Fixed Income Securities and the Canadian Money Market

Learning Objectives Overview of Fixed Income Securities Factors that Determine the Interest Rate Basics of rading Fixed Income Securities Fixed Income and Stoc" #ar"ets $ %e& Differences he #one& #ar"et Im(act on )conomic *rowth Brief +istor& of the ,anadian #one& #ar"et .dvantages for Borrowers .dvantages for Investors Im(ortant ,haracteristics of #one& #ar"et Securities ,a1cu1ating 2rice and 3ie1d on a Discount 4ote &(es of #one& #ar"et Securities ,om(osition of the ,anadian #one& #ar"et reasur& Bi11s $ ,anada reasur& Bi11 .uctions Ban" 2a(er Ban"ers8 .cce(tances ,ommercia1 2a(er $ Information #emorandum $ ,redit Ratings and Defau1t Ris" $ DBRS Short erm ,redit Ratings 3ie1ds and S(reads rading #one& #ar"et Securities De1iver& and Sett1ement Innovation in Securities rading $,DS Securiti9ation: .B,2 and the Financia1 ,risis of 766/;7660 .sset Bac"ed ,ommercia1 2a(er <.B,2= he Financia1 ,risis of 766/;7660 %e& erms ,harts 1 ,anadian 3ie1ds and Rates 7 ,om(osition of the ,anadian #one& #ar"et 3 2rimar& Dea1ers $ ,anada bi11 .uctions ,ommercia1 2a(er Information #emorandum $ +ome ! De(ot ,anada ' 2ercentage of ota1 Outstandings b& ,redit Rating - Interest Rate S(reads / he Securiti9ation 2rocess 0 ,om(osition of th eShort erm Debt #ar"et *ov8t of ,anada $Bi11 .uction .nnouncement > Resu1ts / 5 17 1' 1/ 10 76 1 71 3 3 3 ! ! ' ' / 0 0 5 16 16 11 17 13 13 13 1! 111/ 10 10 15 15 15 76 73

.((endix

7!

FIXED INCOME SECURITIES AND T E CANADIAN MONE! MAR"ET

#earnin$ O%&ecti'es 1? Describe the basic characteristics of fixed income securities 7? @nderstand the features of various t&(es of mone& mar"et securities 3? ,a1cu1ate the (rice and &ie1d of discount notes !? )x(1ain the basics of trading mone& mar"et securities

O'er'ie( o) Fixed Income Securities

7

*overnments and cor(orations must freAuent1& borrow mone& to finance their o(erations? #ost cor(orations borrow from the ban"ing s&stem: using ban" 1oans and ban" 1ines of credit: but the 1argest cor(orations and governments a1so obtain debt financing direct1& through the financia1 mar"et b& issuing fixed income securities which the& se11 to investors? o understand fixed income securities: consider the fo11owing three basic (ointsB Investors who bu& fixed income securities are 1oaning mone& direct1& to the borrower <a1so ca11ed Cthe issuerD= for fixed period of time <ca11ed the Cterm to maturit&D=? Issuers have a contractua1 ob1igation to (a& interest to investors: usua11& at a (redetermined fixed interest rate: and to re(a& the (rinci(a1 amount borrowed on a s(ecific date <ca11ed the Cmaturit& he interest rate is fixed when the securit& is first issued: and norma11& does not change over the 1ife of the securit&: regard1ess of future changes in the 1eve1 of interest rates in financia1 mar"ets?

Fixed income securities can be issued for a1most an& term to maturit&: but terms t&(ica11& range from few da&s to 36 &ears? ,onseAuent1&: the financia1 mar"et (rovides good f1exibi1it& for issuers who need to borrow cash for different (eriods of time? It a1so offers broad range of a1ternatives for 1enders who have cash to invest? B& convention: fixed income securities with terms to maturit& of 3-' da&s or 1ess are ca11ed Cmone& mar"et securitiesD and wi11 be discussed in this cha(ter? Securities with 1onger terms to maturit& are ca11ed CbondsD or CnotesD and wi11 be discussed 1ater in ,ha(ter EE?

