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Guide to Fixed Income Securities

2010

Portfolio Advisory Group


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Table of Contents

What are Fixed Income Securities 2

Why Invest in Fixed Income Securities 2Income, Safety, Liquidity, Balance, Choice

The Many Forms of Fixed Income Investments 3Interest-Bearing Securities; Discount Notes; Mutual Funds

Rewards & Risks of Fixed Income Investing 4Income; Safety; Capital Gains and Liquidity; Tax Considerations

Fixed Income Securities A Buyers Guide 7Bond Types and Features; Term to Maturity; How Bonds are Priced;The Importance of Yield Government, Corporate and Foreign Currency Bonds;

Fixed Income Securities Product Descriptions 10GICs; Treasury Bills; Bankers Acceptances; Commercial Paper; Savings Bonds;Preferred Shares; Stripped Coupon Bonds; Mortgage-Backed Securities;Structured Notes; Fixed Income Mutual Funds;

Appendices

I. The Importance of Credit Ratings 12

II. Checklist for Choosing The Right Fixed Income Securities 14

III. Fixed Income Product Table 15


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What are Fixed Income Securities?

The two best-known asset classes are equity and fixedincome securities.

When you buy equities, you are essentially buying partownership of a company. You therefore participate inboth its profits and losses, measured by any dividendincome you receive plus capital gains or losses from theups and downs of the stock market.

In contrast, a traditional fixed income security isessentially an IOU an obligation stating that theborrower (known as the issuer) will repay the borrowedmoney on a certain date, called the date of maturity. Inaddition, as the name suggests, many fixed incomesecurities pay regular interest or income to investors at afixed interest rate, known as the coupon rate.

Just like stocks, most debt investments trade in themarketplace, and may fluctuate in price. Therefore, youmay record a capital gain or loss if you sell them prior to

maturity. However, fixed income investments aregenerally considered safer than equities because theyprovide a steady stream of income and a set pay-backprice if held to maturity. In addition, the safety of a fixedincome security is reflected in the credit rating of theissuer.

Since fixed income securities pay regular income at theircoupon interest rate, their value is related to theinterest rates of the country and currency in which theyhave been issued. For example, when interest ratesdecrease, the price of a bond generally will increasebecause the bonds coupon rate becomes moreattractive compared to current market interest rates. Incontrast, when interest rates rise, bond prices generallyfall. For investors, considering the future trend of interestrates is an important part of understanding fixed incomesecurities.

Why Invest in Fixed Income Securities?Income

Investors primarily buy bonds and other fixed incomesecurities for the income they generate, be it to fundtheir retirement, education, or any other cash flow need.

Safety

Fixed income securities are also the choice of investorsseeking safety of capital, as they carry, depending ontheir credit quality, a greater degree of principal

protection and guarantee of investment returns thanmost other investments.

Liquidity

Among many investors, stocks are better known andunderstood than fixed income securities. Yet in Canadathe fixed income market is actually about 30 times largein trading volume than the equity market. Due to the sizeof trading volume, market liquidity, (relating to how easilya security can be purchased or converted into cash) is

extremely high.


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Balance

Fixed income securities are an important part of most

investment portfolios. Research has shown thatchoosing the right balance between fixed income andequity securities is the single most important factor ininvestment success.

Investors look to fixed income products for a variety ofbenefits. Each particular fixed income security may alsooffer additional advantages depending on its uniquefeatures. The universe of fixed income product is large

and ever expanding. ScotiaMcLeod offers investorsaccess to and experience on a full range of fixed incomesolutions.

Choice

Todays investors can choose among more fixed incomeproduct than ever before. These range from the tried andtrue Government and Corporate Bonds, GICs andSavings Bonds to innovative products, such as stripbonds and structured notes.

The Many Forms of Fixed Income InvestmentsToday the market offers many forms of fixed income investments. Fixed income securities are often classified accordingto the time they have left until maturity. Those that are short-term (with a maturity of up to one year) are referred to asmoney market or cash investments, because due to their short maturity date they become cash within a shorter timeframe. Cash investments include Government Treasury Bills, Bankers Acceptances, Commercial Paper, term deposits,short-term GICs and money market mutual funds. Other debt instruments, such as bonds, are typically longer in term, withterms of maturity ranging to 30 years and beyond. Another way of classifying fixed income securities is based on whetheror not they pay interest to their holders before maturity.

Interest-Bearing Securities

Traditionally, fixed income investments are interestbearing. They pay interest to investors on a regular

basis, usually once or twice a year, until the investmentmatures. Examples include Canada Savings Bonds,GICs, and government and corporate bonds.

Example: An investor purchases a semi-annual payingbond with a coupon rate (interest rate) of 6% and a faceor par value of $100. Thus the bond pays interest of $6,$3 twice a year. When the date of maturity is reached,the investor also is repaid the par value $100 plus anyaccrued interest.

