Bonds and Debentures
Investors need to remember that all investments have a cost. The financial institutions that provide investment products and services do not work for free. Investors should understand the individual costs associated with their investments so they can better assess each investment’s potential investment returns and ensure that they receive good value for the costs they pay.
As we have discussed in the Classroom: Investment Type section, the terms bond and debenture are often used interchangeably, but the following differentiates the two investments:
A bond is typically a loan that is secured by a specific physical asset.
A debenture is secured only by the issuer’s promise to pay the interest and loan principal.
Note: For the purposes of this discussion we will refer to both bonds and debentures simply as bonds.
When you invest in bonds you may incur any of the following costs:
costs to purchase and sell a bond, and
costs to hold the bond (possibly)
Bonds are a unique type of investment as they do not trade on an organized exchange (like ETFs or common and preferred shares), but instead most bonds trade over-the-counter (OTC) through bond trading desks maintained at a handful of the largest financial institutions.
As a result, if you want to purchase or sell a bond, you will incur the following two levels of costs:
First, there will be a commission charged by the financial institution’s bond desk, and
Secondly, the financial institution’s financial advisor will charge a commission.
Note: If you purchase or sell bonds through a discount brokerage account the same cost structure may exist as both the bond trading desk and the discount brokerage divisions of the financial institution are considered profit centres and charge a fee for their respective services.
Special Note to Investors: Over a number of years Alternative-Trading-Systems (ATS) have been developed to compete with the OTC bond market. The ATS structure creates an "exchange-like" market for bonds with multiple participants, live prices, transparency, and competition. Although the majority of financial firms continue to serve their clients' bond trading needs from their own internal inventory and OTC, a growing number of companies are choosing instead to provide their clients with access to a competitive bond ATS platform like the CBID ATS, operated by Perimeter Markets Inc. By switching to an ATS platform, a few of the discount brokerage firms have been able to substantially reduce the transaction costs retail bond investors pay by eliminating the Bond Trader's commission. These same firms are beginning to also detail the transaction costs associated with bond investments on client transaction confirmations. Bond investors need to understand their options.
Unlike other investment types, most financial firms do not disclose bond transaction costs. The costs are often built into the bond’s purchase/selling price and these costs are often not disclosed to the investor on their transaction confirmations or investment account statements.
So, for example, if you purchase a bond for $101.00 for each $100.00 of maturity value and the stated yield is 4.0%, then your price of $101.00 already includes the costs associated with purchasing this bond and the 4.0% yield has been calculated after the investment costs have been added into the $101.00 price.
What are your costs to purchase and sell corporate and government bonds?
The answer to the question regarding how much you will be paying if you buy or sell your bond generally comes in two parts:
- Determining the Bond Desk Commission - You and your advisor will never know how much commission the bond trader has charged.
- Determining the Advisor’s Commission – Because no costs are disclosed on your transaction confirmation or your account statement, you will need to request this information directly from your advisor.
Each firm, whether a discount or full service broker, will maintain their own cost schedule for bond transactions and this schedule is set as a guide only for advisors. The advisor is given some discretion as to how much retail commission they can charge you to buy or sell a bond.
Note: Our discussion focuses on bonds that are purchased and sold in the over-the-counter (OTC) or secondary bond market. Bonds can also be purchased as a new issue (also called an Initial Public Offering (IPO)) directly from the issuing institution. Bonds purchased as a new issue do not charge the retail investor commission costs, but the issuing institution does pay the advisor and their financial institution a commission. Indirectly, the commission costs are incorporated into the bond’s new issue pricing.
The amount of commission charged will be influenced by the following characteristics:
- the length of time to the bond’s maturity date
- the maturity value of the bond, and
- the bond’s credit quality or credit rating
Note: If a bond is held to its maturity date, there is no investment cost incurred. The bond simply matures and the bond principal and interest income are deposited to your investment account.
The bond’s maturity date
In general, the commission schedule that guides bond desks and advisors is constructed on a sliding scale with costs lower for the shorter bond maturities. For example, the cost guidelines provided to the financial institution’s bond desk and advisor may look something like this:
- for a 1-year bond: the transaction cost would typically equal 0.25% of the maturity value of the bond
- for a 5-year bond: the transaction cost would typically equal 0.50% of the maturity value of the bond
- for a 10-year or longer maturity date: the transaction cost would typically equal 1.00% of the maturity value of the bond
Note: Each firm will have their own variation of the commission schedule, and the commission rates may be forced downward as interest rates continue to decline and it becomes more and more difficult to charge rates that potentially consume a significant portion of the bond’s yield.
Note: The impact of investment costs on your rate of return will depend on the bond’s term to maturity. The shorter the bond’s term to maturity, the greater the impact of transaction commissions. For example, according to the Investment Dealers Association of Canada, if you were charged 1.0% commission to purchase a bond with a term to maturity of 5 years, trading at its par value with an annual interest rate of 4.0%, your annual yield would be reduced by approximately 0.22%. If the same 1.0% commission were charged on a bond with a term to maturity of 30 years, your annual yield would be reduced by only 0.06%.