Factors that Determine the Interest Rate on Fixed Income Securities o understand how the interest rate on fixed income securities is determined: remember that investors who bu& them are 1oaning mone& to the issuer? Investors wi11 (urchase securities on1& if the& be1ieve that the& wi11 be com(ensated for default risk F the ris" that the issuer ma& not re(a& the 1oan? If there is no defau1t ris": as in the case of securities that are issued and guaranteed b& the governments of financia11& strong countries 1i"e ,anada and the @nited States: investors earn on1& the rea1 rate of interest (1us an inf1ation (remium? ,onseAuent1&: the interest rate that investors earn on defau1t$free government securities is determined b& on1& b& the securit&Gs term to maturit& and the genera1 1eve1 of interest rates in the financia1 mar"et? Hhen investors bu& securities issued b& more ris"& borrowers: such as cor(orations and some governments: the& demand a higher interest rate that is determined b& the financia1 strength of the issuer and the (robabi1it& of defau1t? he difference between the interest rate on a ris"& securit& and the rate on a defau1t$free securit& with the same term to maturit& is ca11ed the credit s(read <or sim(1& Cthe s(readD=? It ref1ects the (robabi1it& that the issuer ma& not (a& interest and (rinci(a1 in fu11 and on a time1& basis? 3

he fact that the interest rate is fixed for the entire term of the securit& creates another source of ris" for investors: es(ecia11& when the& bu& a securit& that wi11 not mature for man& &ears? If future economic conditions: such as strong growth or inf1ation: cause interest rates to rise: investors wi11 receive no additiona1 return and the& wi11 suffer an o((ortunit& cost? o com(ensate investors for that uncertaint&: 1ong term fixed income securities usua11& (a& higher interest rates than those with shorter terms to maturit&? *asics o) Tradin$ Fixed Income Securities @n1i"e stoc"s: fixed income securities are not 1isted or traded on an organi9ed exchange? Instead: transactions are conducted through a networ" of investment dea1ers who bu& and se11 securities b& te1e(hone or com(uter? his is ca11ed the O , or Cover the counterD mar"et? ransaction costs a1so differ because commissions are charged on stoc" trades but not on trades invo1ving fixed income securities? On fixed income trades: the on1& transaction cost to investors is the CbidFas" s(readD which is the difference between the (rice at which the dea1er wi11 bu& <the bid (rice= or se11 <the ask or offer (rice= a securit&? #ost fixed income securities are marketable F the& can be so1d to an investment dea1er or to another investor in the O , mar"et at an& time (rior to their maturit& date? +owever: the fact that a securit& is mar"etab1e does not mean that it has good liquidity? If a securit& is ver& liquid: &ou can se11 a ver& 1arge amount ver& Auic"1& and for a good (rice? On the other hand: se11ing an i11iAuid securit& ma& be difficu1t: ex(ensive or: at times: im(ossib1e? *enera11&: fixed income securities issued b& the government are ver& 1iAuid: whi1e those issued b& cor(orations are not? he 1iAuidit& of different t&(es of securities wi11 be discussed 1ater in this cha(ter? Fixed Income Markets and Stock Markets + "ey Di))erences .1most ever&one is aware of stoc"s and stoc" exchanges: but man& outside the investment industr& do not understand fixed income securities? he& a1so do not rea1i9e that the fixed income mar"et is at 1east 16 times 1arger than the stoc" mar"et? Information on fixed income mar"ets is difficu1t to obtain because fixed income securities are traded in the O , dea1er mar"et which (rovides re1ative1& 1itt1e data on individua1 (rices and amounts traded? Stoc" mar"et data: b& contrast: is ver& eas& to obtain because stoc" (rices and trading vo1umes are (ub1ished dai1& in the *1obe and #ai1: Financia1 2ost: Ha11 Street Iourna1 and other business news(a(ers: and the& are a1so avai1ab1e on free (ub1ic websites such as 3ahoo Finance and *1obe Investor? his eas& access to accurate: time1& mar"et information is ca11ed Ctrans(arenc&D?

The Money Market

Debt or Cfixed incomeD securities with terms to maturit& of 1ess than one &ear are issued and traded in a (art of the financia1 mar"et ca11ed the C#one& #ar"etD? 2artici(ants in the mone& mar"et are 1arge borrowers: inc1uding governments: cor(orations: ban"s and other entities that !