Discount Notes

A second type of fixed income security, known asdiscount notes, does not pay interest. Instead, it ispurchased at a discount to its face value, and is

redeemed at full price at maturity. Examples areTreasury Bills and strip bonds.

Example: A strip bond is purchased for $92, a discount

to its face value of$100. It pays no interest, but on thedate of maturity the investor is paid $100, giving a totareturn of $8.

Mutual Funds

Another way to invest in fixed income securities is to buymutual funds, such as money market or bond fundsThese mutual funds provide investors with a diversifiedportfolio of fixed income products, with many of thebenefits of investing directly in the securities. Howeverwhen investing in fixed income mutual funds, youreceive the appreciation or depreciation of the value o

that fund, but you do not necessarily receive the regulacash flows that may come from the underlying securitiesin the fund.


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Rewards & Risks of Fixed Income InvestingThe rewards and risks of investing in fixed income securities flow from the unique features of each product. For example,

some securities offer regular income; others offer the potential for capital gains. Some are highly liquid; others are lockedin until a set maturity date.

The following section defines the key features that may apply to a fixed income investment. To help you see whichfeatures relate to a particular kind of fixed income security, check the reference table at the back of this guide.

Although fixed income investments (bonds) are generallyconsidered to be safe, they are subject to two key typesof risk. The first is interest rate risk. Once you havepurchased a bond, and you are locked in to a set rate ofinterest for a specific term, there is always the chancethat rates will rise and the rate you are earning may nolonger be competitive. The longer the term of your bond,

the greater the chance that rates will rise at some point.The second type of risk is credit risk, the possibility thatyour principal will not be repaid or that the issuer willdefault on the interest payments. Different investmentswill offer varying degrees of security depending onspecific features of the investment and the issuersability to service the debt and repay the principal uponmaturity. Investments issued by the Government ofCanada are of the highest quality because thegovernment has an almost unlimited ability to meet debtobligations through tax levies or printing money.Corporate issues rank behind federal, provincial, andmunicipal government issues in quality, primarily

because they have limited resources. An easy way tocompare the quality of various debt or preferred issues isby referring to bond ratings published by firms such asthe Dominion Bond Rating Service, Standard & Poorsand Moodys Investment Services.

Fixed income investments vary in price as interest rateschange during the period preceding maturity. As interestrates rise, fixed income securities prices generally fall toprovide the market rate of return. Conversely, fallingrates imply higher prices. Fundamental factors whichmight influence the issuers ability to pay also affectprices. All but sophisticated and wealthy investorsshould avoid purchasing fixed income securities that areunrated or rated below BBB(Low). Although yields arenormally higher to reflect the increased risk, issuers mayfail to pay interest or be unable to make requiredprincipal payments, resulting in a loss of capital or adelay in the receipt of funds.

Another type of investment risk is related to the type ofsecurity and its place in the pecking order of preferencein liquidation. Equity investments, or common stock, aremost susceptible to the risk of loss if a company'sfortunes deteriorate. On the other hand, a collateralizedbond, for example, debt secured by an airplane owned

by an insolvent airline, can still be repaid, even inbankruptcy.

While investing in foreign securities makes sense fodiversification and enhanced returns, they may be morevolatile in the short term and are subject to manyadditional risk factors, both political and economic.

Finally, market prices are a function of human emotionsas well as rationally determined supply and demandTherefore, even when fundamental investmenobjectives are achieved, individual security or generamarket prices can decline, often for protracted periods o

time. Investors must have patience and perseverance aswell as the courage to invest or hold when things lookthe bleakest.

The client must make the final purchase or saledetermination. While your ScotiaMcLeod Wealth Advisoshould be relied upon for unbiased advice, on occasionthose recommendations will not produce the expectedresults because of the complex nature of the risksdescribed above. Since neither your Wealth Advisor norScotiaMcLeod shares in the rewards of successfuinvestments, the client necessarily bears the risk of lossfrom unsuccessful investing. Investing is a seriousbusiness, which, while offering prospectively goodreturns, merits a client's careful attention to the decisionmaking process. Investors should remember that thehigher the potential reward, the greater the potential riskof an investment.


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Reducing Risk Through Diversification

The best way to reduce risk is by diversifying your

portfolio, by investing in different asset classes, durationand industries.

We recommend that you complete a personalinvestment review to help you determine your tolerancefor risk and to help you see at a glance, what amount ofassets you hold in each category. This should then bereviewed with your Wealth Advisor, at least annually, toensure that your portfolio is in the proper balance givenyour personal circumstances and current marketconditions. Your ScotiaMcLeod Wealth Advisor canassist you in building a diversified portfolio and in helpingyou understand the amount and type of risk inherent in

each type of investment you hold.

While it is a clients right to expect his/her financialadvisor to use his or her best efforts in recommendinginvestments that will perform for the client and aresuitable for his/her financial circumstances, it is theclient's responsibility to ensure that their Wealth Advisortakes the time to look at the big picture of their finances.It this way, the client can most intelligently bear the risksand reap the rewards of his/her investment selections.

