A Maple Glaze Or A Different Flavour Altogether?
By: John Carswell
Maple Bonds are quickly becoming an important factor in the Canadian bond market. John Carswell, of Canso Investment Counsel Ltd., examines the growth of these bonds.
Since 2004, CIBC World Markets reports that $22 billion of fixed rate Canadian dollar bonds have been issued by foreigners and the pace of issuance is accelerating. The $11.5 billion issued in 2005 is almost double the $6 billion issued in 2004. There have been $5 billion of Canadian dollar bonds issued by foreign issuers in the first two months of 2006 alone!
Since a good bond sales pitch requires a good moniker, Bay Street has taken to calling the Canadian dollar bonds of foreign issuers ʻMaple Bonds.ʼ They are becoming an important factor in the Canadian bond market rising to eight per cent of Canadian dollar debt issuance in 2005, as Chart 1 shows.
Ralph’s Maple Tsunami
This tsunami of Canadian dollar debt issuance by foreigners is due to the removal of the Foreign Property Restriction (FPR) for registered pension and retirement accounts. Where registered plan investors formerly used their scarce room under the FPR for foreign equities, the lifting of the FPR has opened up the Canadian fixed income playing field to foreign debt issuers. The average plan sponsor has considerable foreign equity holdings and needs Canadian denominated fixed income assets to match their actuarial liabilities.
The shortage of higher rated bond issuers in the Canadian bond market also benefits foreign issuers.
As well, the liquidity and derivative restrictions in many Investment Policy Statements (IPS) means that investors prefer to leave the heavy lifting of currency and interest rate hedging to the major swap banks and their issuer clients. This creates a preference for buying the Canadian dollar issues of foreign issuers, rather than buying foreign currency bonds or hedging them back into Canadian dollars.
Is The Maple Bond Train Out Of Control?
The rapid growth in the issuance of Maple Bonds has made their potential inclusion in portfolios a pressing issue for consultants, investment managers, and plan sponsors. However, hopping on the freight train of investment fashion with bonus-hungry investment bankers at the controls is usually a recipe for disaster.
The question to ask of any new investment trend or fashion is whether it makes sense from a fundamental investment point of view. To put it in a truly Canadian perspective, since many truly important Canadian decisions are made in donut shops, “Are foreign issuers a maple glaze to the Canadian bond market or a truly different flavour altogether?”
Canadian Interest Rates Are The Major Factor
For plan sponsors, the question of whether to allow Maple Bonds in their portfolios concerns the potential for the return of Maple Bonds to behave differently than their Canadian cousins. The major factor affecting Maple Bond returns is Canadian interest rates which are determined by the Canadian bond market. Although global interest rates differ in their response to their respective economies, an issuerʼs bonds in a foreign currency will respond primarily to the interest rates in that foreign market, rather than the domestic interest rate of the issuerʼs home market.
The United States has a large and active ʻYankeeʼ market which is comprised of foreign issues in U.S. dollars. The Canadian federal government, provinces, municipalities, and many Canadian corporations issue in this market. These Canadian Yankee issues move with changes in U.S. treasury bonds, as well as the change in yield spreads for domestic U.S. issuers rather than with the movements of the Canadian bond market. Arbitrage between the Canadian and U.S. markets keeps yield spreads similar considering the hedging costs, although major differences can develop based on issue size, currency, and interest rate movements.
Maple bonds behave in the same fashion as Yankee bonds. The Canadian dollar issues of the Kingdom of Austria move with the yield of Canada bonds in the same way that the U.S. dollar issues of Canada move in concert with U.S. Treasury bonds in the Yankee market. This means the return of Maple Bonds will be highly correlated to domestic Canadian issues going forward.
Hedging And Currency
The supply of Maple Bonds depends on the hedged financing cost for issuers. Without getting too complicated, treasurers and swap banks observe the relationship between currencies and interest rates which they call the ʻbasis.ʼ Issuers borrow in one currency and use derivative transactions to return the financing cost to their home currency. They will choose to issue in Canadian dollars when it is attractive financing for them.
Demand is more stable. Studies have shown the ʻhome preferenceʼ of investors for the issuers of their native country. Investors tend to venture abroad when they see a higher return. If the swapped financing cost is insufficient to attract issuers, no deals will be done. If swap economics mean that supply exceeds the demand, spreads will widen until issuance becomes unattractive.
