that are not convertible fall in price, the ABC bond will have a conversion value of at least $880 because it can be converted into 40 common shares that trade at $22 (calculated as 40 shares × $22 = $880). If the common shares now trade at $27, the price of the bond will rise accordingly to at least $1,080, even if the comparable bonds that are not convertible still trade at $980. The reason is simple: the investor holds a security that can be sold today for $1,080 (calculated as 40 shares × $27) if converted. In this example, the conversion price of the ABC convertible is $24.50, which is the bond price divided by the number of shares that the bond can be converted into (calculated as $980 ÷ 40). You can think of the price of $24.50 as the price per share to buy the common stock if the investor purchased those shares by first buying the convertible bond for $980 and then converting the bonds into shares. SINKING FUNDS AND PURCHASE FUNDS Some issuers must repay portions of their bonds for redemption before maturity. They fulfil this obligation in one of two ways: By calling them on a fixed schedule of dates (through a sinking fund obligation) By buying them in the secondary market when the trading price is at or below a specified price (through a sinking fund or a purchase fund) SINKING FUNDS Sinking funds are sums of money that are set aside out of earnings each year to provide for the repayment of all or part of a debt issue by maturity. Sinking fund provisions are as binding on the issuer as any mortgage provision. Some corporate bonds have a mandatory call feature for sinking fund purposes. The issuer will attempt to buy the debt in the secondary market when the price is at or below a specified price. If it is unable to purchase the required amount, it will resort to calling the debt in order to meet its obligations. EXAMPLE ABC 6.89% debentures, due June 17, 2035, have a mandatory sinking fund. The company must retire $1,000,000 of the principal amount on June 17 every year, from 2022 to 2035 inclusive. Any debentures purchased or redeemed by the company other than through the sinking fund can be paid to the trustee as part of the sinking fund obligation. The debentures are redeemable for sinking fund purposes at the principal amount plus accrued interest to the date specified. PURCHASE FUNDS Some companies have a purchase fund instead of a sinking fund, whereby a fund is set up to retire a specified amount of the outstanding bonds or debentures through purchases in the market. The purchases must be available at or below a stipulated price. EXAMPLE DEF Inc. 5.5% debentures, due April 15, 2030, have a purchase fund. Beginning on July 1, 2022, the company must make all reasonable efforts to purchase at or below par 1.125% of the aggregate principal amount during each quarter. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      FIXED-INCOME SECURITIES: FEATURES AND TYPES 6 13 Sinking fund provisions are binding, whereas purchase funds retire bonds only under the right market conditions. Therefore, purchase funds may retire a smaller portion of an issue than a sinking fund depending on market conditions. PROTECTIVE PROVISIONS OF CORPORATE BONDS In addition to principal repayment features, corporate bonds may also have general covenants that secure the bond. The covenants make it more likely for the investor to receive all of the due proceeds. These covenant clauses, also known as protective provisions, are essentially safeguards in the bond contract to guard against any weakening in the security holder’s position. The object is to create a strong instrument that does not force the company into a financial constraint. Some of the more common protective covenants found in Canadian corporate bonds are listed below: Security In the case of a mortgage or an asset-backed or secured debt, this clause includes details of the assets that support the debt. Negative pledge This clause provides that the borrower will not pledge any assets if the pledge results in less security for the debt holder. Limitation on sale This clause protects the debt holder against the firm selling and leasing back assets that and leaseback provide security for the debt. transactions Sale of assets or This clause protects the debt holder in the event that all of the firm’s assets are sold or merger that the company is merged with another company, forcing either the retiring of the debt or its assumption by the newly-merged company. Dividend test This provision establishes the rules for the payment of dividends by the firm and ensures equity will not be drained by excessive dividend payments. Debt test This provision limits the amount of additional debt that a firm may issue by establishing a maximum debt-to-asset ratio. Additional bond This clause states