Rewards

Income

Many fixed income securities offer income in the form ofregular interest payments. The rate of interest is knownas the coupon rate, and is generally paid annually orsemi-annually. Interest-bearing securities are helpful toinvestors who require a steady flow of income to meettheir expenses, or for those who are looking to steadilybuild their savings over time.

Depending on their yield, inflation, and the currenmarket situation, fixed income securities also may offercompetitive returns compared to other forms oinvestments such as equities.

Safety

For many investors, a key benefit of fixed incomesecurities is their relative safety. Safety comes from thefact that many products offer regular interest paymentsAs well, although the price of the security may fluctuatein the marketplace, at maturity the issuer is obliged torepay the face value to the investor.

The ability of the bond issuer to fulfill its obligation is alsoan important aspect of bond safety. In some casesbonds are secured by the issuers physical assets

specified in the bond contract. In contrast, a debenture isusually not secured by specific assets. Sincegovernment bonds are never secured by assets buinstead by the general credit of the government, they aretechnically debentures. In practice, however, they arereferred to as bonds.

Many debt securities are issued by governments andwell-established corporations, providing greater securityto the investment. The issuers credit rating helps aninvestor judge the safety of an investment. Canadianand U.S. rating agencies provide independent crediratings for most major bond issuers. Should the worshappen, a companys fixed income investments areconsidered safer than its shares because debt-holdersrank ahead of shareholders when a company goesbankrupt.

Your advisor can help you assess which fixed incomesecurities are safest and most appropriate for you


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Capital Gains and Losses

Fixed income investments offer the potential for capitalgains or losses. The gain or loss comes from the

difference between the price at which the security isbought and the price at which it is sold.

Like stocks, many fixed income securities trade on asecondary market. Market prices fluctuate due tochanges in interest rate movements, which in turn arerelated to changes in the supply and demand for credit,monetary policy, fiscal policy, exchange rates, economicconditions, market psychology and concerns aboutinflation.

Traditionally, fixed income securities were considered abuy and hold investment. Investors would buy them at a

certain price, gain regular income, and then be repaidthe face value at maturity. These days, however, manyinvestors choose to trade fixed income securities prior tomaturity. If market prices rise, they profit; but if pricesfall, they may incur a capital loss. Successful trading offixed income securities is linked to positioning your fixedincome securities to the future direction of interest rates.

Liquidity

Liquidity is the ability to buy and sell an investmentquickly, at a reasonable price. Unlike stocks that arelisted on an exchange, most debt securities trade on thesecondary over-the-counter debt market, allowing you tosell your investment if you wish, at a price set by currentmarket conditions. Some fixed income securities, suchas GICs are non-redeemable/non-transferable and lockan investor in for a set period of time.

Tax Considerations

When purchasing a fixed income security, there arecertain tax considerations that should be considered. Atraditional fixed income security will provide periodicinterest payments (coupon payments). These aretaxable as interest income.

When you purchase a bond, you buy it at a set pricedetermined by the marketplace. The difference, if any,between what you paid for the bond and what youreceive when you sell or redeem the bond can beconsidered a capital gain or loss.

Taxation on the Sale of a Bond Prior to Maturity

We at ScotiaMcLeod advise you to consult a taxspecialist when reviewing the tax implications of youfixed income investments. Your tax advisor will be ableto address tax issues as they pertain to your personasituation.


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Fixed Income Securities A Buyers GuideBonds

To recap, bonds are issued by governments andcorporations in order to raise money. The bondrepresents an obligation, committing the issuer torepaying the borrowed amount (the principal or facevalue) on a certain date (the maturity date). Traditionally,in the period before maturity, the borrower pays intereston set dates, usually twice a year, at a fixed rate calledthe coupon rate.

In the following sections, we highlight the key featuresand varieties of bonds and give examples of how they

are priced in the marketplace.

Bond Types and Features

Bonds come in many different forms. They varydepending on their term to maturity; whether their issueris a government or corporation; the currency in whichthey are denominated; their special features, includingcall provisions; and whether they are traditional interest-paying bonds or zero-coupon bonds.

Term to Maturity

The term to maturity of a bond can be anywhere fromone year to more than 30 years. Bonds that have up tofive years remaining to maturity are normally consideredshort-term bonds; while medium-term bonds have fromfive to ten years remaining to maturity, and long termbonds have more than ten years remaining to maturity.Bonds with a term to maturity of less than one year areusually traded alongside money market securities.

How Bonds are Priced

Like stocks, bonds are traded in the marketplace, andtheir prices fluctuate over time. Bond prices are quotedas percentage points of the face value and do notinclude any accrued interest. For example, if a bond isquoted with a price of $95, a bond with a face value of$1,000 will cost $950, plus any accrued interest.

