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Canada Needs a Transparent Bond Market

In the stock market, you can take certain things for granted.
 
You know what you are buying. You can see the bid-ask spread. You know what it will cost to buy it. And, day-in and day-out, you can see what other people are paying for it.
 
In the bond market, you generally don’t know any of these things and you can’t find out. And you have been kept in the dark for too long. 
 
It’s time to set up a bond exchange in this country where investors will benefit from live buy and sell offers, best execution and immediate reporting of trades.
 
The fixed income market is increasingly central to Canadians.  Always important to older retail investors, pension funds and life insurance companies, bonds have regained a more prominent role after the crash in worldwide equity markets.
 
Canadian retail investors buying or selling money market instruments or bonds in the over-the-counter market have the right to know that they are getting the best available price and paying a fair commission – just like those transacting in shares on an exchange.  The traditional “trust us” response of the financial services industry is not adequate in the vastly changed investing landscape of 2009.
 
The fixed income market is huge, complex, and not transparent
The fixed income market is huge.  At May 31, 2009 there were $1.5 trillion in outstanding bonds and related instruments, and another $358 billion in the money market (terms up to one year).  It’s bigger than the total capitalization of Canadian equity markets at $1.5 trillion.
 
The market is complex, ranging from Government treasury bills and commercial paper to corporate and provincial bonds, repos and securitizations.  Prices vary by type, rating, duration, liquidity, size of order, and 16 other factors.  Less liquid provincial and corporate bonds can go months without a trade.
 
And the market is not transparent.  There is no central exchange for fixed income instruments.  Transactions are not reported on a systematic basis.  Commercial information providers show indicative bids and offers.  Prices for benchmark Government issues and some corporate bonds are covered in the press and on web sites. 
 
Retail investors are not well served
There are only 12 primary dealers in Canadian Government bonds.  The market is dominated by the Big 6 banks.
 
We don’t know how many retail investors are deterred from investing in fixed income securities by the lack of information.  When a broker suggests that an investor purchase a bond, no negotiation takes place.  In almost all cases the customer and her broker are captives of the dealer’s trading desk.
 
Retail activity is concentrated in the smaller issues and structured products that offer higher yields and commissions to their sponsors.  Many retail investors are pushed into bond mutual funds that promise to decode this arcane market for them – at an average cost (MER) of 1.9%.  With short term rates near 0% and longer-term rates of 2.5% to 4%, this is a near-guaranteed formula for most mutual fund bond investors to under-perform.  The rapidly-growing bond Exchange Traded Fund sector offers much lower fees.
 
Most on-line dealers offer a varied assortment of bonds, catering to the increasingly popular do-it-yourself segment.  Despite their greater knowledge, however, these DIY-ers remain vulnerable to lack of disclosure about commissions and spreads.
 
Obstacles to an exchange
Bonds have traded over-the-counter (OTC) since the dawn of recorded financial history.  No major international market has forced all bonds to trade on an exchange.  Defenders of the current Canadian system claim that it has met the needs of corporate issuers and institutional buyers, while also serving individual investors.  They warn of higher costs and technical difficulties each time changes are proposed.
 
But the technical difficulties hardly seem insurmountable if convertible debentures already trade on the Toronto Stock Exchange.  It is hard to avoid the suspicion that the case against a bond exchange serves mostly to protect the lucrative dominance of the fixed income market by Canada’s powerful banks.
 
IIROC has proposed some good first steps
The Investment Industry Regulatory Organization of Canada has proposed new rules governing fixed income and other OTC securities that should hopefully be implemented soon.  The rules require investment dealers to fairly and reasonably price OTC securities; to disclose the yield to maturity of fixed income instruments; and to include a statement that “remuneration has been added to the price in case of a purchase.” 
 
IIROC’s steps towards greater disclosure and stronger investor protection are positive.  Until Canada attains complete transparency with debt securities trading on an exchange, such protective steps are necessary.  Surveillance and enforcement are even more important, to ensure that those who violate the rules receive meaningful deterrent punishments.
 
Conclusion: a bond exchange would shed light
 
As US Supreme Court Justice Louis Brandeis said, “Sunlight is the best disinfectant and electric light the most efficient policeman.”  Total transparency builds investor trust.  Yet the fixed income and over-the-counter markets still operate in near complete darkness.
 
Moving to a fully transparent bond market with bid and ask prices and trade reporting could attract more participants, provide greater liquidity and reduce spreads.  It would assure the fair treatment of all investors and improve market efficiencies. 

This article was published in the Globe and Mail’s Report on Business on Tuesday, July 28.

Click here for the FAIR Canada submission to IIROC.

July 29, 2009