The demand of foreign investors for Canadian dollar debt changes as well. Prior to the recent change in the FPR, Canadian dollar bond issues by foreigners were done primarily for foreign investors. Much of this demand was from retail investors – the Belgian dentist of market lore who purchased Canadian dollar issues on an absolute yield and currency basis. European asset managers and institutions also played the currency game. This made for wide swings in demand for Canadian dollar bonds in the Eurobond market as currency views changed.
The removal of the FPR is changing the Canadian dollar Eurobond market into a market dominated by Canadian institutional investors and Maple Bond issuance. This means that currency is unlikely to play as important a role going forward.
Maple Bond Returns
These factors result in a changing interest differential or ʻspreadʼ between Maple and domestic issues that will cause a difference in returns. These should not be significant if historical returns are any indication. Scotia Capital Markets (SCM) has maintained a Euro Canadian Bond Index for many years. Table 1 shows the historic returns for domestic and foreign issuers in the one- to five-year sector (to control for term differences). This shows that in the Euro Canadian market over five and 10 years, the difference in returns between foreign and domestic corporate issuers is 0.3 per cent and 0.2 per cent respectively. The difference between foreign and domestic government issuers is greater at 0.5 per cent over five years and 0.4 per cent over 10 years.
It is interesting to note that the foreign issuers, both government and corporate, have lower returns than the domestic Canadian issuers in the Euro Canadian market. This reflects the high quality of foreign issuers in the Euro Canadian market and the investor preference for their own governments and companies.
Credit Moves With Global Sectors
The credit risk of Maple Bond issuers should not be significantly different than that of domestic Canadian issuers. A foreign government issuer or a company whose business prospects are focused in its domestic economy will have its credit fortunes dictated by national economic factors. This does not differ from a Canadian company with its operations concentrated in one province or a Canadian provincial or municipal issuer.
Using S&P ratings, the credit risk of a global issuer is actually less than that of a Canadian issuer. S&Pʼs default data says a Canadian investment grade issuer had a cumulative five-year default rate of 1.7 per cent which was higher than the global issuer default rate of 1.2 per cent. This perhaps reflects the smaller and cyclical nature of Canadian companies.
Another factor to consider in terms of Maple Bond investment is that the movement in the credit spread of a particular issuer is based on its own credit fundamentals and the demand and supply for its bonds. As we saw in the ʻharmonizationʼ of the Canadian Bond Rating Service ratings into the S&P global ratings system after the CBRS acquisition in 2000, the global credit rating agencies analyze issuers by industry and develop their metrics on this basis. This means that a Canadian pulp producer has to meet the same rating criteria as its Finnish peers. This implies that rating actions will generally affect Maple Bonds by industry sector more than by country of origin. This is already the case with the domestic bonds of Canadian companies.
Credit Skill Should Determine Credit Constraints
With Maple issues, as with domestic issues, the risk of default increases substantially within the lower credit cohorts. In our opinion, as credit analysts, there is far less risk in allowing AAA and AA Maple Bonds in a Canadian bond portfolio than allowing investment in Canadian BBB issues without credit skill or resources. S&P says, on a global basis, an AA rated issuer has a 0.3 per cent cumulative default rate over five years compared to the 2.8 per cent for a BBB rated issuer. This rises to 24 per cent for a B rated issuer!
A plan sponsor considering Maple Bonds should take a long and hard look at the credit skill of their bond manager before allowing investment in BBB and lower rated issuers. This risk could be reduced by limiting foreign issues to AA or above, which would still allow investment in many of the large and liquid high quality issuers. If your bond manager is a successful credit manager, the current investment policy constraints should be sufficient to manage the portfolio credit risk.
Legal And Regulatory Risks
The Eurobond market has developed a standardized legal and regulatory structure for a largely European investor base that has developed into a global debt financing system.
Large global issuers maintain a ʻEuro Shelfʼ prospectus that allows them to issue both fixed and floating rate debt in a variety of currencies on a continuing basis. Maple Bond underwriters are using the Eurobond documentation and shelf prospectuses to create bonds which are then issued by Private Placement exemption in Canada.
The sophistication and scale of the Eurobond market removes much of the legal and regulatory risk in Maple Bond investment. Settlement is done either through EuroClear, the Eurobond clearing system, or through CDS, the Canadian domestic settlement system, which reduces the settlement risk to that of foreign equity investment. Maple issuers do not become reporting public issuers in Canada. Since they are reporting public issuers in their home markets, however, these bonds trade like public issues in the Canadian bond market.
Investment Policy Considerations
Maple Bond investment requires a change to your IPS to remove the fixed income foreign issuer prohibition which was usually included due to the FPR restriction. The IPS should also be amended to treat private placements by public foreign issuers as public issues and not as illiquid investments.