When a bond trades at par ($100), it means the bondsprice equals its face value. If a bond trades below par, iis said to be trading at a discount. If it trades above parit is said to be trading at a premium.

Although many factors affect bond prices, the mosimportant is interest rates. In general, when interesrates decline, bond prices rise. Thats because the fixedinterest rate offered by the bond becomes moreattractive as current interest rates in the market godown. For example, if you own a bond with a couponrate of 6%, and the current interest rate declines to 4%your bonds price will rise on the market. Likewise, when

interest rates rise, the yields offered by bonds look lessattractive, and prices in general fall.

Other factors affecting the price of a bond include thecredit rating of the issuer; the time remaining untimaturity; liquidity; and special features of the bond.

The Importance of Yield

When you buy a bond, it is important to understand therate of return that the investment offers, both now andover time. For a traditional bond, the rate of return iscalculated as the yield to maturity. In essence, the yield

to maturity is the return you would make if you held thebonds to maturity, taking into account both your capitagain or loss plus the stream of interest payments youwould receive until the end of the term of the bondassuming each interest payment is reinvested at theoriginal yield. This is called the effect of compounding.

Comparative Growth Paths

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Scotia Capital 91-day T-Bill

IndexDEX Universe Bond Index

S&P/TSX Composite Index

Value of $100 invested on December 31, 1980


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Government Issues

In Canada, bonds are issued by federal, provincial and

municipal governments, and agencies associated withthose governments, such as Crown Corporations. Thesebonds are not secured by any specific assets, butinstead are backed by the general credit of the issuinggovernment.

Bonds issued by the Government of Canada representthe benchmark for all Canadian fixed income securities.Although Canada bonds are not secured by specificassets, the Federal Government has the ability to printmoney to pay down the principal and interest to cover itsdebt. No other level of government is provided with thisprivilege.

Provincial government bonds vary according to eachprovinces financial health and taxation power. Theyusually carry lower credit ratings than the FederalGovernment. Thus provincial bonds usually trade at ahigher yield, but are still considered safe investmentsbecause of the government guarantee.

Hundreds of municipalities issue their own bonds.Municipalities do have lower borrowing needs, andtherefore their issues tend to be less liquid thanprovincial or Canada bonds. However, municipalitieshave direct taxing authority over property and in themajority of cases must have balanced budgets and

conservative management of their balance sheet. Forthese reasons, they are also considered safeinvestments and achieve an investment grade rating.

Corporate Issues

Corporations do not have the benefit of sourcing theirincome from the tax base. Instead, they rely on theprofitability of their business to generate income. Sincecorporate profitability is affected by the economicclimate, consumer behavior, future industry prospects,and the political environment, there is a wide variety ofsafety in the bonds issued by corporations.

The Canadian corporate bond market has evolved overthe years from a market exclusive to blue chipcompanies to a market available to a wide variety ofcredit ratings. Investment grade bonds usually haveratings ranging from AAA to BBB. In the past few years,

Canada has developed a market for high yield ornoninvestment grade bonds, usually rated BB or lowerHigh yield securities are very speculative in nature andare not suited to every investors goals and objectives.

The main types of corporate debt issues include: (inorder of repayment ranking)

First Mortgage Bonds, where fixed assets, usually aproperty,are pledged as security for the debt.

Asset-backed Securities, are secured by assets suchas insured mortgages, accounts receivable, etc.

Bonds and Debentures, which range fromstraightforward vanilla issues to complex varieties. Whenbuying a corporate bond, it is important to understand

both the unique features of the bond as well as the credirating and credit outlook of the corporation. Debenturesdo not have specific assets pledged to support the debtbut contain other protective covenants such as wherethey rank in the issuers obligations. Such rankings (inorder of repayment priority) include senior notesdebentures, and subordinate notes

Capital and Preferred Securities offer a premium yieldto other debt of the issuer in exchange for lessprotection, including ranking, coupon deferral featuresand potentially payment in shares instead of cash.

Foreign Currency Bonds

Investors have the opportunity to buy fixed incomesecurities that are issued in currencies other than theCanadian dollar. The international bond market iscomprised not only of bonds issued in foreign currenciesby foreign countries and corporations, but the variouslevels of Canadian governments and corporations alsoissue their own bonds denominated in foreigncurrencies.

Governments and corporations regularly makeinvestments outside of their domestic markets. In orderto remove the risk of adverse movements in the

exchange rates where their investments are heldgovernments and corporations utilize the ability tofinance in outside countries, to better match their assetsand liabilities. In Canada, where the United States is oulargest trading partner, it stands to reason that manyCanadian companies finance in the United States tomatch their receivables. Bonds issued by non-domesticgovernments and corporations in the U.S. domesticmarket, denominated in U.S. dollars, are known asyankee bonds.