which financial tests and other circumstances allow the firm to issue provisions additional debt. Sinking or purchase This clause outlines the provisions of the sinking or purchase fund and the specific dates fund and call and price at which the firm can call the debt. provisions GOVERNMENT OF CANADA SECURITIES 3 | Summarize the features and characteristics of Government of Canada securities. The Government of Canada issues fixed-income securities to finance deficits, fund its programs, and finance infrastructure projects (highways, transportation networks, water, and electric systems). The different types of government debt issues are described below. © CANADIAN SECURITIES INSTITUTE 6 14 CANADIAN SECURITIES COURSE      VOLUME 1 BONDS The Government of Canada issues marketable bonds in its own name. It also allows Crown corporations to issue debt that has a direct call on the Government of Canada. Government of Canada bonds have a specific maturity date and a specified coupon or interest rate. They are also transferable, which means that they can be traded in the market. EXAMPLE The Farm Credit Corporation, a Crown Agency, issues medium- and long-term notes that are “…direct obligations of Farm Credit and as such will constitute direct obligations of Her Majesty in right of Canada. Payment of principal and interest on the Notes will be a charge on and payable out of the Consolidated Revenue Fund.” All Government of Canada bonds are noncallable; therefore, the government cannot call them for redemption before maturity. When comparing the bonds issued by Canadian issuers (including corporations as well as federal, provincial, and municipal governments), investors assign the highest quality rating to federal government bonds. Foreign investors, on the other hand, compare the quality of Canadian issues to the issues of other governments. The relative risk of investing in each country is reflected in the yields of their bonds, and those yields fluctuate in response to political and economic events. TREASURY BILLS Treasury bills (T-bills) are short-term government obligations offered in denominations from as low as $1,000. These securities appeal to a broad range of investors, including large institutional investors such as banks, insurance companies, and trust and loan companies, as well as to retail investors. T-bills do not pay interest; instead, they are sold at a discount (below par) and mature at 100. The difference between the issue price and par at maturity represents the return on the investment. Under the Income Tax Act, this return is taxable as income, not as a capital gain. Every two weeks, regular T-bills are sold at auction by the Ministry of Finance through the Bank of Canada. These bills have original terms to maturity of approximately three months, six months, and one year. REAL RETURN BONDS Like conventional bonds, real return bonds pay interest throughout the life of the bond and repay the original principal amount upon maturity. Unlike conventional bonds, however, the coupon payments and principal repayment are adjusted for inflation to provide a fixed real coupon rate. At each interest payment date, the real coupon rate is applied to a principal balance that has been adjusted for the cumulative level of inflation since the date the bond was issued. The cumulative level of inflation is known as the bond’s inflation compensation. EXAMPLE Government bonds carrying a 4.25% coupon were priced at 100 at issue date. They provide a real yield of about 4.25% to maturity on December 1, 2025. Both the semi-annual interest payments and the final redemption value of each bond are calculated by including an inflation compensation component. Assume that the rate of inflation (as measured by changes in the consumer price index) was 1.5% over the first six-month period after issue. Therefore, the value of a $1,000 real return bond at the end of the six months was $1,015. The interest payment for the half-year was based on this amount ($1,015), rather than the original bond value of $1,000. At maturity, the maturity amount is calculated by multiplying the original face value of the bond by the total amount of inflation since the issue date. