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Bonds (Debt Instruments)

Treasury Bonds, bank acceptances and commercial paper make up what is called the money market. This is the short-term borrowers and lenders market (maximum one year).

Treasury Bonds

Treasury Bonds are reputed to be one of the most secure investments, especially when the term is three months or less. They are short-term debt instruments issued by governments in strips ranging from $1,000 to $1,000,000. Treasury Bonds are sold in multiples of $1,000, subject to a minimum and can be sold before the maturity date. They are sold under the par value (face value received on the due date).

The difference between the price paid and the par value represents the profit made by the investor. From a tax point of view, this gain is considered mainly as interest income and is taxed accordingly. Please consult your tax expert on this topic or for any additional information.

Like other money market products, the performance of Treasury Bonds is generally weaker than that of longer-term investments.

Bank Acceptances

Bank Acceptances (or "Banker's Acceptances") are a type of negotiable short-term debt instrument issued by a non-financial company whose capital and interest are guaranteed by a financial institution. The acceptance is a guarantee of payment from the bank; the instrument accepted in this way can be negotiated on the money market. The bank offering this guarantee collects an acceptance commission.

Commercial Paper

Commercial Paper is a short-term negotiable debt instrument that is issued by companies. The guarantee attached to this instrument is provided solely by the operations of the issuing company. The issuing company agrees to repay the capital upon the maturity date. Like Treasury Bonds and bank acceptances, commercial paper is sold below the par value (at a discount) and reaches its full value by the maturity date. Since the level of risk is higher than other money market instruments, commercial paper generally performs better than Treasury Bonds and bank acceptances.

Bonds

Bonds make it possible to meet the capital needs of issuers and are offered in various strips. They are debt instruments by which the issuer promises to pay the holder a certain amount of interest for a determined period and to repay the capital upon the maturity date.

Bond issuers are:

  • Federal government
  • Provincial governments
  • Municipalities
  • School Boards and other para-governmental organizations
  • Corporations

Maturity dates for bonds can vary from 1 to 30 years. The interest paid to the holder of the bond corresponds to a percentage of the face value set at the issuance and is generally paid out in two segments each year. When a bond is issued, the issuing price is set at $100. This is the primary market. The performance by the bond maturity date is therefore equal to the coupon rate attached to the bond.

The bond is then negotiated on the secondary market. It is therefore possible to buy or sell a bond after it is put into circulation. Bond prices are sensitive to interest rate variations. There is an inverse relationship between the bond price and the current interest rate, meaning that a rate increase lowers the bond price and inversely a lower rate increases the bond price. The price variation is more pronounced when the bond maturity date is long and when the coupon rate is low.

The bond price is also sensitive to the issuer's solvency. For example, the price of a bond from a corporation (or company) in financial difficulty will have a tendency of dropping quickly on the secondary market. Company bonds are generally more risky than government bonds and therefore offer a rate that is superior to government bonds.

Debentures are company bonds that are not guaranteed by specific assets, but solely by a simple acknowledgement of debt. Debentures are evaluated based on the credit reputation of the issuer.

Cautious investors choose to diversify their bond portfolio based on issuers and the maturity date rather than concentrating capital in one single issuer and one single due date.

Consulting the credit rating agencies to find out the quality of a bond is a wise step when looking to invest in corporate bond.

Strip Coupons and Residual Bonds

A strip coupon (or "stripped coupon") is the interest portion that was detached from a bond. The maturity date corresponds to the payment date for the interest coupon. The strip coupon is sold below the maturity value and there is no interest payment between the time of purchase and maturity. The gain therefore corresponds to the difference between the maturity value and the price paid. Please consult your tax expert regarding this matter.

It is also possible to sell this investment before maturity. Like bonds, the coupon price varies in an inverse manner with current interest rates. It is therefore possible to realize a gain or loss by selling the coupon on the secondary market before maturity. If we compare a bond and a stripped coupon with the same credit risk and the same maturity date, the coupon price is considerably more volatile than the bond price.

A residual bond (or "residual") is a bond that has been entirely stripped of its interest coupons. It is sold below the maturity value and has, just like the coupons, an inverse relationship with interest rates. The level of volatility in residual bonds is similar to that of strip coupons.