reAuire short term debt financing: and 1arge investors who have cash to invest for short time (eriods? he most (o(u1ar mone& mar"et investment is government treasur& bi11s? Im,act on economic $ro(th . 1iAuid: we11$deve1o(ed mone& mar"et is essentia1 for the growth of a modern econom& because it (rovides cor(orations and governments with a re1iab1e source of short$term financing: denominated in 1oca1 currenc&? For 1arge cor(orations: the mone& mar"et (rovides a stead& su((1& of 1ow$cost wor"ing ca(ita1 which the& reAuire to ex(and their domestic business o(erations and ex(ort their (roducts to foreign mar"ets? Businesses and individua1s who need to borrow mone& from the ban"ing s&stem a1so benefit because the mone& mar"et is an additiona1 source of funding that ban"s can use to ma"e 1oans whenever their customersG 1oan demand exceeds the amount of cash the& can obtain from de(ositors? Investors: inc1uding businesses and cor(orations who have tem(orar& cash sur(1uses: a1so benefit because the mone& mar"et (rovides them with an o((ortunit& to invest 1arge amounts of cash easi1& and safe1&: and earn a reasonab1e return? For that reason: a we11 deve1o(ed mone& mar"et he1(s to create wea1th: further contributing to economic growth and confidence? Fina11&: a11 as(ects of the econom& benefit because a we11$deve1o(ed mone& mar"et he1(s the centra1 ban" to im(1ement monetar& (o1ic&? If the mone& mar"et is active and re1iab1e: the centra1 ban" can easi1& se11 or bu& 1arge amounts of reasur& bi11s to increase or decrease 1iAuidit&: and inf1uence interest rates?

A *rie)

istory o) the Canadian Money Market

,anadian financia1 mar"ets were undeve1o(ed unti1 the Ban" of ,anada was estab1ished in 153': and the ,anadian mone& mar"et did not exist? Before Hor1d Har I: the government of the Dominion of ,anada: as our countr& was ca11ed then: obtained short term financing b& se11ing treasur& bi11s to investors in the London mone& mar"et? Since British investors demanded (a&ment in (ounds ster1ing: the ,anadian government cou1d not obtain short term funding in its own currenc&? Hhi1e ,anadaGs historic (o1itica1 ties to Britain caused our government to borrow in the London mone& mar"et: ,anadian ban"s turned to 4ew 3or" for short term funding? #ost ban" financing transactions were denominated in @S do11ars: so the ,anadian ban"s were ex(osed to exchange rate ris"s? 3et: des(ite those ris"s: the 1ac" of ,anadian do11ar a1ternatives did not seem to deter the ban"s from using the 4ew 3or" mar"et because it offered good 1iAuidit& and a convenient 1ocation: c1ose to ,anadian financia1 centers of #ontrea1 and oronto? In fact: the ban"sG eas& access to a we11$deve1o(ed mone& mar"et in 4ew 3or" (robab1& inhibited the deve1o(ment of a mone& mar"et in ,anada for man& &ears? Because the ,anadian ban"ing industr& focused on 4ew 3or": our domestic mone& mar"et did not deve1o( unti1 the Ban" of ,anada and the government of ,anada decided to ta"e action in the 1536Gs? In its first annua1 re(ort: re1eased in 153'J: the Ban" of ,anada em(hasi9ed that '

effective im(1ementation of monetar& (o1ic& reAuired the deve1o(ment of an active mone& mar"et in ,anadaB It is universally recognized that a central bank is hampered in its operations where an active bill market does not exist? he need for a domestic mone& mar"et (rom(ted the *overnment of ,anada to issue treasur& bi11s in ,anadian do11ars in 153!? Regu1ar ,anada treasur& bi11 auctions started three &ears 1ater in 153/? +owever: an active mone& mar"et did not begin to deve1o( in ,anada unti1 the 15-6Gs because most treasur& bi11s were bought b& ban"s which he1d them to maturit& and did not trade? .1so: due to ban"ing regu1ations that (ersisted through the 15-6Gs: non$government issuers were absent from our mone& mar"et? hen: in 15-/: the Ban" of ,anada initiated a series of changes: inc1uding the remova1 of interest rate cei1ings on ban" 1oans: which increased mone& mar"et (artici(ation b& ban"s and investment dea1ers? Ban"s became more active: cor(orate borrowers began to issue mone& mar"et securities as an a1ternative to ban" 1oans: and ban"ersG acce(tances were introduced? hese (ivota1 events (romoted the deve1o(ment of the active mone& mar"et that exists in ,anada toda&? SourceB htt(B;;www?g76?utoronto?ca;docs;ca(ita1mar"ets$canada?(df

Ad'anta$es )or *orro(ers For governments and 1arge cor(orations who borrow to finance their short term wor"ing ca(ita1 reAuirements: the mone& mar"et (rovides a re1iab1e source of 1ow cost debt financing? heir borrowing costs are reduced because the interest rate the& (a& to issue mone& mar"et securities is usua11& 1ower that the rate the& wou1d have to (a& on a ban" 1oan? Savings can be significant: as i11ustrated in ,hart 1? 4ote that mone& mar"et rates are much 1ower than the C2rime RateD: which determines the interest rate that ban"s charge on 1oans made to their best customers? F1exibi1it& is better: too: because the mone& mar"et a11ows borrowers to match the amount and maturit& date of their borrowing to their cash reAuirements? @nfortunate1&: not a11 borrowers can access the mone& mar"et? Issuance is 1imited to borrowers who routine1& reAuire 1arge amounts of short term debt financing: t&(ica11& K'6 to K166 mi11ion or more: and have strong ba1ance sheets? C ART -