The maturity value of the bond
The costs to purchase and sell a bond are calculated by using the bond’s maturity value, not the amount of money invested in the bond. This may seem a bit strange. While at first you may not think much of this fact, in fact this small difference in the calculation of commission can lead to a substantial increase in your costs for two reasons:
First, because the cost is charged as a percentage your commission costs will increase for larger bond purchases.
Secondly, when you invest in compounding bonds (often referred to as a discount, coupon, or residual bond) the amount invested will cost substantially more than if you invested in a regular bond.
Example: Costs to buying a regular bond vs. a compounding bond
If you invest $20,000 in a 5-year regular bond with a maturity value of $20,000, the commission costs will typically be $100.00 ($20,000 X 0.50%). However, if you invest the same $20,000 in a 5-year compounding bond with a maturity value of $24,333.00, then the commission costs will be $121.66 ($24,333.00 X 0.50%). As a result, investing the same $20,000 in a compounding bond can be 21.66% more expensive than investing in a regular bond.
Remember: Advisors typically have discretion as to how much commission they charge on bond purchases and sales, so when purchasing compounding bonds simply ask them to ensure that the commission cost is the same as it is for a regular bond.
The bond’s credit quality
The bond’s credit quality, as represented by its credit rating, can influence the cost to purchase and sell. For a retail investor, the bond’s credit quality can have a negative or a positive influence on the commission you are charged. How is this possible? Well, simply put, a bond’s credit quality can influence the demand and supply characteristics in the bond market.
For example, if you own a bond that has its credit rating reduced, typically the bond’s price will also decline and the overall investor demand to own this bond will also decrease. The price decline will cause the bond’s yield to increase. The change in investor demand and the increased yield will create room for the bond desks and advisors to charge higher commission costs on purchase and sales.
In addition to the above example, if a bond’s credit rating is raised or if the bond consistently receives a high credit rating, then investor demand for the bond will be strong. If investor demand is strong then bond desks and advisors have an ability to charge more for purchases and sales.
What is your cost to hold a bond?
When investing in individual bonds you will pay a commission to purchase and sell, but simply holding a bond is not accompanied with an annual investment cost unless the bond is held within an account type that charges an annual service/management fee. A few examples of accounts that charge annual fees include the following:
- mutual funds
- segregated funds
- exchange-traded funds
- wrap accounts
- fee accounts
Example: Costs associated with buying a regular bond and holding it in a fee charging account
If you invest $20,000.00 in a 5-year regular bond, with a maturity value of $20,000, the commission costs will typically be $100.00 ($20,000 X 0.50%). If the bond were held in a non-fee account and held until it matured then your only investment cost would be $100.00. Or if you averaged this amount over the 5-year life of the bond, your annual cost would be $20.00. If, on the other hand, you held this bond to its maturity date within an account that charges 1.0% per year, then over the bond’s 5-year life you would pay an additional $1,000.00 and your 5-year cost to purchase and hold the bond would be $1,100.00. This large increase in investment costs will reduce the income you earn on your savings by $1,000.00.
Additional cost considerations
Yield to maturity: final tally of transaction costs?
When you purchase or sell a bond the transaction costs are already built into the bond’s market price and yield to maturity. When comparing two or more bond investments, you will want to compare each bond’s yield to maturity as it represents the amount of money you will earn after your purchase transaction costs, but not any annual fees charged to hold the bond.
Example: The impact of transition costs on bond yield?
As an example of the direct impact transaction costs can have on your bond yield, let's compare the purchase of a bond with no transaction costs as outlined in Table A, with a bond purchased with transaction costs as outlined in Table B.
Table A: Bond with a 5-year maturity date with no transaction costs
|Bond with a 5-year maturity date with no transaction costs|
|Price Per $100 Par Value||$100.00|
|Your Yield to Maturity||4.65%|
Table B: Bond with a 5-year maturity date including transaction costs
|Bond with a 5-year maturity date including transaction costs|
|Price Per $100. Par Value||$100.00|
|Your Yield to Maturity||4.43%|
As you can see in this comparison above the transaction costs decrease your rate of return, which is reflected by the bond’s reduced yield to maturity.
Semi-annual yield vs. annual yield: make sure you compare apples to apples when you buy!
When purchasing a bond, you will be shown a purchase/sell price and a resulting yield to maturity. The price and yield already include the transaction costs. Your transaction’s confirmation statement/contract will show two yields stated as a semi-annual yield to maturity and an annual yield to maturity. When you are comparing two or more bonds or similar Fixed Income investments, such as Guaranteed Investment Certificates (GICs), it is important that investors use the same yield. For example, the interest rate on a GIC is an annual yield and should be compared with a bond’s annual yield to maturity, not the semi-annual yield to maturity.
Note: The negative impact of transaction costs are the same for any type of bond investment (regular, compounding, discounted, Real Return, etc.).
Note: When you open an account, whether with an online discount broker or a full-service broker, no matter what the investment strategy or type of investment used, you should always discuss compensation with their advisor. You need to determine whether transaction-based or fee-based is more suitable for you.
Note: Convertible Bonds, which have a feature enabling the holder to convert their bond into common shares of the issuer, trade on the organized stock exchanges in Canada, not in the over-the-counter-market (OTC) or any of the Alternative-Trading-Systems (ATS).
Note: For more information regarding bonds, see our section Class Room – Investment Type: Bonds.