Investment Strategies: Evolving Composition of Bonds

The landscape of the Canadian bond market has changed dramatically in recent years, and further change is certain to be on the horizon. The primary driver of this shift has been the rush by all levels of government in Canada to join the global trend toward fiscal discipline. Less government borrowing means a declining supply of government bonds, however non-government borrowers ranging from the traditional corporate issuers to the more recently created “alphabet soup” of fixed income securities (MBS, CMBS, ABS and so on) have been quick to fill the bond supply pipeline. The resulting changing composition of the Canadian bond market has important implications for the investment approach of institutional fixed income investors in Canada, including property and casualty insurance companies.

Past reflections

Ten years ago, the combined weighting of Government of Canada and provincial bonds in the Canadian bond market, as represented by the Scotia Capital Markets Universe Index was 86.5%. Traditional corporate bond issues comprised only 11.2% of the Index. The typical investment approach for Canadian institutional bond investors at the time was to focus their efforts on anticipating movements in overall interest rates, which then stood above 11%. Further, the opportunity to add value by correctly forecasting interest rate shifts was significant: during 1990, 10-year Government of Canada yields traded in a wide range of 225 basis points. Corporate credit analysis, and the evaluation of new security structures, tended to receive less attention in this environment of high, and volatile, interest rates.

The Canadian economic and financial market environment is very different today. The federal government’s annual budget has shifted dramatically from deficit to surplus, and the Conference Board of Canada predicts that the Canadian government will record a surplus for the 2000/1 fiscal year in excess of $10 billion. At the same time, all the provinces in Canada are now at, or very near, a balanced budget position on an annual basis. As a result, Government of Canada and provincial bonds now comprise just 75.5% of the Scotia Capital Universe Index, with corporate bonds currently at a 23.4% weighting. This fact alone would suggest that increased attention should be paid by investors to non-government bond issuers. But the trend is bolstered by the fact that interest rates overall are currently relatively low and stable, with 10-year Canada bond yields having traded within a 100 basis point range over the past twelve months.

So, investors have been prompted to look to alternative market sectors such as MBS, CMBS, and ABS in search of added value. A brief description of these instruments follows.

Source: Scotia Capital Markets Universe Index

New product offerings

Mortgage-Backed Securities (MBS) were first introduced into the Canadian fixed income market in 1987. These securities represent an undivided interest in a pool of underlying residential mortgages. Unlike the situation in the U.S., the MBS market in Canada is dominated by NHA (National Housing Act) MBS, which were developed with the active participation of Canada Mortgage and Housing Corporation (“CMHC”). NHA MBS represent pools of insured mortgages, and these securities carry a timely principal and interest guarantee from the Government of Canada. As such, NHA MBS are “AAA” rated and carry little credit risk. In fact, from a fixed income managers’ perspective, the primary difference between NHA MBS and conventional federal government bonds are the differing cash flow characteristics, as NHA MBS feature a monthly payment combining principal and interest, rather than a semi-annual interest payment.

Commercial Mortgage-Backed Securities (CMBS) are a fairly new product in the Canadian fixed income market, having first been introduced in late 1998. CMBS bear little resemblance to NHA MBS, primarily because they are secured by underlying commercial mortgages, and carry no government guarantee. As such, the credit quality of CMBS varies widely, with some tranches of CMBS carrying a “AAA” rating, while others carry a lower credit rating, and offer a higher yield to investors. Investors considering participating in the CMBS market must undertake an extensive analysis of both the cash flow characteristics of the securities, as well as the credit quality of the underlying mortgages and associated real estate.

Asset-Backed Securities (ABS) are a very diverse product group, referring to securities which are backed by underlying obligations including credit card balances, car loans, equipment leases, lines of credit, and more. With such a broad array of security types, ABS are represented across the full credit rating spectrum, and also cover a wide range of payment structures, from conventional semi-annual interest payments to amortizing structures involving both interest and principal repayments.

Other Products

In addition to the securitized products described above, traditional corporate bond issuance has also seen a resurgence in Canada over the past few years, as evidenced by the rising corporate component in the Scotia Capital Markets Universe Index. In addition, the types of corporate issuers coming to the bond market has been changing, with a “high yield” corporate market now developing in Canada, although this market sector is still in its infancy relative to the growth of the high yield corporate bond market in the U.S.

Implications for

Canadian insurers

As suggested above, while governments in Canada have reduced their borrowing needs, and are expected to continue to do so, there remains little likelihood of an overall “bond shortage”. However, the new and innovative products that have been introduced to the Canadian fixed income market demand an increasingly high degree of analytical expertise. For many insurance companies, it is more efficient to obtain this expertise by hiring an outside investment manager than by developing such a capability “in-house”. At the same time, it is essential that this investment manager have a thorough understanding of the investment objectives and constraints that are, in many cases, unique to insurance companies.

Scudder Kemper Investments established Scudder Investment Asset Management (SIAM) specifically to address this market need, and SIAM now manages more than US$30 billion in fixed income investments on behalf of insurance companies. Furthermore, Scudder Kemper has established “sector teams”, where investment professionals focus their energies on specific product lines such as ABS, MBS, and high yield corporate bonds. This sector team approach reflects the strong conviction of our firm that global fixed income markets, including the Canadian bond market, will become even more diverse and complex as government bond issuance continues to decline.

Scudder Kemper Investments Inc. specializes in the management of Canadian fixed income portfolios. The company is a member of the global Zurich Financial Services Group.