Canadian !ie.ds and Rates

-

2revious Latest T/%i..s 1$month 3$month -$month 1$&ear *anker0s Acce,tances 1$month 3$month -$month *ank #oans 1 De,osits Ban"s8 2rime Rate *I,8s 56 da&s 1?11?76 1?70 3?66 6?-6 1?71 1?7/ 1?70 3?66 6?-6 6?06?00 6?5' 1?66 6?0/ 6?00 6?5! 6?55 Da&

Hee" .go 6?05 6?05 6?53 6?5! 1?77 1?71?7/ 3?66 6?-6

! Hee"s .go 6?51 6?5' 1?66 1?63 1?71 6?50 1?37 3?66 6?-6

SourceB Financia1 2ostL Iune 77: 7617 htt(B;;www?financia1(ost?com;mar"ets;data;mone&$&ie1ds$canMus?htm1

Ad'anta$es )or In'estors For investors: mone& mar"ets offer the o((ortunit& to invest their cash easi1& and safe1&: whi1e a1so earning interest rates that are usua11& su(erior to the rates the& can earn on ban" de(osits? he mone& mar"et a1so (rovides investors with the o((ortunit& to invest in securities with different terms to maturit&: ranging from overnight to 3-' da&s: so can se1ect the maturities that best meet their needs? In addition: most mone& mar"et securities are Cnegotiab1eD so ownershi( can be transferred from one investor to another? he& are a1so Cmar"etab1eD so investors can se11 them in the O , mar"et if the& need cash (rior to the maturit& date? +owever: the fact that a securit& is mar"etab1e does not necessari1& im(1& that investors can se11 a 1arge amount at a fair mar"et (rice? he abi1it& to rese11 a 1arge ho1ding of a securit& Auic"1& for a good (rice is ca11ed C1iAuidit&D? LiAuidit& in the mone& mar"et is variab1e: de(ending on the securit& t&(e? .s we wi11 see 1ater in this cha(ter: *overnment of ,anada reasur& Bi11s have exce11ent 1iAuidit&: and trade active1& in ver& 1arge amounts in the secondar& mar"et? B& contrast: most mone& mar"et securities issued b& cor(orations have 1ow 1iAuidit& so investors must often acce(t a 1ower (rice if the& se11 them before the maturit& date? Investors who bu& mone& mar"et securities inc1ude financia1 intermediaries such as (ension funds: insurance com(anies: mutua1 funds and ban"s: as we11 as cor(orations and governments /

that have short term cash sur(1uses to invest? Individua1 or Cretai1D investors ma& a1so invest in mone& mar"ets: but their (artici(ation is usua11& 1imited b& the fact that this is a Cwho1esa1e mar"etD in which the minimum transaction si9e is ver& 1arge <t&(ica11& K166:666 or more=?

Im,ortant characteristics o) Money Market Securities2 #one& mar"et securities genera11& have the fo11owing four characteristicsB 1? 7? he& mature in 1ess than one &ear <3-' da&s= he& are essentia11& IO@Gs F CunsecuredD 1oans made b& investors to governments and cor(orations

3? #ost are mar"etab1e and high1& 1iAuid F the& can be Auic"1& converted to cash at fu11 mar"et va1ue !? .1most a11 are Cdiscount notes? #one& mar"et securities do not ma"e se(arate interest (a&ments to investors? Instead: the& are Cdiscount notesD which investors bu& for a (rice that is 1ess than their va1ue at maturit&? he difference between the maturit& va1ue of a securit& <a1so ca11ed the face or par value= and the (urchase (rice is the amount of interest earned b& the investor? he interest rate or yield earned on a mone& mar"et securit& is inf1uenced b& the Covernight rateD in the financia1 mar"et and ex(ressed as an annua1 rate? B& convention: mone& mar"et &ie1ds are ca1cu1ated on a Cbond eAuiva1ent basisD or B)3: that ref1ects sim(1e interest <no com(ounding= and: for ,anadian securities: a 3-' da& &ear?