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      FIXED-INCOME SECURITIES: FEATURES AND TYPES 6 15 PROVINCIAL AND MUNICIPAL GOVERNMENT SECURITIES 4 | Summarize the features and characteristics of provincial and municipal government securities. Provincial bonds, like Government of Canada bonds, are actually debentures, which means that they are simply promises to pay. Their value depends upon the province’s ability to pay interest and repay principal. No provincial assets are pledged as security. All provinces have statutes governing the use of funds obtained through the issue of bonds. Provincial bonds are second in quality only to Government of Canada direct and guaranteed bonds because most provinces have taxation powers second only to the federal government. However, different provinces’ direct and guaranteed bonds trade at differing prices and yields. Bond quality is determined by two primary factors: credit quality and market conditions. The credit quality of a province—that is, the degree of certainty that both principal and interest will be paid when due—depends on such factors as the amount of existing debt in the province per capita, the level of federal transfer payments, the stability of the provincial government, and the wealth of the province in terms of natural resources, industrial development, and agricultural production. GUARANTEED BONDS Many provinces also guarantee the bond issues of provincially appointed authorities and commissions. EXAMPLE The Ontario Electricity Financial Corporation’s 8.5% notes, due May 26, 2025, are “Irrevocably and Unconditionally Guaranteed by the Province of Ontario.” Provincial guarantees may also extend guarantees to cover municipal loans and school board costs. In some instances, provinces extend a guarantee to industrial concerns, usually as an inducement to a corporation to locate or remain in that province. Most provinces (and some of their enterprises) also issue T-bills. Investment dealers and banks purchase them, both at tender and by negotiation, usually for resale. In addition to issuing bonds in Canada, the provinces and their enterprises also borrow extensively in international markets. Unlike the federal government, whose policy is to borrow abroad largely to maintain exchange reserves, the provinces resort to foreign markets to take advantage of lower borrowing costs. Their decision to borrow from these markets depends on the foreign exchange rate and financial market conditions. Issues sold abroad are underwritten by syndicates of dealers and banks similar to those that handle foreign financing for Crown corporations of the federal government. In recent years, issues have been sold, for example, payable in Canadian dollars, U.S. dollars, euros, Swiss francs, and Japanese yen. PROVINCIAL SECURITIES Some provinces may offer their own savings bonds with the following characteristics that distinguish them from other provincial bonds: They can be purchased only by residents of the province. They can be purchased only at a certain time of the year. They may have redemption rules, which can vary depending on the province. Some provinces may issue different types of savings bonds. Check with the securities regulator in your province for more information. © CANADIAN SECURITIES INSTITUTE 6 16 CANADIAN SECURITIES COURSE      VOLUME 1 MUNICIPAL SECURITIES Today, the instrument that most municipalities use to raise capital from market sources is the instalment debenture (also called a serial bond). Part of this bond matures in each year of its term. EXAMPLE A debenture of $1 million may be issued so that $100,000 becomes due each year over a 10-year period. The municipality is actually issuing 10 separate debentures, each with a different maturity. At the end of 10 years, the entire issue will have been paid off. Instalment debentures are usually non-callable, which means that the investor purchases them knowing beforehand how long the funds are expected to remain invested. Also, if the money is needed at future specific dates, it can be invested in an instalment debenture so that it will be available when it is needed. Generally, a municipality’s credit rating depends upon its taxation resources. All else being equal, the municipality with a diversified industrial sector is a better investment risk than a municipality built around one major industry. TYPES OF CORPORATE BONDS 5 | Summarize the features and characteristics of corporate bonds. Corporations have more choices than governments to raise capital. They can sell ownership of the company by selling stocks to investors or they can borrow money from investors by selling fixed-income securities. Generally, corporate bonds have a higher risk of default than government bonds. This risk depends on various factors including the market conditions prevailing at the time of issue, the credit rating of the corporation issuing the bond, and the government to which the bond issuer is being compared. The various types of corporate fixed-income securities are described below. MORTGAGE BONDS A mortgage is a legal document containing an agreement to pledge land, buildings, or equipment as security for a loan. The agreement entitles the lender to take over ownership of these properties if the borrower fails to pay interest or repay the principal when it is due. The lender holds the mortgage until the loan is repaid, at