4.5 Bond Market Trading & Bond Indexes

Most investors never see a bond trade happen, because the bond market works very differently from the stock exchange. Understanding its structure explains bond pricing, dealer spreads and how bond performance is measured.

An Over-the-Counter Dealer Market

There is no central exchange for most bonds. Instead, investment dealers quote bid and ask prices and trade as principals, buying bonds into inventory and selling from it. The market has several layers:

Inter-dealer brokers match dealers who want to buy and sell without revealing who they are, which helps dealers manage inventory without signalling their positions. IDBs act as agents and do not take positions themselves.

Retail Bond Pricing

When a retail client buys a bond, the dealer usually sells from inventory at a price that includes a markup rather than charging a separate commission. The markup appears in the price and yield the client receives. CIRO requires dealers to make reasonable efforts to ensure the price of a debt trade is fair and reasonable given market conditions, and trade confirmations must disclose that the dealer acted as principal. CIRO also publishes data on bond trades to improve transparency.

Retail investors should expect wider spreads on small trades and on less liquid issues, such as small corporate or municipal bonds, than institutions pay on large trades in benchmark government bonds.

The Repo Market and CORRA

Dealers finance their bond inventories in the repurchase (repo) market: they sell bonds with an agreement to buy them back the next day (or later) at a slightly higher price, which is effectively a secured loan. The Canadian Overnight Repo Rate Average (CORRA), administered by the Bank of Canada, measures the cost of overnight general-collateral repos in Government of Canada securities. Since CDOR ended in 2024, CORRA has been the main Canadian reference rate for floating-rate notes, loans and derivatives.

Settlement and Accrued Interest

Most Canadian bond trades settle T+1. The buyer pays the quoted (clean) price plus accrued interest from the last coupon date up to the settlement date, calculated on an actual/365 basis. Bonds in default trade flat, without accrued interest.

Liquidity Differences Across the Bond Market

Bond liquidity varies far more than stock liquidity:

• Government of Canada benchmark bonds (the most recently issued bonds at key terms such as 2, 5, 10 and 30 years) trade in large volumes with very narrow spreads.
• Provincial bonds of large provinces such as Ontario and Quebec are also actively traded.
• Corporate and municipal bonds trade far less often. Many issues change hands only occasionally after they are first sold, and a dealer may have to search for a buyer or seller.

Less liquid bonds have wider bid-ask spreads and can be hard to sell quickly at a fair price, especially in a market crisis. For investors who may need to sell before maturity, liquidity should be part of bond selection, not an afterthought.

Who Buys Bonds

Institutional investors dominate the Canadian bond market. Pension funds and insurance companies buy long bonds to match long-term liabilities, banks hold government securities for liquidity, mutual funds and ETFs buy on behalf of retail investors, and foreign investors hold a significant share of Government of Canada bonds. Retail investors usually own bonds through funds or in modest direct holdings, often arranged as a ladder.

Bond Indexes

A bond index tracks the total return of a defined group of bonds, including both price changes and coupon income. In Canada the main family is the FTSE Canada bond indexes:

Why Bond Indexes Matter

1. Benchmarking: a bond fund manager's performance is judged against the index that matches the fund's mandate.
2. Index investing: bond index funds and ETFs try to replicate an index, usually by sampling because the universe contains hundreds of bonds.
3. Risk measurement: the index's duration and credit mix show the risk of the market as a whole, so managers can see how far their portfolios deviate.

A manager who expects rates to fall might hold a portfolio with a longer duration than the Universe index; if rates do fall, the portfolio should outperform. Choosing the right benchmark matters: comparing a short-term bond fund with the Universe index would be unfair in a year when long bonds rallied.