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Bond investors need to know how the game is played!

Believe it or not, when it comes to investing their hard earned savings, Canadian’s invest more money in bonds than they do in stocks! But you would never know it from all the attention paid to stock markets by investors and investment commentators.

This lack of interest in bond markets might be because the bond markets are quite different from stock markets. And as we discussed in my last article, unlike the stock market, there’s no central organized market place where investors meet to buy and sell bonds. Instead, bonds are bought and sold through one of two types of markets:

  • The Over-The-Counter (OTC) market, where the majority of bonds are bought and sold today.

or

  • The Alternative Trading System (ATS) market, which is a newer market structure where bonds are traded in a market that is similar to stock markets in its structure. However, the ATS market for bonds is still fairly small in comparison to its older OTC market rival.

Understanding these two bond markets

If you’re investing in bonds (as a lot of Canadian investors are doing!), it’s important that you understand how bonds are priced, bought, and sold in these two very different bond markets. To put it simply, buying and selling bonds can be a buyer-beware sport!

Specifically, when you buy or sell a bond you need to know

  • how the bond’s market prices are set (and by whom)

and

  • who is buying and selling your bonds.

Note: Typically you don’t have a choice as to which type of market (OTC or ATS) to use when you’re buying and selling your bonds. The broker that holds your investment account will decide which bond structure to use.

The OTC bond market: buyer beware!

The OTC market is the oldest and most commonly used in Canada. The majority of full-service and discount brokerage firms use the OTC market for all of their clients’ bond trading.

The first thing to understand about the OTC bond market is that it isn’t really a market at all according to the traditional definition of a market as defined by Investopedia. Here a market is defined as:

A medium that allows buyers and sellers of a specific good or service to interact in order to facilitate an exchange. The price that individuals pay during the transaction may be determined by a number of factors, but price is often determined by the forces of supply and demand.

So, by this definition, if the OTC were an actual market, it would have two basic characteristics. It would allow:

  1. A large number of investors competing with each other to buy and sell the same bonds, and
  2. A bond’s market price to be established by supply and demand.

The important point to note here is that when you’re investing within an OTC market, your financial institution employs a group of professional bond traders to buy and sell with bond traders at other financial institutions. These bond traders buy and sell bonds for the financial institutions’ personal bond inventory. In fact, these bond traders are considered a profit centre for the financial institution. So, buyer and seller beware!

At the same time, financial institutions also have a Retail Bond Desk that trades bonds on their behalf involving clients at the institution’s full-service or the discount brokerage firms. In an OTC market, when you want to buy or sell a bond, you have no choice – you must buy and sell to the financial institution at the price they set. There are no multiple buyers or sellers, supply and demand don't set the prices and you’re not in control of your savings.

The diagram below outlines how an OTC bond market for individual investors is actually structured.

Sometimes a picture is worth 1000 words!

But there is another alternative bond market. While the majority of financial institutions still use an OTC bond market structure, financial institutions are slowly adopting a new market structure for buying and selling bonds – the Alternative Trading System (ATS).

The ATS bond market: a more level playing field for buying and selling bonds

As a result of widespread adoption of computers and new technologies in the late 1990s, a new electronic market platform for trading bonds called the ATS was introduced in Canada. Initially, the ATS platform was created as a real-time, electronic market for institutional bond traders only. Over time, the ATS market was opened up to include other professional traders such as large mutual funds, insurance companies, pension funds and leading broker-dealers. In recent years, the ATS trading platform has been expanded even further to include individual retail investors – like you and me!

In Canada there are three registered and regulated bond ATS markets.

  • CanDeal: Formed in 2001 to provide an electronic bond market for institutional bond traders at over 250 global financial institutions. Canada’s six major bank-owned investment dealers and the TMX Group currently own CanDeal. Note: Individual, retail investors do not have access to this ATS market.

 

  • MarketAxess: is an American owned ATS market in Canada for institutional traders including investment advisers, mutual funds, insurance companies, public and private pension funds, hedge funds, and leading investment broker-dealers, for both primary dealers and regional firms. Note: Individual retail investors do not have access to this ATS market.

 

  • CBID Institutional: Owned by the Canadian company, Perimeter Markets Inc., this ATS bond market supports bond trading for institutions and individual investors. CBID Institutional provides electronic and anonymous trading between the country’s largest financial institutions - Full Service and Discount Brokers. Note: CBID offers an ATS bond market for investment dealers, investment counselors and discount brokerage firms that serve individual Canadian investors.

Unlike the previous diagram outlining the OTS bond market, the following diagram outlines how an ATS bond market works for individual investors:

In an ATS bond market, the larger participants (such as discount brokerage firms, investment firms, large money managers and investment counselors) provide liquidity for buyers and sellers of individual bonds. Large participants create liquidity by placing many bids to buy and offers to sell in the ATS market. These liquidity providers enable smaller bond investors (individual investors, money managers, bond traders and investment advisors) to have greater access to a larger variety of bonds from a greater number of issuers.

Factoid: When a market or investment is said to have greater liquidity, this means there are lots of buyers and lots of sellers actively trading. When an investment has lots of active buyers and sellers (i.e., lots of liquidity), it will be easier for you to buy and sell that investment at a market price you desire.

By bringing multiple buyers and sellers together, an ATS bond market functions similar to our stock markets by providing individual investors with better pricing and greater liquidity – both when buying and selling individual bonds.

Note: Not all brokers use an ATS bond market for their clients, so check with your broker to see which market they use (i.e., OTC or ATS) when buying and selling your bonds.

Game on!

So, once you become aware of these two different market arenas for investing in bonds, you can play a better game and save yourself a lot of money. And the best way to improve your game is to keep educating yourself.

 

Recent Article on Buying BondsShopping for bonds: a tale of two markets

 

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