which point the agreement is cancelled or destroyed. The lender cannot take ownership of the properties unless the borrower fails to satisfy the terms of the loan. There is no fundamental difference between a mortgage and a mortgage bond except in form. Both are issued to allow the lender to secure property if the borrower fails to repay the loan. First mortgage bonds are the senior securities of a company. They are so named because they constitute a first charge on the company’s assets, earnings, and undertakings before unsecured current liabilities are paid. In analyzing a company’s financial position, you must study each first mortgage issue to determine exactly what properties are covered by the mortgage. First mortgage bonds are generally regarded as the best security a company can issue, particularly if the mortgage applies to “all fixed assets of the company now and hereafter acquired”. This last phrase, called the after-acquired clause, means that all assets can be used to secure the loan, even those acquired after the bonds were issued. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      FIXED-INCOME SECURITIES: FEATURES AND TYPES 6 17 FLOATING-RATE SECURITIES Floating-rate securities (also called variable-rate securities) are a type of corporate issue that automatically adjusts to changing interest rates. These securities can be issued with longer terms than more conventional issues. Floating-rate securities have proved popular because they offer an advantage to investors during periods of rising interest rates. For example, when interest rates are rising, the interest paid on floating-rate debentures is adjusted upwards at regular intervals of six months, which improves the price and yield of the debentures. The disadvantage of these bonds is that when interest rates fall, the interest payable on them is adjusted downwards at six-month intervals. A minimum rate on the bonds can provide some protection, although the minimum rate is normally relatively low. DOMESTIC, FOREIGN, AND EUROBONDS Bonds can be classified according to where and how they are issued. Domestic bonds are issued in the currency and country of the issuer. Therefore, bonds issued by a Canadian corporation or by the Canadian government, in Canadian dollars, in the Canadian market are domestic bonds. These bonds are the most common type. Foreign bonds are issued outside of the issuer’s country and denominated in the currency of the country in which they are issued. Foreign bonds give the issuers access to sources of capital in other countries. EXAMPLE When a Canadian company issues bonds in U.S. dollars in the United States, these bonds are considered foreign bonds in the U.S. market. They are also called Yankee bonds. When a British company issues yen-denominated bonds in Japan, the bonds are called Samurais and are considered foreign bonds in the Japanese market. When a foreign company issues Canadian dollar-denominated bonds in Canada, the bonds are called Maple bonds and are considered foreign bonds in the Canadian market. Some bonds offer the investor a choice of interest payments in either of two currencies; other bonds pay interest in one currency and the principal in another. These so-called foreign pay bonds offer investors increased opportunity for portfolio diversification while providing the issuer with cost-effective access to capital in other countries. Eurobonds are international bonds issued in a currency other than the currency of the country where the bond is issued. The Eurobond market is a large international market with issues in many currencies, including Canadian dollars. This market attracts both international and domestic investors looking for alternative investments. EXAMPLE Assume that the Canadian government has decided to issue a new bond denominated in U.S dollars in the Euromarket. The news of the issue attracts investors around the globe. However, as a Canadian investor seeking foreign currency exposure, you may also be interested in the new bond. If a Canadian corporation or government issues Eurobonds denominated in Canadian dollars, the bonds are called EuroCanadian bonds. Eurobonds denominated in U.S. dollars are called Eurodollar bonds. Other examples are shown in Table 6.2. © CANADIAN SECURITIES INSTITUTE 6 18 CANADIAN SECURITIES COURSE      VOLUME 1 Table 6.2 | Types of Bonds by Currency and Location Issuer Issued In Currency of Issue Called Canadian Canada CAD Domestic bond Canadian Mexico MXN Foreign bond Canadian France USD Eurobond (Eurodollar) Canadian European Market CAD Eurobond (EuroCanadian) Canadian United States USD Foreign (Yankee) bond Other types of corporate debt issued in the marketplace include the following fixed-income securities: Collateral trust bond Collateral trust bonds are secured