Bonds for Canadians E-Book

Andrew Allentuck

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 426

Veröffentlichungsjahr: 2009

Beschreibung

PRAISE FOR BONDS FOR CANADIANS "Andrew Allentuck is one of the premiere financial journalist covering fixed income markets from a uniquely Canadian perspective. His knowledge of the bond market is second to none." --Randy LeClair, CFA, Vice-President & Portfolio Manager, AIC Investment Services Inc. "Andrew Allentuck's new book explains the complexities of the bond market to Canadians in an engrossing and deliciously entertaining manner. Superbly written, Bonds for Canadians is both a blueprint for financial prosperity as well as a delightful and often humorous look at the most misunderstood and idiosyncratic of markets. I wish this book had been around 26 years ago when I began my career." --Tom Czitron, CFA, Managing Director, Head of Bonds and Fixed Income, Sceptre Investment Counsel Ltd. "Canadian retail investors are 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 anecdoteladen account of what boods 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 "Bonds for Canadians shows how to escape the roller-coaster of risks of the stock market while generating a tidy fortune for retirement. It's an important contribution to financial planning." --Daniel F. Stonach, Registered Financial Planner, President, Stronach Financial Group Inc.

Leseprobe

Table of Contents

Praise

Title Page

Copyright Page

Dedication

Preface

WHO SHOULD READ THIS BOOK

GIVING CREDIT

Chapter 1 - BONDS

WHAT’S A BOND?

WHERE BONDS BEGAN

THE IDEA OF A BOND

WHAT INTEREST MEANS

THE GROWTH OF THE BOND MARKET

BONDS: THE LIMITS OF RISK AND RETURN

WHEN SOVEREIGN BONDS DEFAULT

VALUING BONDS

INTEREST RATE HISTORY

INTEREST RATE FORECASTING

Chapter 2 - THE SEDUCTION OF RISK

A TASTE FOR RISK

RISK HAS MANY FACES

IMAGING RISK

MANAGING RISK

CALIBRATING BOND RISK

THE FLAVOURS OF RISK

THE MEANING OF EXPECTATION

TIMING BOND RETURNS

A FEW FINAL WORDS ON RISK

Chapter 3 - TAKING A MEASURE OF CREDIT

STEP BONDS

CONVERTIBLES

PACKAGED LINKERS

COMMODITY-LINKED BONDS

HIGH-YIELD BONDS

CREDIT DEFAULT SWAPS

Chapter 4 - ALTERNATIVE BONDS

PAY IN KIND BONDS

PREFERRED SECURITIES

COLLATERALIZED DEBT OBLIGATIONS

INTELLECTUAL PROPERTY BONDS

FIXED INCOME DERIVATIVES

DISHONOURED BONDS

OLD AND DEFUNCT BONDS

PRIME BANK NOTES

Chapter 5 - GLOBAL BONDS

THE ARGENTINE FIASCO

PARMALAT: A CASE OF BONDS GONE SOUR

THERE ARE NO CINDERELLAS

BRADY BONDS

GLOBAL REAL RETURN BONDS

IN SUM

Endnotes

Chapter 6 - WHAT’S A BOND WORTH?

PRICING GOVERNMENT BONDS

DURATION

THE POWER OF REINVESTMENT

CLIMBING THE RUNGS OF RATES

NOT ALL BONDS ARE EQUAL

PRICING CORPORATE BONDS

DEBT AND RISK

THERE’S BAD, AND THEN THERE’S AWFUL

RISK AND STRATEGY

BONDS AND LIFE PLANS

Chapter 7 - BOND FUNDS

FEES AND RETURNS

EXCEPTIONS TO THE RULE: BOND FUNDS WITH STRONG PERFORMANCE

MORTGAGE FUNDS

MONEY MARKET FUNDS

BONDS AND BOND FUNDS—CRITICAL DIFFERENCES

SPECIALTY BOND FUNDS

DIVIDEND AND INCOME FUNDS

CLOSED-END BOND FUNDS

THE LIMITS OF BOND RETURNS

THE FUTURE OF PACKAGED PRODUCTS

Chapter 8 - BOND TRADING TACTICS

BONDS COME BACK INTO FASHION

ANALYZING TRENDS

BOND SELECTION

CUSTODY

VIGILANCE

TRADING SMART

DIRECT SALES

BOND TIMING

DEALING SMART

TRADING TIPS

GETTING A GOOD DEAL

Chapter 9 - THE FUTURE ENVIRONMENT FOR BONDS

THE TRENDS

WEIGHTING BONDS

THE ELDERBOMB

BEYOND GOVERNMENT BONDS

CALIBRATING BONDS FOR LONG-TERM PORTFOLIO PROTECTION

THE CHINA SYNDROME

THE IMPLICATIONS

Chapter 10 - BOND STRATEGIES

WHAT IS SAFETY WORTH?

BOND PRICE CYCLES

A RATIONALE FOR ALLOCATION

THE OPPORTUNITY COST OF BONDS

PORTFOLIO METRICS

PORTFOLIO INSURANCE

GLOBAL BONDS

REAL RETURN BONDS

QUALITY: A LONG-RUN VIEW

BOND FUNDS

RISK MANAGEMENT

CONCLUSION: THE VIRTUES OF BONDS

Glossary

Bibliography

Index

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 bond-market 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.

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, 1943-Bonds for Canadians : how to build wealth and lower risk in your portfolio / Andrew Allentuck.

eISBN : 978-0-470-73902-0

1. Bonds—Canada. 2. Bond market—Canada. I. Title.

HG5154.A.63’230971 C2006-901432-9

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

For my children, Adam and Sarah

Preface

Bonds 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 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 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 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 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.

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 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 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

In 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, 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.