Ca.cu.atin$ 3rice and !ie.d on a Discount Note2

P =

F n 1+ k 365

Hhere F N the face or (ar va1ue: 2 N the mar"et (rice: n N da&s to maturit&: " N &ie1d to maturit& B& convention: the (rice is Auoted as the cost of bu&ing K166 face or (ar va1ue Example 1 . ,anadian discount note has a term of 06 da&s remaining unti1 maturit& and its bond$eAuiva1ent &ie1d is !?'O? Hhat is the Auoted (rice of this noteJ

PT -bill =

F $100 = = $99.0233. n 80 1 + k BEY 1 + 0.045 365 365

So the Auoted (rice is K55?6733 (er K166 face or (ar va1ue

Example ! +ow much must &ou (a& to bu& K1 mi11ion face va1ue of this discount noteJ $1,000,000 $99.0233 = $990,233 $100

Example " Hhat is the &ie1d on a K166:666 ,anadian treasur& bi11 with 106 da&s unti1 maturit& and a mar"et (rice of K50:766J F P 365 $100,000 $98,200 365 = = 3.72% P n $98,200 180

k BEY =

4Exam,.es are ada,ted )rom *ooth 1 C.eary5

In the @nited States: the (rice and &ie1d on @S government reasur& bi11s ma& be Auoted different1&: on what is ca11ed a Cban" discount basisD: using ca1cu1ations that are based on a 3-6 da& &ear: and use F as the denominator Example # Hhat is the &ie1d on a K166:666 @S treasur& bi11 with 106 da&s unti1 maturit& and a mar"et (rice of K50:766: if the &ie1d is ex(ressed on a ban" discount basisJ k BD = F P 360 $100,000 $98,200 360 = = 3.60% F n $100,000 180

$ote how differences in %anadian and &' market convention impacted the results we obtained in for the treasury bill yield calculations shown in Examples " and #( Increasing1&: the @S is moving to a 3-' da& &ear for mone& mar"et ca1cu1ations: but methodo1og& cannot be assumed? Hhen trading in @S treasur& bi11s: it is im(ortant to confirm the basis on which ca1cu1ations are being made because differences wi11 cause (rice discre(ancies: 1eading to significant errors in the (ricing of 1arge trades?

Ty,es o) Money Market Securities

#one& mar"et securities are c1assified b& the t&(e of issuer F government: ban" or cor(oration? .11 are avai1ab1e for (urchase b& investors in mu1ti(1es of K1:666 face or (ar va1ue: but minimum transaction amounts var&? Com,osition o) the Canadian Money Market he amount outstanding of each t&(e of securit& in the mone& mar"et changes over time: and is inf1uenced b& the re1ative borrowing needs of governments: ban"s and cor(orations? Hhen governments run 1arge deficits: as the& did during the recession that fo11owed the financia1 crisis of 7660: the& must finance those deficits b& borrowing from investors? .s shown in ,hart 7: deficit financing causes the do11ar va1ue of government securities to increase: so government securities re(resent a 1arger (ercentage of tota1 securities avai1ab1e for investors to (urchase in the mone& mar"et? 4ote that short term borrowings b& governments: which re(resented on1& !7O of a11 mone& mar"et securities in 766-: increased to --O b& 7611?

C ART 6 Com,osition o) the Canadian Money Market %y Do..ar 7a.ue o) Securities Outstandin$

16

SourceB DBRS

Treasury %i..s are short term securities issued and guaranteed b& a government? .1so ca11ed $bi11s: the& are usua11& the safest and most 1iAuid securities in an& 1oca1 mar"et? $bi11s issued b& the federa1 governments of financia11& strong countries: such as ,anada and the @nited States: are considered Cris" freeD investments? Due to their 1ow ris" and high 1iAuidit&: the& (rovide the 1owest &ie1ds: re1ative to other mone& mar"et securities with the same term to maturit&? ,anada reasur& Bi11s )%*+,s- are one of the most (o(u1ar investment a1ternatives in the ,anadian mone& mar"et? he& are viewed as the safest investment because the& are a direct ob1igation of the *overnment of ,anada? he& are a1so the most 1iAuid: so the& can be so1d: even in ver& 1arge amounts: whenever investors need to raise cash on ver& short notice? In ,anada: the governments of 1arge (rovinces: such as Ontario and Puebec: a1so issue treasur& bi11s on a regu1ar basis? 2rovincia1 $Bi11s are guaranteed b& the issuing (rovince and (rovide investors with s1ight1& higher &ie1ds than $bi11s issued b& the *overnment of ,anada because the& are 1ess 1iAuid and ma& have sma11 defau1t ris"? o( are ne( Canada treasury %i..s created8 Canada Treasury *i.. Auctions *overnment of ,anada treasur& bi11s are issued through an auction (rocess conducted b& the Ban" of ,anada: which acts in its ca(acit& as the fisca1 agent of the federa1 government? .uctions: which are announced in advance on the Ban" of ,anadaGs website: are he1d twice a month on uesda&s: for a (revious1& announced do11ar amount and range of terms to maturit&: usua11& 3 months: - months and one &ear? he announcement of a recent ,anada treasur& bi11 auction is shown in .((endix 1? 2artici(ation in the treasur& bi11 auction is strict1& contro11ed b& the Ban" of ,anada to ensure that the mar"et remains fair: trans(arent and ver& 1iAuid? On1& authori9ed (rimar& dea1ers and government securities distributors are (ermitted to bid for the new treasur& bi11s: and the& ma& submit bids for their own account and on beha1f of their customers? wo t&(es of bids are a11owedB Com,etiti'e %ids: in which the dea1er states the (rice and &ie1d at which he is wi11 to bu& an amount of $ bi11s: u( to a s(ecified amount: and Non/com,etiti'e %ids: in which the dea1er agrees to bu& a s(ecified amount of $bi11s at the weighted average auction (rice of successfu1 com(etitive bids?