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Governments and corporations can also finance in aforeign currency outside of the domestic market of thatparticular foreign currency through issuing eurobonds.Eurobonds are issued under the jurisdiction of the

European market but are eligible to be purchased byboth domestic and foreign investors. Bonds issued inthis manner denominated in Canadian dollars are knownas Euro-Canadian-dollar bonds, and can offer attractivealternatives for Canadian investors.

Finally, governments and corporations can also issueglobal bonds. These bonds are issued usually in agovernments or corporations domestic currency withthe caveat that the bonds will trade and settle forpayment in the worlds major financial centers.

Foreign currency bonds provide investors all the benefits

of investing in bond markets, including the matching offoreign currency income requirements. They are alsosuitable for Canadian investors seeking to diversify theirholdings among foreign currencies, in order to protectagainst adverse movements in the Canadian dollar.

Special Features

Bonds may also have special features. Below is a listdefining the most common:

Callable bonds give the issuer the right to retire bonds onor after a future date. When a bond is called forredemption, the yield is altered. Investors thereforeshould always compare the yield-to-call against theyield-to-maturity. A common callable feature is theCanada Call which allows the issuer to call back theissue at the greater of par or a price based on the yieldof the equivalent term Government of Canada bond, plusa certain yield pickup. This pickup is normally much

lower than that pickup when the bond was originallyissued, and the exercise of this type of call normallyrepresents a significant gain to the holder.

Step-up Extendible Notes give the issuer the rights toextend the term of the bond, usually at a higher couponrate (hence the coupon steps up.) Due to the uncertainmaturity, these notes usually offer a yield premium toother bonds of similar term/credit quality.

Floating Rate bonds have a unique coupon rate thatypically adjusts quarterly or monthly, in response tochanges in a benchmark interest rate (usually the yieldon 3-month Bankers Acceptance Notes). Floating-ratebonds work to protect investors in volatile or risinginterest rate environments since their rates adjust to theprevailing interest rate.

Fixed-Floating Rate bonds, commonly issued byCanadian Banks and Insurance companies, are bondsthat have a fixed coupon rate for an initial period, afterwhich the issuer has the option to either call the bondsor extend the maturity. In volatile markets where liquidityand funding are uncertain the possibility of a bond notbeing called exists. If extended, the bond essentiallybecomes a floating rate bond as described aboveHowever, given the normally high floating rate, combinedwith potential negative capital treatment, historicallythese bonds have never been, and are likely not to beextended beyond their fixed coupon period.

Convertible bonds allow the investor to convert thebond into common shares at a specified price for astated period of time.


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Fixed Income Securities Product DescriptionsGuaranteed Investment Certificates (GICs)

Guaranteed Investment Certificates (GICs) are interestbearing notes issued by banks and trust companies andas a result, are protected by the Canadian DepositInsurance Corp. (CDIC) up to a maximum of $100,000per issuer. GICs pay the investor regular interest at a setrate, but the principal must remain invested for a certainperiod of time. GICs usually have terms ranging fromone to five years. Normally the longer the period, thehigher the interest rate offered.

Treasury Bills

T-Bills are short-term notes issued by the Government ofCanada or by Canadian Provinces. They have varyingterms to maturity, up to one year. Treasury Bills do notbear interest. Instead, they are sold at a discount to theirface value, and the annual yield or interest rate isdetermined by the difference between the discountedpurchase price and the maturity value (par). Governmentof Canada T-Bills are considered to be virtually risk-free,and can be traded at any time.

Bankers Acceptances

A Bankers Acceptance (BA) is a commercial draft (i.e. a

written instruction to make payment) drawn by aborrower for payment on a specified date. Issue termsrange from one day to one year. Each BankersAcceptance is accepted or guaranteed at maturity bythe borrowers bank. BAs are suitable for money marketinvestors accepting bank credit risk in return for a higheryield over Government of Canada T-Bills.

Commercial Paper

Commercial Paper is a promissory note which can besecured or unsecured, issued by a corporation or trust.Issue terms range from one-day to one-year.Commercial Paper ranks equal, or senior, to unsecuredlong-term debt, and junior to secured debt. Corporationsthat access the money market are large firms with anestablished financial history and rating agencies rank thepaper according to the issuers ability to meet short-termdebt obligations. These types of issues are suitable for

money market investors who are willing to accept a

corporate credit in order to obtain a higher yield. A keyratio requirement for commercial paper is to have 100%committed bank lines supporting the borrowing programThis provides added security to note holders.

Canada Savings Bonds and Canada Premium Bonds

Canada Savings Bonds are not marketable instruments they are not freely traded. They are however safe andliquid, and can be redeemed anytime, although interestis not paid out until after the initial three-month holdingperiod. The Federal Government issues them annuallyto the public. They are available in both compound and

regular interest formats, with varying maturities. Similato Canada Savings Bonds, Canada Premium Bondsoffer a higher yield, however, in return they are onlyredeemable on an annual basis.

