3.1 The Fixed-Income Marketplace, Bond Terminology & Security

The Fixed-Income Marketplace

The Canadian bond market is larger by value outstanding than the stock market, and governments (federal, provincial and municipal) are its largest issuers. Corporations issue the rest. Almost all bonds trade over the counter through investment dealers rather than on an exchange.

Investors hold fixed-income securities for several reasons:

• Income: regular, predictable interest payments.
• Safety of capital: high-quality government bonds are repaid in full at maturity.
• Diversification: bond prices often rise when stocks fall during recessions.
• Capital gains: bond prices rise when interest rates fall.

Understanding a bond starts with its basic terms.

Core Terminology of Fixed-Income Securities

A fixed-income security is a debt instrument that obligates the borrower (issuer) to pay the lender (investor) a specified stream of interest income and return the principal amount at a predetermined future date. To analyze fixed-income securities in the Canadian financial marketplace, you must understand several core contractual terms.

Par Value, Face Value, and Principal

The par value (also termed face value or principal) is the stated nominal dollar amount that the issuer agrees to repay to the bondholder at maturity. In Canada, corporate and government bonds are typically issued in denominations of $1,000, $10,000, or $100,000, though retail trading is standardized around a $1,000 base unit.

Coupon Rate and Nominal Yield

The coupon rate (or nominal yield) is the annual contractual rate of interest paid on the par value. For example, a bond with a $1,000 par value and a 5.50% coupon pays $55.00 in total interest annually. In Canada, standard market practice dictates that bond coupons are paid semi-annually. Thus, the investor in a 5.50% bond receives two equal payments of $27.50 every six months.

Maturity Date and Term Classifications

The maturity date is the final date on which the loan contract terminates and the issuer must repay the remaining principal to the investor. Fixed-income securities in Canada are grouped by term to maturity:

• Short-term: a common convention, used by the FTSE Canada bond indexes, is 1 to 5 years to maturity (money market instruments mature in one year or less).
• Mid-term (intermediate): 5 to 10 years.
• Long-term: more than 10 years (commonly 20 or 30 years for major government and infrastructure issues).

Definitions vary by source, so follow the term ranges given in a question.

Price Quotation Conventions: Points and Percentages

Canadian fixed-income securities are quoted as a percentage of par value, where 100 points equals 100% of par:

• Trading at Par: A bond priced at 100.00 trades at exactly 100% of par ($1,000 for a $1,000 bond). At par, the bond's yield to maturity matches its coupon rate.
• Trading at a Discount: A bond priced below 100 (e.g., 97.50) trades below its face value ($975.00 per $1,000 bond). Bonds trade at a discount when prevailing market interest rates rise above the bond's coupon rate.
• Trading at a Premium: A bond priced above 100 (e.g., 104.25) trades above its face value ($1,042.50 per $1,000 bond). Bonds trade at a premium when prevailing market interest rates decline below the bond's coupon rate.

Clean Price vs. Dirty Price and Accrued Interest

When a bond trades between coupon dates, the buyer must compensate the seller for the interest accrued from the last coupon payment date up to (but not including) the settlement date:

$\text{Dirty Price (Settlement Price)} = \text{Clean Price (Quoted Price)} + \text{Accrued Interest}$

In Canada, bond accrued interest is calculated using an actual/365-day convention (counting the actual number of elapsed days divided by 365). If a bond is in default and pays no interest, it trades "flat", meaning no accrued interest is added to the clean price.

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The Trust Indenture and the Role of the Trustee

A bond is not merely an informal promissory note; it is a complex, legally binding contract known as a trust indenture (or deed of trust). The indenture is signed between the issuing corporation and a designated trustee.

Why a Trustee is Required

Because an issue of corporate debt may be held by thousands of individual and institutional investors across the country, it is legally impractical for each creditor to negotiate terms, hold security deeds, or monitor corporate financial health individually. Instead, the corporation appoints an independent, federally or provincially licensed trust company to act as the collective fiduciary representative for all bondholders.

Primary Responsibilities of the Trustee

1. Authenticating Securities: Certifying that the number and value of bonds issued match the limits established in the indenture.
2. Holding Collateral: Retaining physical or electronic custody of pledged mortgage titles, security deeds, or financial collateral.
3. Monitoring Covenant Compliance: Scrutinizing the issuer's quarterly and annual financial statements to verify compliance with financial ratios and debt restrictions.
4. Administering Sinking and Purchase Funds: Overseeing the regular receipt of retirement funds and conducting redemptions or market buybacks.
5. Representing Creditors in Default: If the issuer breaches a covenant or fails to make scheduled payments, the trustee issues a formal notice of default, accelerates principal repayment, or initiates legal proceedings to seize and liquidate pledged collateral on behalf of all bondholders.

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Secured Bonds vs. Unsecured Debentures in Canada

In American parlance, the term "bond" is often used as a blanket synonym for any long-term debt instrument. In the Canadian securities industry, however, there is a strict and critical legal distinction between a bond and a debenture.

Secured Bonds

A bond is a fixed-income security that is backed by a mortgage or specific physical or financial collateral owned by the issuer. If the issuer defaults, the trustee has the legal right to liquidate those specific pledged assets to satisfy the bondholders' claims.

• First Mortgage Bonds: Represent a first charge or senior mortgage on specified physical assets, such as real estate, manufacturing plants, or utility facilities. They carry the lowest default risk among corporate debt. Indentures often contain an after-acquired clause, which automatically attaches the bond's security lien to all future real estate or plants acquired by the company.
• Collateral Trust Bonds: Issued primarily by holding companies that own minimal physical real estate. Instead of physical property, the debt is secured by financial assets—such as shares, bonds, or notes of operating subsidiaries—deposited directly with the trustee.
• Equipment Trust Certificates (ETCs): Used extensively in capital-intensive transportation sectors (railroads, commercial airlines, shipping). Under the traditional "Philadelphia Plan," legal title to the rolling stock or aircraft remains with the trustee until the entire debt issue is completely retired. The company merely leases the equipment; upon default, the trustee can immediately reclaim the equipment without lengthy bankruptcy litigation.

Unsecured Debentures

A debenture is a debt instrument backed solely by the general creditworthiness, reputation, and earning power of the issuing corporation. No specific property or collateral is pledged to secure the loan. If the company fails, debenture holders become general unsecured creditors.

• Senior Debentures: Rank ahead of other unsecured debt and preferred shares, holding a primary claim on all unencumbered corporate assets.
• Subordinated Debentures: Junior debt that contractually agrees to rank below senior debentures, bank loans, and other designated creditors in liquidation. Because subordinated debentures carry higher credit risk, they offer higher coupon yields and are frequently issued with a conversion feature (convertible debentures) to attract investors.

Comparison of Debt Security Types