11

he amount that a sing1e bidder can bu& is 1imited to (revent one or more dea1ers from dominating the mar"et? Resu1ts for a recent *overnment of ,anada $bi11 auction are shown in .((endix 7? C ART 9

3rimary Dea.ers + Canada T/*i.. Auctions

Ban" of #ontrea1 ,anadian Im(eria1 Ban" of ,ommerce Deutsche Ban" Securities Limited +SB, Ban" ,anada Laurentian Ban" Securities Inc? #erri11 L&nch ,anada Inc? 4ationa1 Ban" Financia1 Inc? RB, Dominion Securities Inc? Scotia ,a(ita1 Inc? he oronto$Dominion Ban" 'ource +ank of %anada *ank ,a,er is issued b& chartered ban"s to fund their short term cash needs: and so1d to investors in the mone& mar"et? ,a11ed certificates of de(osit <,DGs= or bearer de(osit notes <BD4Gs=: and issued in denominations of at 1east K166:666: these securities are effective1& 1arge si9e ban" de(osits? he ban"s freAuent1& issue ,DGs and BD4Gs to obtain 1arge amounts of who1esa1e funding : which su((1ements the de(osits the& receive from their retai1 customers: and is used to ma"e 1oans? Some ban" (a(er (a&s interest se(arate1&: but most is so1d in the form of discount notes for which (rice ca1cu1ations are identica1 to treasur& bi11s? #ost ban" (a(er is negotiab1e but 1iAuidit& is genera11& (oor: so investors who (urchase ban" (a(er usua11& ho1d it unti1 the maturit& date? *ankers: acce,tances <B.Gs= are short term (romissor& notes issued b& cor(orations and unconditiona11& guaranteed b& a ,anadian chartered ban"? )ssentia11&: the& are 1oans that the ban" has guaranteed and so1d to investors? he term Qacce(tanceQ means that the borrowing cor(oration (aid the ban" a Cstam(ing feeD: usua11& between 6?/'O and 1?'O: to guarantee time1& re(a&ment of the amount borrowed? For that reason: the ris"iness of ban"ersG acce(tances is determined on1& b& the financia1 strength and credit rating of the Cacce(tingD ban"? Ban"ers8 acce(tances are usua11& issued for terms of 1 to 3 months: and trade in the mone& mar"et under the name of the ban" that (rovided the guarantee <ie B#O 3 month B.s=? he& are attractive to investors because the& are 1iAuid securities that (rovide higher &ie1ds than *overnment of ,anada $bi11s of com(arab1e term to maturit&: and have on1& s1ight1& more ris"? Li"e treasur& bi11s: the& are discount notes? 17