Provincial Savings Bonds

Similar to Canada Savings Bonds, Provincial SavingsBonds are issued by certain Provincial Governmentsexclusively to residents of those provinces. Some aremarketable instruments, and can be sold prior tomaturity. Some issues are also redeemable on setredemption dates.

Preferred Shares

Preferred shares are a hybrid of fixed income securitiesand equities. They are a form of ownership in acompany, but also provide income through a reguladividend, typically paid quarterly. Preferred shares donot normally carry voting rights, as common sharesusually do. However, preferred shareholders rank aheadof common shareholders should a company wind up itsaffairs. For Canadian investors, an advantage of referredshare ownership is the tax credit received on dividendincome.

Mortgage-Backed Securities

Mortgage-backed securities are created when a financiainstitution pools a group of mortgages and packagesthem as securities. In Canada, the underlying mortgagesare either government-insured first residentiamortgages, or commercial real estate properties securedby a first lien. They pay interest and principal monthlyGovernment-insured residential mortgage-backedsecurities are unconditionally guaranteed by Canada


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Mortgage and Housing Corporation (CMHC) andNational Housing Association (NHA), are highly liquid,and provide a level of security equivalent to that ofgovernment securities. Commercial mortgage-backed

securities are not guaranteed by CMHC, and offer ahigher yield. They come in a variety of credit ratingsranging from AAA to BBB depending upon their creditenhancements.

Strip (Zero Coupon) Bonds

Strip or zero coupon bonds are created when investmentdealers take a traditional bond and separate it into itstwo basic components: the semi-annual interestcoupons, and the principal or face value repayable atmaturity. The two components are then sold separately.Like Treasury Bills, both stripped coupons and the final

principal balloon payment (known as the residual) aresold at a discount, reflecting the term to maturity and thecredit quality of the issuer. This discounted value is thenew price for each individual investment. Strip bondshave become extremely popular investments. Theytypically are derived from federal or provincialgovernment securities and are high quality and liquidinvestments. As well, yields on strip bonds tend to behigher than those of the traditional underlying issue.

Strip bonds also eliminate reinvestment risk. Since theyproduce no cash flow until maturity, the problem ofreinvesting coupon payments (links to investment risk) atrates that are continually changing is eliminated. In thisway, investors know at the outset what their yield will beif held to maturity. There also is a large and liquidsecondary over the counter zero coupon bond market,so investors are not locked into holding them untilmaturity.

However, because these investments do not offerregular income, strip bond prices tend to be more volatilethan traditional bonds with coupons, reacting more tochanges in market yields. In addition, the CanadaCustoms and Revenue Agency (CCRA) requires acertain amount of the difference between the purchaseprice and the maturity value to be recognized annually

as accrued interest. This feature makes themunattractive to hold in a taxable account since interest isclaimed but not paid. To defer paying tax, manyinvestors hold strip bonds within tax exempt accountssuch as RSPs and TFSAs.

Structured Notes

As the term suggests, these are bonds that can bestructured to meet both investors and borrowers unique

investing or funding requirements. This includes step-upextendible notes, and principal protected notes, whichallows investors to participate in the rise of a particularmarket index, mutual fund, commodities, or otheunderlying assets, while guaranteeing the return of theinitial investment. The issuers of structured notestypically are federal crown corporations, provinces andthe major chartered banks.

Fixed Income Mutual Funds

Mutual funds are pools of investors savings that offerthe benefits of diversification and professiona

management. Investors own units representing aninterest in the portfolio.

Several types of mutual funds invest in fixed incomesecurities. Money market mutual funds invest ininstruments such as Treasury Bills, and pay regulainterest income. Bond funds invest in a range of bonds inorder to generate income and capital gains. There areboth domestic and international bond funds on themarket. Dividend funds usually hold a large proportion opreferred shares, as well as other fixed incomeinvestments. Balanced funds seek to hold an appropriatemix of fixed income, equity and cash investments inorder to balance risk and reward.

Exchange Trades Funds

An exchange traded fund (ETF) is an open-endedmutual fund that is listed and traded on a stockexchange. ETFs are unlike traditional mutual funds inthat they are not actively managed by a portfoliomanager, but instead they have a static portfolio that isoverseen by an administrator.

Purchasing an ETF is identical to buying a publiclytraded stock where investors purchase units at any time

during the trading day from current holders who wish tosell. In comparison, traditional mutual funds trade at theend of the day directly from a mutual fund companyWhen redeeming ETFs the investor can both redeem forcash or the underlying securities held by the ETFhowever the primary market for ETFs is on a stockexchange. In addition, many ETFs pay dividends equato the payments of the underlying portfolio (usually on aquarterly basis) and their performance tracks thesecurities that back the fund.


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The Importance of Credit RatingsOne of the most useful tools available to the fixed

income investor is the credit rating.

