Anatomy of a bond — and why some debt is better than others

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Investors may have a strong preference among Canadian government bonds, provincial bonds and corporate bonds. But looking more closely at each bond flavour they’re really very similar — a contract between a borrower and lender determining when the loan, and any interest due on the principal, will be repaid.

“The major difference among types of bonds is the nature of the borrower, and the term of the loan — how long the borrower has to repay,” says Timothy Hicks, chief investment officer at Lysander Funds Limited. “The nature of the borrower is really about the level of certainty that the borrower will repay the loan and settles into two major categories, public and private.”

For example, the Canadian government can print money to meet its obligations on a Canada government bond, so payment is assured. A provincial bond is marginally less secure, but is almost certainly going to be repaid. Corporate bonds issued by larger private entities can offer a range of promises and security regarding repayment.

However, there’s a typical trade-off. The most secure bonds can pay the least interest over the longest terms. That can be particularly concerning when rising interest rates eclipse government bond rates and result in an overall negative position for government bondholders. The current government bond market is characterized by high duration and low yields.

As a Canadian, employee-owned investment fund manager, Lysander offers funds invested in the second major class of fixed income — corporate debt. The loan agreements on these bonds typically involve far greater levels of detail that may include arrangements to secure the debt through collateral, or whether the debt is subordinated — that is, debt that is repaid only after senior debt is settled, should the borrower enter bankruptcy.

The portfolios of the Lysander-Canso fixed income funds are managed by portfolio manager Canso Investment Counsel. These are carefully managed corporate fixed-income funds that aim to invest in bonds that offer higher yields that adequately compensate for risk, and a favourable position to receive compensation in case of default.

“These funds offer exposure to a range of corporate bonds that individual investors would not normally be able to access, except for a small subset, and often at a mark-up,” says Hicks. “Also, individual investors don’t have access to an organized marketplace, like the stock market, that would allow them to sell or trade these bonds if they want to liquidate early, or improve their position.”

Selecting the bonds that make up the Lysander funds requires significant experience — part science, part art. In some cases, companies are approached with an offer of funds and a specific set of terms. Others represent referrals from banks for whom such loans don’t meet exacting lending criteria, or a response to a request to borrow.

The use of a proprietary rating system allows Canso to assess the issuer (borrower), including any collateral, and its ability to generate cash flow, stay the course and repay the lender. When compensation is adequate for risk, Canso may be willing to make a significant investment.

The funds are actively managed, as some bonds are sold and switched out for other opportunities, with the aim of maintaining an overall acceptable risk profile.

“A bond is different from an equity, in which investors are often looking to an optimistic story about company growth and making it more valuable,” says Hicks. “All we really need to know is whether they’ll do well enough to repay their loan.”

Unlike most equity securities as well, corporate bonds often offer no prospectus, because preparing one typically adds to the cost of borrowing. It’s the familiarity of private debt specialists with those borrowers that allow them to offer credit, even without that guidance.

“Bonds are all debt at the end of the day,” says Hicks. “Expertise and experience allow one to determine why some debt is better than others.”

For more information on Lysander Funds, visit: lysanderfunds.com

For more information on Canso Investment Counsel, visit: cansofunds.com

The views and information expressed in this article are for informational purposes only. They are not intended as investment, financial, legal, accounting, tax or other advice and should not be relied upon in that regard. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.

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