Ban"ersG acce(tances are a 1arge and ver& im(ortant com(onent of the ,anadian mone& mar"et? In 7611: the& accounted for K'1 bi11ion: or a1most '6O of a11 non$government securities? <see ,+.R 7= 4oteB Ban"ers8 acce(tances are uniAue to the ,anadian mar"et? he term Cban"ersG acce(tanceD is a1so used in the @S but there it refers to a different t&(e of securit& that is used to finance internationa1 trade? Commercia. ,a,er is a short term: unsecured (romissor& note <an IO@= issued b& a major cor(oration? hese discount notes are usua11& issued for 1: 7 and 3 month terms to maturit&: but ma& be issued for an& term from 1 da& to 1 &ear? he &ie1d on commercia1 (a(er is determined b& the creditworthiness of the issuer: the term to maturit& and current financia1 mar"et conditions? #inimum transaction amounts are 1arge: t&(ica11& K166:666 or more? ,ommercia1 (a(er is negotiab1e but 1iAuidit& is not good: so investors who (urchase commercia1 (a(er usua11& ho1d it unti1 its maturit& date? Before (urchasing commercia1 (a(er: investors usua11& contact the O , trading des"s of severa1 major ban"s and investment dea1ers to obtain information on avai1ab1e securities: rates and (rice Auotations? Investors who are ver& "now1edgeab1e and active in the mone& mar"et sometimes b&(ass the dea1ers and obtain s1ight1& better rates b& (urchasing commercia1 (a(er direct1& from the treasur& de(artment of an issuing cor(oration? In ,anada : on1& ver& 1arge cor(orations with we11 deve1o(ed commercia1 (a(er (rograms: such as *) ,a(ita1: se11 their notes direct1& to investors?

In)ormation Memorandum ,or(orate borrowers who want to issue securities in the mone& mar"et must (rovide investors with a 1ega1 document ca11ed an Information .emorandum which out1ines "e& facts about their commercia1 (a(er (rogram: inc1uding the maximum amount to be issued: the extent of bac"$u( ban" 1ines of credit avai1ab1e to cover an& cash shortfa11s: the credit rating and the investment dea1ers who wi11 se11 the notes to investors? ,hart ! shows high1ights of the Information #emorandum for +ome De(ot ,anadaGs commercia1 (a(er (rogram? %e& facts that investors need to "now before (urchasing this (a(er inc1udeB Hho is the issuerJ Hho is the guarantorJ Hhat is the maximum tota1 do11ar amount of (a(er that can be outstanding at an& timeJ Hhat wi11 the issuer do with the (roceedsJ 13

 Hhich investment dea1ers shou1d &ou contact if &ou want to bu& +ome De(ot ,anadaGs commercia1 (a(erJ Hhat is the credit ratingJ In &our o(inion: how safe is it to invest in +ome De(ot ,anada commercia1 (a(erJ

C ART ;

1!

Credit Ratin$s and De)au.t Risk he financia1 strength of the issuer is ver& im(ortant because investors who bu& commercia1 (a(er are ma"ing an unsecured 1oan to the issuing cor(oration? Since the 1oan is bac"ed on1& b& the issuerGs (romise to (a& <an IO@=: investors wi11 (urchase on1& commercia1 (a(er issued b& cor(orations that have 1ow defau1t ris": and have received an investment grade credit rating from at 1east one of the major credit rating agenciesB Dominion Bond Rating Service <DBRS=: #ood&s and Standard and 2oors <S>2=? ,ommercia1 (a(er with an R1 rating from DBRS is considered to be Cinvestment gradeD? It is divided into sub$sectionsB R1 $ +igh: R1 $ #edium and R $1 Low? e of these three ratings? D*RS Short/Term De%t Ratin$s he DBRSR short$term debt rating sca1e (rovides an o(inion on the ris" that an issuer wi11 not meet its short$term financia1 ob1igations in a time1& manner? Ratings are based on Auantitative and Aua1itative considerations re1evant to the issuer and the re1ative ran"ing of c1aims? he R$1 and R$7 rating categories are further denoted b& the subcategories C<high=D: C<midd1e=D: and C<1ow=D? R/- 4hi$h5 +ighest credit Aua1it&? he ca(acit& for the (a&ment of short$term financia1 ob1igations as the& fa11 due is exce(tiona11& high? @n1i"e1& to be adverse1& affected b& future events? R/- 4midd.e5 Su(erior credit Aua1it&? he ca(acit& for the (a&ment of short$term financia1 ob1igations as the& fa11 due is ver& high? Differs from R$1 <high= b& a re1ative1& modest degree? @n1i"e1& to be significant1& 1'