Simply defined, a credit rating is the opinion of thegeneral credit worthiness of the borrower with respect toa particular debt security or other financial obligation,based on relevant risk factors by a recognized creditrating agency. Since fixed income investments areprimarily designed to preserve an investors capital whilepaying interest income, the credit worthiness of theborrower is extremely important.

In the Canadian fixed income market the two mostcommonly used rating agencies are the Dominion Bond

Rating Service (DBRS) and Standard & Poors (S&P).Although their opinions may vary regarding the creditworthiness of a particular issue or issuer, both DBRSand S&P use a very similar rating scale for long-termcredit ratings.

The rating scale is meant to provide an indication of therisk that the borrower (obligor) will not fulfill theirobligations in a timely manner with respect to bothinterest and principal commitments. The rating scalealso takes into account the protection afforded by, andthe relative position of, the investment in the event ofbankruptcy or reorganization. Listed below is the credit

rating scale used for long-term debt, ranging from thehighest quality credit to default, with a brief definition ofthe credit worthiness associated with the rating:

Credit Rating Scale

AAA Bonds rated triple A are of the highest creditquality. The obligors ability to meet its financialcommitment on the repayment of principal and interest isextremely strong. Issuers achieving the AAA ratinghave stable earnings, operate a dominant position in astrong and profitable industry, show strong liquidity andcoverage ratios, and have established a track record ofsuperior performance. Due to the extreme criteria veryfew entities are able to achieve the triple A rating.

AA Bonds rated double A are of superior credit qualityand only differ from obligations rated triple A to a smalldegree. The obligors ability to meet its financial

commitments is very strong. Issuers achieving the AArating are considered strong credits, offer above average

strength in areas of profitability and liquidity, and areunlikely to be affected by foreseeable market conditions.

A Bonds rated single A are of satisfactory crediquality. The obligors ability to meet its financiacommitment is strong. However, issuers receiving theA rating are more susceptible to the adverse effects ofchanges in circumstances and economic conditions.

BBB Bonds rated BBB are of adequate credit qualityThe obligors ability to meet its financial commitment isconsidered adequate. However, adverse economicconditions or changing circumstances are more likely to

lead to a weakened capacity of the obligor to meet itsfinancial commitments.

BB Bonds rated BB are defined as speculative. Theobligors ability to meet its financial commitment isconsidered uncertain. Issuers in the BB category havelimited access to capital markets and additional liquiditysupport. They face ongoing uncertainties or exposure toadverse business, financial, or economic conditions thareduce their capacity to meet commitments on theirobligations.

B Bonds rated B are highly speculative. The obligors

ability to meet its financial commitment on an ongoingbasis is highly uncertain. Although the obligor is currentlymeeting its financial commitment, adverse businessfinancial, or economic conditions greatly reduce theissuer is capacity or willingness to meet its obligations.

CCC / CC / C Bonds rated in any of these categories arevery highly speculative. The obligor, without thepresence of favourable business, financial, andeconomic conditions, is in danger of not meeting itsfinancial commitments.

D Bonds rated D are in default of either interest oprincipal. Unlike other ratings, D is not prospective. Itis only used where a default has occurred.

As an additional enhancement, credit rating agenciesalso modify each rating to show the issuers relativestanding within the major rating categories. In the caseof DBRS, a borrower may be further classified as beinghigh or low within the rating category. S&P also providesmodification to their ratings, however, they tack on a plus(+) or minus (-) symbol.


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To further assist investors in determining the creditworthiness of an issue or issuer, credit rating agencieswill provide a rating outlook or place the issuer on awatch list. This happens when an event or deviation from

an expected trend has occurred and further informationis required to provide an accurate appraisal of theissuers credit worthiness. Subsequent to an issuerbeing placed on watch, a rating agency will perform arating review and release the results in a timely fashion.Both DBRS and S&P use the same rating outlookterminology: negative (potential downgrade), positive(potential upgrade), and stable.

To reassure depositors and investors, regulatory bodiescreated the term investment grade to describeobligations that would be eligible for investment byinstitutions such as banks, insurance companies, and

trust companies. The term has gained widespread use inthe investment community. An obligation that isrecognized as investment grade falls within the fourhighest rating categories, AAA, AA, A and BBB. Thelowest accepted investment grade rating is BBB (low) or(-).

Issues that are rated BB or lower are referred to as highyield or speculative grade. Market liquidity in theseissues does not have the same depth as investmentgrade bonds. Investors who participate in the high yieldmarket will attempt to maintain smaller positions,spreading them out across a variety of sectors andissues. Investors who do not have the magnitude tobroadly diversify their holdings would be advised toparticipate in high yield investments through a mutualfund offering this service.

Finally, it should be noted that a credit rating is only anopinion, and that there may be extenuating or unknowncircumstances that could have a significant negativeimpact on an issuers ability to meet interest andprincipal payments in a timely fashion. Investors shouldnot rely solely on credit ratings when making theirinvestment decision.


