A strange thing has been happening in the Canadian bond market. Institutional buyers, frightened of even the minuscule risk that a major chartered bank will fail while markets are closed at night or over a weekend, have been dumping any kind of debt with the words “bank,” “bankers,” or “mortgage” in favour of short-term government debt.
Never mind that the chance that Royal Bank of Canada or any major chartered bank will fail is about as likely as being hit by lizards falling from the sky. (It’s rare, but it can happen: there was a storm of frozen reptiles in Florida on Jan. 2.) Institutional money managers have been fleeing bank and home-loan debt and wider categories of corporate debt in favour of government debt. The flight from risk has a cost, for government bonds have been priced up so high that short-term obligations that pay less than 2% are guaranteed to produce a loss vs Canadian inflation, which is running at 2.5% per year.
The process of taking money from corporate debt and transferring it to government debt has been underway since the summer of 2007. Spurred by the asset-backed commercial paper crisis, failures of structured investment vehicles in the U.S., the collapse of the subprime mortgage market and cho-ruses of oracles calling for the decline and fall of the banking system, institutional money managers have inverted the money market.
In late March, 90-day Canada treasury bills were priced to yield 1.9%, vs bankers’ acceptances yielding 3.6%. The alarmist sensi-bilities of institutional investors has created a bizarre situation. Advisors can get better returns for their clients in ordinary deposits at banks and credit unions with sums far below what institutional inves-tors are able to get on multimillion-dollar accounts.
For example, Achieva Financial, a virtual bank owned by Cambrian Credit Union in Winnipeg, offers 3.85% on daily balances with interest compounded monthly. ING Direct Canada offers 3.3%, while chartered banks offer less — Bank of Nova Scotia, 2.75%, and RBC, 3% — on high-interest savings accounts. For one-year deposits, Achieva offers 3.9%; ING, 3.75%. (Rates are subject to change, of course.)
The curious inversion of the idea that big money gets the best rates shows up in money market fund yields. Money market funds generally hold 90-day obligations. By tradition, they maintain units at $10. Credit-sensitive debt that could default is unacceptable, for any loss would tend to be shifted to the parent that operates the fund. As of late March, funds offered an average 90-day return of 1.08%. That’s 4.32% on an annualized basis, but fund returns are headed down, along with T-bill yields.
Edward Jong, senior vice president for fixed-income at MAK Allen & Day Capital Partners Inc. and portfolio manager of frontierAlt Opportunistic Bond Fund in Toronto, explains the rate disparity: “The institutional manager needs liquidity. He can’t lock money into a guaranteed investment certificate. Moreover, he has to mark his portfolio to market every day. If he buys corporate debt and finds government debt outperforming, then he is taking a relative loss on the corporates. And there is fear, after all. The institutions got burned on ABCP, and now they hesitate to hold credit-sensitive paper like bankers’ acceptances. They can’t handle the risk.”
Money market fund yields, Jong argues, will fall to the point that the managers will have to cut fees. Management expense ratios for Canadian money market funds currently range up to 2.4%, with a median value of 1.1%. If Canada three-month T-bill yields hold at 1.9%, that leaves a measly net return of 0.8% for unitholders. With very little shopping, a retail client can do better in an insured bank account. Canada Deposit Insurance Corp. coverage is $100,000 per person per member institution. Credit unions and caisses populaires offer account insurance, which varies by province.
Jong suggests that fund managers may cut fees. But, more important, he says, the low net returns of Canadian money market funds will tend to push clients and advisors to move money into bond funds with higher returns: “Money market fund clients can get 50 basis points extra yield by switching to a diversified Canadian bond fund or pick up 35 bps in a short bond fund.”
As well, bond funds can generate capital gains if interest rates continue to fall, which is not something that money market funds with terms of no more than 90 days can do.
@page_break@The curious disparity of rates is likely to continue, argues Chris Kresic, senior vice president for investments at Mackenzie Financial Corp. in Toronto. “There is a squeeze in the T-bill markets. They need liquidity, so they are buying T-bills, pushing down the yields.”
What’s ahead is becoming clear. There is a widespread belief that the Bank of Canada will follow the U.S. Federal Reserve Board, lowering interest rates by 100 to 200 bps by autumn. Money markets have already anticipated the decline. As rates fall, some inves-tors will be driven to accept risk in bankers’ acceptances, which have carried an average 200-bps yield advantage over T-bills during the debt market’s difficulties. Investors can also abandon short-term debt and move up the yield curve. In the present environment, money market fund returns, hampered by fees that will take the largest part of T-bill returns, are not competitive.
In terms of risk and liquidity, retail clients have an advantage the institutional manager lacks. Advisors and clients do not mark credit-sensitive debt to any market. They are not concerned with relative performance or spreads of credit-sensitive debt over government debt. Moreover, government and credit union association insurance covers retail-sized deposits. A balance of high-interest savings accounts at virtual banks, or GICs at banks or other deposit-taking institutions, takes care of liquidity.
Fixed-income managers acknowledge that, for the moment, the grass is greener in equities. “At current yields, bonds and money market instruments do not offer compelling value,” says Michael McHugh, vice president and fixed-income portfolio manager at Dynamic Mutual Funds Ltd. in Toronto. “Bear markets create buying opportunities.”
In his view, the price of sanctuary in very risky fixed-income investments is too high, and he suggests: “Look at equity investments.”
That’s heresy in bond circles, but with relatively secure chartered banks paying dividends at junk-bond levels, it can pay to embrace some risk. IE
Fear of risk creating strange inversions
The flight from credit-related investments means the usual rules don’t apply
- By: Andrew Allentuck
- April 29, 2008 October 31, 2019
- 09:30