by a pledge of securities, or collateral. They differ from mortgage bonds that are secured by a pledge of real property. Collateral trust bonds are issued by companies, such as holding companies, that own few, if any, fixed assets on which they can offer a mortgage. However, they normally own securities of subsidiaries. Equipment trust Equipment trust certificates pledge equipment as security instead of real property. For certificates example, a railway company may issue these kinds of bonds, using its locomotives and train cars (called rolling stock) as security. These certificates are usually issued in serial form, with a set amount that matures each year. Subordinated Subordinated debentures are junior to other securities issued by the company or other debentures debts assumed by the company. The exact status of an issue of subordinated debentures is described in the prospectus. Corporate notes A corporate note is a short-term unsecured promise made by a corporation to pay interest and repay the funds borrowed at a specific date, or specific dates. High-yield bonds High-yield bonds (also called speculative bonds) are considered non-investment grade. These lower credit-quality bonds have a higher risk of default because they are deemed to have greater uncertainty over the issuer’s repayment of their financial obligations. These bonds typically pay higher coupons and have higher yields to compensate investors for the added risk. Investors looking to improve portfolio returns in a low interest rate environment may consider high-yield bonds. Investors can access these bonds through mutual funds and exchange-traded funds that specialize in bond investments. OTHER FIXED-INCOME SECURITIES 6 | Summarize the features and characteristics of other fixed-income securities. Bonds and debentures tend to dominate media reports about the fixed-income securities market. However, you should also be familiar with other types of fixed-income securities, including those described below. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      FIXED-INCOME SECURITIES: FEATURES AND TYPES 6 19 COMMERCIAL PAPER Commercial paper is either an unsecured promissory note issued by a corporation or an asset-backed security backed by a pool of underlying financial assets. Issue terms range from less than three months to one year. Like T-bills, commercial paper is sold at a discount and matures at face value. Commercial paper is issued by large firms with an established financial history. Rating agencies rank commercial paper according to the issuer’s ability to meet short-term debt obligations. These securities may be bought and sold in a secondary market before maturity at prevailing market rates. They generally offer a higher yield than Government of Canada T-bills. TERM DEPOSITS Term deposits offer a guaranteed rate for a short-term deposit (usually up to one year). A penalty normally applies for withdrawing funds before a certain period (e.g., within the first 30 days after purchase). GUARANTEED INVESTMENT CERTIFICATES Guaranteed investment certificates (GIC) offer fixed rates of interest for a specific term. Both principal and interest payments are guaranteed. They can be redeemable or non-redeemable. Non-redeemable GICs cannot be cashed before maturity, except in the event of the depositor’s death or extreme financial hardship. Interest rates on redeemable GICs are lower than non-redeemable GICs of the same term, given that they can be cashed before maturity. Banks can also customize their GICs to provide investors with more choice. For example, investors can choose a very brief term (although, a large investment may be required) or a term of up to 10 years, depending on the amount invested. Investors can choose other features, such as the frequency of interest payments (e.g., monthly, semi- annual, yearly, or at maturity). They can be set to automatically renew at maturity, or they can be sold to another buyer privately or through an intermediary. Many GICs offer compound interest. The various types of GICS and examples of each type are described in Table 6.3. Table 6.3 | Types of Guaranteed Investment Certificates GIC Type Special Feature Example Escalating-rate The interest rate for these GICs increases over Michel invests $1,000 in a three-year GIC the GIC’s term escalating rate GIC. The GIC pays interest of 1.00% in year 1, 1.20% in year 2, and 1.65% in year 3. Laddered GIC* The investment for these GICs is evenly Andira invests $5,000 in GICs that mature divided into multiple-term lengths. As in year 1, year 2, and year 3 for a total each portion matures, it can be reinvested investment of $15,000. After the first or redeemed. This diversification of terms year, when her one-year GIC matures, she reduces interest rate risk. purchases a