Another important issue is that some Maple Bonds are not qualified investments for registered savings plans under the Income Tax Act (ITA). Although the repeal of the FPR allows foreign bonds to be held in RRSPs and DPSPs, they must meet the prescription of a qualified investment under the ITA. These are tricky and at times nonsensical rules. Although sovereign bonds are allowed, state sponsored enterprises might not qualify as well as corporations that do not have publicly listed equities on a prescribed stock exchange.
Direct Foreign Bond Investment
The obvious ʻplain vanillaʼ alternative to investing in Maple Bonds would be to invest in foreign currency bonds of foreign issuers. Without dwelling on theory, the currency risk has dominated unhedged foreign bond investment by Canadian investors. The strong rise in the Canadian dollar over the past few years has decimated this investment strategy and overwhelmed the potential risk-adjusted credit return.
Foreign bond investment with currency hedging has not proven a wise strategy either. Exposure to the ʻbasisʼ between the U.S. and Canadian dollar bond markets has been very negative as Canadian interest rates moved from 0.5 per cent above to 0.5 per cent below U.S. rates. This meant a currency hedged return of 2.5 per cent in Canadian dollars (assuming no hedging costs) on the U.S. Merrill Lynch Bond Market Index in 2005 compared to the 6.5 per cent return on the Canadian SCM Bond Universe Index.
Swapping from foreign pay to Canadian pay is possible, but this would not be allowed by any investment policy statements that do not permit derivatives use or that would consider the hedged position to be illiquid.
Besides, the swap pricing obtained by Maple issuers on their substantial deals with global swap banks is likely to be much better than could be obtained on smaller amounts by investment managers.
Implications For Canadian Investors
A ready supply of higher quality global issuers means that Canadian domestic issuers will need to pay wider spreads to attract investment. This should increase returns to Canadian bond investors. It will also help to alleviate the supply bottleneck for higher quality Canadian dollar issues. This should bring Canadian valuation levels more into line with international norms in the provincial and corporate market where many names traded expensively due to ʻscarcity value.ʼ
The ability to diversify credit risk internationally is especially important in financial services. In this sector, government policy and regulation is very important to the credit rating agencies and investors. This gives Maple Bonds a major advantage. Since the creditworthiness of Canadian banks is very dependent on the Canadian regulatory environment and the Canadian economy, the ability to diversify within this sector is very difficult in Canadian issues. The possibility of ʻcontagionʼ between two domestic banks is much higher than with Kommunalbank of Norway, which only lends to Norwegian municipalities, or Commonwealth Bank of Australia, which is primarily an Australian retail bank.
The Canadian financial sector could be due for a correction. Many Canadian bond portfolios have significant exposures to all five major Canadian banks.
The stretch for yield has also caused many Canadian bond investors to buy ʻhybrid securitiesʼ which are essentially preferred shares of Canadian banks for very little additional yield advantage. Canadaʼs expensive bank and hybrid markets could cheapen considerably as Maple bond issuance increases.
Canadians Should Dominate Maple Bonds
A question to ask is whether foreign issuer bonds should be managed by Canadian bond managers or their foreign competitors.
Given the Canadian penchant for things foreign, one canʼt be too sure, but the real answer lies in the currency.
Canadian investors, investment managers, and investment dealers dominate Canadian dollar bond trading for a good reason. The major holders of Canadian dollar bonds are Canadians who save and invest in their home currency. Unlike foreign investors and investment banks, which come and go with currency prospects, Canadians will be the long-term players in the Canadian debt markets as long as Canada maintains its own currency. The historically poor showing of the major global investment banks in the Canadian bond market is proof positive of this fact. Canadian bond managers know the traders, the market flows, and the Canadian dollar issuers and should have better success at generating positive risk-adjusted returns for their portfolios.
The Maple Flavour Will Get Stronger
Currency risk, market efficiency, scale, and ease of transaction are powerful forces that benefit Maple Bonds over direct investment in foreign issues. Now that the structural impediment of the FPR has been removed, the Maple Bond issuance channel will continue to grow and will remain the preferred way to diversify credit risk internationally within Canadian dollar bond portfolios.
When Ralph Goodale planted his FPR seed, conventional wisdom saw increased foreign equity exposure as the result. The substantial growth in Maple Bond issuance has surprised many, but creates substantial diversification and value-added opportunities for Canadian bond portfolios. The growing maple flavour to the Canadian bond market is a welcome development for Canadian bond investors!
John Carswell is president of Canso Investment Counsel Ltd.
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