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Checklist for Choosing the Right Fixed Income SecuritiesAs you assess each investment, consider the following factors:

1 Income, Yield and Capital GainsHow much interest will you receive and how often? Whatwill the yield be if held to maturity? Or if it is called beforematurity? If you sell before maturity, how much moneywill you receive? Is there potential for capital gains orlosses?

2 Term to MaturityIs the term right for your investment horizon? Can yousell before maturity without penalty?

3 Quality and SafetyIs the investment safe? Who guarantees it? What is theissuers credit rating?

4 LiquidityCan you sell quickly if you need to? If you sell quickly,could you lose money?

5 FeaturesDoes the security have any special features? Do youunderstand all the terms involved?

6 Tax ImplicationsIs it RRSP/RRIF eligible? How often do you have todeclare the interest from the investment? Have youdiscussed the tax implications with your personal taxadvisor, if necessary?

7 Pricing and CostsWhats the price of the investment? What denominationsis it available in? What costs or fees are involved?

8SuitabilityIs the risk profile of the investment in line with your ownrisk tolerance? Does it provide the features and benefitssuch as regular income or tax advantages, that you wantin an investment? Does it fit in with the overall asset

allocation planned for your portfolio? Have youdiscussed the purchase with your ScotiaMcLeod WealthAdvisor?

Answering these questions gives you the framework foevaluating each investment. Your ScotiaMcLeod Advisor hasthe expertise to help you weigh the risks and rewards of eachproduct, taking into consideration your objectives and thecurrent market environment. Working together, you and youadvisor will make the most of the fixed income portion of youportfolio.


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Guide to Selected Fixed Income Securities

Security Quality Backed by Income Frequency Suitable for

T-Bills Highest Federal Government MaturityInvestors seeking short-term investment

Canada Savings Bonds Highest Federal Government Annual/ CompoundingVery conservativeinvestors seekingincome

Provincial SavingsBonds

High Provincial GovernmentAnnual/Semi-Annual/Compounding

Very conservativeinvestors/ residents ofprovince

GICs Highest

Canada DepositInsurance Corporation up to $100,000 principaland interest per issuer

Annual/Semi-Annual/Monthly/ Compounding

Very conservativeinvestors seekingincome over fixed term

Government of CanadaBonds Highest Federal Government Semi-Annual

Conservative investors

seeking quality andincome

Provincial Bonds High Provincial Government Semi-AnnualConservative investorsseeking higher yieldthan federal bonds

Municipal Bonds Varies Municipality Semi-annualInvestors seeking higheryield than federal orprovincial bonds

Corporate Bonds Varies Corporation Semi-AnnualInvestors seeking higheryield than governmentbonds

Strip Bonds FederalProvincial

HighFederal/ProvincialGovernment

Maturity

Investors who do notrequire regular incomeand have tax exempt

accounts

Strip Bonds Corporate Varies Corporation Maturity

Investors who do notrequire regular incomeand have tax exemptaccounts

CMHC NHA Mortgage-Backed Securities

Highest Federal Government MonthlyInvestors seekingmonthly income

Commercial Mortgage-Backed Securities

VariesCommercial Real EstateProperties secured by afirst lien

Monthly

Investors seekingmonthly income andhigher yields thanCMHC mortgage-backed securities

Non-Canadian ForeignCurrency Bonds

VariesForeign Government orCorporation

Annual/ Semi-Annual/Monthly/ Compounding

Investors comfortablewith internationaldiversification and risk


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Registered trademark of The Bank of Nova Scotia, used by ScotiaMcLeod under license. ScotiaMcLeod is a division of Scotia Capital Inc. Scotia Capital Inc. is a

member of the Canadian Investor Protection Fund..

Copyright 2010 Scotia Capital Inc. All rights reserved.

This report has been prepared by Scotia Capital Inc. as a resource for its clients and may not be redistributed. While the information provided is believed to b

accurate and reliable, neither Scotia Capital Inc. nor any of its affiliates makes any representations or warranties, express or implied, as to the accuracy orcompleteness of such information. Nothing contained in this report is or should be relied upon as a promise or representation as to the future. This report is not

intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation or particular needs of any

specific person. Investors should seek advice regarding the appropriateness of investing in financial instruments and implementing investment strategies discussed o

recommended in this report and should understand that statements regarding future prospects may not be realized. The pro forma and estimated financial information

contained in this report, if any, is based on certain assumptions and managements analysis of information available at the time that this information was prepared,

which assumptions and analysis may or may not be correct. There is no representation, warranty or other assurance that any projections contained in this report will

be realized. Opinions, estimates and projections contained in this report are our own as of the date hereof and are subject to change without notice. The information

and opinions contained in this report have been compiled or arrived at from sources believed reliable but no representation or warranty, express or implied, is made as

to their accuracy or completeness. Neither Scotia Capital Inc. nor its affiliates accepts any liability whatsoever for any loss arising from any use of this report or its

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