three-year GIC so that her laddered GIC investment continues. Instalment GIC An initial lump-sum contribution is made Marco invests in a $5,000 GIC and for these GICs, with further minimum arranges to have an additional $100 taken contributions made weekly, bi-weekly, or monthly from his bank account to put monthly. toward buying GICs. © CANADIAN SECURITIES INSTITUTE 6 20 CANADIAN SECURITIES COURSE      VOLUME 1 Table 6.3 | Types of Guaranteed Investment Certificates Index-linked GIC These GICs provide the investor with a return Maura buys a five-year GIC linked to that is linked to the direction of a market the S&P/TSX 60 Index with a 55% index, with the hope that a higher market participation rate. Over five years, the return will generate a higher GIC return than index grows by 61%. Her gain upon would typically be expected from a standard maturity is 55% of the index return, for a GIC. The GIC guarantees a return of the initial total gain on her investment of 33.6%. investment at expiry while providing some exposure to equity markets. They may be indexed to domestic or global indexes or a combination of benchmarks. Interest-rate These GICs offer interest rates linked to the Ajeet buys a one-year cashable GIC with linked GIC change in other rates such as the prime rate, an annual interest rate linked to his bank’s the bank’s non-redeemable GIC interest rate, prime interest rate. If the prime rate or money market rates. changes, the interest rate of his GIC will automatically adjust. *Though more of a strategy than a type, laddered GICs are included in the list of potential GIC types. DID YOU KNOW? Some banks have developed their own GICs with specialized features. For example, some GICs can be redeemed in case of a medical emergency, whereas others are designed as homebuyers’ plans, where regular contributions accumulate for a down payment. FIXED-INCOME MUTUAL FUNDS AND EXCHANGE-TRADED FUNDS The demand for fixed-income mutual funds and exchange-traded funds that specialize in bonds has grown significantly over the past decade. Increased demand is largely due to equity market uncertainty and a low-interest- rate environment. These managed products provide investors with easy access to a diversified portfolio of debt securities for both domestic and global markets that would be difficult for individual investors to replicate. They also include other attractive features, such as professional investment management, liquidity, and low investment costs. Fixed-income mutual funds and exchange-traded funds are particularly attractive for investors who have a limited amount of money to invest or who find investing in individual bonds too complex. FIXED-INCOME SECURITIES Can you describe the features of the various types of fixed-income securities issued by the Government of Canada, provincial and municipal governments, and corporations? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      FIXED-INCOME SECURITIES: FEATURES AND TYPES 6 21 HOW TO READ BOND QUOTES AND RATINGS 7 | Interpret bond quotes and ratings. A typical bond quote is illustrated in Table 6.4. Table 6.4 | ABC Bond Quote Issuer Coupon Maturity Date Bid Ask Yield to Maturity ABC Company 11.5% July 1, 2028 99.25 99.75 11.78% The quote in Table 6.4 is for an 11.5% coupon bond of ABC Company that matures on July 1, 2028. It shows that, at the time reported, the bond could be sold for $99.25 and bought for $99.75 for each $100 of par or principal amount. (Remember that bond prices are quoted as a percentage of par rather than an aggregate dollar amount.) To buy $5,000 face value of this bond would cost $4,987.50 (calculated as $5,000 × 0.9975 = $4,987.50), plus accrued interest. Some media sources publish a single price for the bond, which may be the bid price, the midpoint between the final bid and ask quote for the day, or an estimate based on current interest rate levels. Convertible issues are usually grouped together in a separate listing. In Canada, DBRS, Moody’s Canada Inc. (Moody’s), and the Standard & Poor’s Bond Rating Service (S&P) provide independent rating services for many fixed-income securities. These ratings can help investors assess the quality of their debt holdings and confirm or challenge conclusions based on their own research and experience. Table 6.5 provides an overview of the Moody’s global long-term rating scale. The definitions indicate the general attributes of debt bearing any of these ratings. They do not constitute a comprehensive description of all the characteristics of each category. Similar services in the United States have provided ratings on a ranked scale for many years. Investors closely watch these ratings. Any change in rating, particularly a downgrading, can have a direct impact on the price of the securities involved. From a company’s point of view, a high rating provides benefits such as the ability to set lower coupon rates on issues of new securities. Ratings classify securities from investment grade through to speculative and can be used to compare one company’s ability to meet its debt obligations with those of other companies. The rating services do not manage funds for investors, nor do they buy and sell securities or recommend securities for purchase or sale. DID YOU KNOW? Investment-grade bonds are bonds issued by high-quality issuers such as the federal government, provincial governments, and select corporations. Investment-grade bonds are considered to have adequate credit quality and an acceptable capacity for the payment of financial obligations. These bonds carry a credit rating of Baa3 from Moody’s (or BBB- from S&P, or BBB from DBRS) and higher. © CANADIAN SECURITIES INSTITUTE 6 22 CANADIAN SECURITIES COURSE      VOLUME 1 Table 6.5 shows the rationale Moody’s uses for the various ratings in its long-term rating scale. Table 6.5 | Moody’s Long-Term Rating Scale Rating Description Aaa Obligations rated Aaa are judged to be of the highest quality, subject to the lowest level of credit risk. Aa Obligations rated Aa are judged to be of high quality and are subject to very low credit risk. A Obligations rated A are judged to be upper-medium grade and are subject to low credit risk. Baa Obligations rated Baa are judged to be medium-grade and subject to moderate credit risk, and as such may possess certain speculative characteristics. Ba Obligations rated Ba are judged to be speculative and are subject to substantial credit risk. B Obligations rated B are considered speculative and are subject to high credit risk. Caa Obligations rated Caa are judged to be speculative, of poor standing, and are subject to very high credit risk. Ca Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest. C Obligations rated C are the lowest rated and are typically in default, with little prospect for recovery of principal or interest. Note: Moody’s appends the numerical modifiers 1, 2, and 3 to each generic rating classification from Aa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic category. Source: Moody’s Web Site, www.moodys.com (Information is accurate as at time of publishing.) BOND QUOTES AND RATINGS How well can you interpret bond quotes? How sound are the investment decisions you make based on bond ratings? Complete the online learning activity to assess your knowledge. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6      FIXED-INCOME SECURITIES: FEATURES AND TYPES 6 23 SUMMARY In this chapter, we discussed the following key aspects of fixed-income securities: Companies use fixed-income securities to finance and expand their operations or to take advantage of operating leverage. Bonds pay regular interest in the form of a coupon. Face value (or par value) is the amount the bond issuer contracts to pay at maturity. A bond is secured by physical assets, whereas a debenture is secured by the issuer’s credit rating or other non- physical asset. Bonds come with many different features and options. For example, a callable bond gives the issuer the right, but not the obligation, to pay off the bond before maturity, whereas a convertible bond gives the holder the option to exchange the bond for common shares of the issuing company. Corporate bonds are typically secured with protective covenants. Sinking funds are sums of money taken out of earnings each year to provide for the repayment of all or part of a debt issue by maturity. A purchase fund arrangement establishes a fund to retire a specified amount of the outstanding bonds through purchases in the market if these purchases can be made at or below a stipulated price. Government of Canada fixed-income securities include bonds, real return bonds, and T-bills. Provincial bonds, like Government of Canada bonds, are actually debentures because they are promises to pay and no physical assets are pledged as security. They are second in quality only to Government of Canada bonds. Municipalities typically raise capital from market sources through instalment debentures or serial bonds. Types of corporate fixed-income securities include first mortgage bonds, collateral trust bonds, equipment trust certificates, and subordinated debentures. Other types of fixed-income securities include commercial paper, term deposits, and GICs. A typical bond quote includes the issuing company, the coupon rate, the maturity date, the bid and ask price, and the yield on the bond. In Canada, DBRS, Moody’s, and S&P provide independent rating services for many debt securities. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 6 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 6 FAQs. © CANADIAN SECURITIES INSTITUTE