vu1nerab1e to future events? R/- 4.o(5 *ood credit Aua1it&? he ca(acit& for the (a&ment of short$term financia1 ob1igations as the& fa11 due is substantia1? Overa11 strength is not as favourab1e as higher rating categories? #a& be vu1nerab1e to future events: but Aua1if&ing negative factors are considered manageab1e? R/6 4hi$h5 @((er end of adeAuate credit Aua1it&? he ca(acit& for the (a&ment of short$term financia1 ob1igations as the& fa11 due is acce(tab1e? #a& be vu1nerab1e to future events? R/6 4midd.e5 .deAuate credit Aua1it&? he ca(acit& for the (a&ment of short$term financia1 ob1igations as the& fa11 due is acce(tab1e? #a& be vu1nerab1e to future events or ma& be ex(osed to other factors that cou1d reduce credit Aua1it&? R/6 4.o(5 Lower end of adeAuate credit Aua1it&? he ca(acit& for the (a&ment of short$term financia1 ob1igations as the& fa11 due is acce(tab1e? #a& be vu1nerab1e to future events? . number of cha11enges are (resent that cou1d affect the issuerGs abi1it& to meet such ob1igations? SourceB DBRS .ccording to records maintained b& DBRS: a11 commercia1 (a(er current1& outstanding in the ,anadian mone& mar"et is rated R$1? <4oteB )Auiva1ent investment grade ratings used b& other credit rating agencies areB #ood&s 2$1 and S>2 .$1?= he data (resented in ,hart ' c1ear1& indicates that investors wi11 not acce(t the defau1t ris" associated with bu&ing non$ investment grade (a(er: rated R$7 or 1ower? he im(1ication is that cor(orations with 1ower credit ratings cannot borrow direct1& through the mone& mar"et? Instead: the& must obtain a ban" guarantee and issue ban"erGs acce(tances? C ART <

SourceB DBRS

!ie.ds and S,reads 1-

he &ie1d on a mone& mar"et securit& ref1ects investorsG (erce(tion of the (robabi1it& that the issuer ma& defau1t? he difference between the &ie1d on ris" free $bi11s and the &ie1d on commercia1 (a(er with the same term to maturit&: ca11ed the Ccredit s(readD: is the com(ensation demanded b& investors for assuming the ris" that an issuer ma& not re(a& the amount borrowed? ,redit s(reads are im(acted b& the defau1t ris" and credit rating of the s(ecific issuer: and a1so b& financia1 mar"et conditions?

During high ris" (eriods: such as occurred during the financia1 crisis of 766/ and 7660 when severa1 ban"s and cor(orations fai1ed or reAuired government bai1outs: a11 credit s(reads increased shar(1& as worried investors refused to assume an& ris"? he& refused to bu& commercia1 (a(er at an& (rice: and (urchased on1& *overnment reasur& bi11s because of their ris"$free status? In times of crisis: this Cf1ight to Aua1it&D disru(ts mar"ets: creating circumstances that ma"e it ex(ensive and: sometimes im(ossib1e: for some 1arge cor(orations to finance their wor"ing ca(ita1 reAuirements?

C ART = Interest Rate >S,reads? Di))erence %et(een the yie.ds on C3 1 T/*i..s

Money Market Spreads (CansimV121812,V121778,V121796)
300 250 200 150 100 50 11/4/2007 11/4/2008 11/4/2009 11/4/2006 3/4/2006 5/4/2007 9/4/2007 5/4/2008 1/4/2009 1/4/2006 5/4/2006 7/4/2006 9/4/2006 1/4/2007 3/4/2007 7/4/2007 1/4/2008 3/4/2008 7/4/2008 9/4/2008 3/4/2009 5/4/2009 7/4/2009 9/4/2009 1/4/2010 3/4/2010 0

CP

BA

Tradin$ Money Market Securities + De.i'ery and Sett.ement In the (ast: reasur& bi11s were (h&sica1 (a(er certificates: issued in Cbearer formD to faci1itate 1iAuidit& and fast trading? 4o records of ownershi( were "e(t and whoever had (h&sica1 (ossession of the treasur& bi11 certificate was deemed to be the owner? @nderstandab1&: the use 1/

of bearer certificates created an unsafe situation that 1eft the financia1 s&stem o(en to theft and fraud? For safet&: other t&(es of mone& mar"et securities were registered in the name of the owner: using (a(er records which reAuired time$consuming manua1 adjustment whenever the securities were bought or so1d? Hith the advent of com(uter techno1og& in the 1506Gs: trading became safer and more efficient? )1ectronic ownershi( records: maintained b& the ,anadian De(ositor& for Securities <,DS= and its g1oba1 counter(arties: re(1aced (a(er certificates: bearer securities and (a(er transfers for most t&(es of securities? Since 4ovember 155': reasur& bi11s and most commercia1 (a(er are issued in g1oba1 certificate form on1&? he fu11 amount owned b& an investor is registered e1ectronica11& at ,DS: and trades are (rocessed e1ectronica11&? his im(ortant innovation: which re(1aced (h&sica1 trading of (a(er securit& certificates with a Cboo" basedD <e1ectronic= s&stem: shortened the Csett1ement (eriodD on trades and reduced trading ris"s? )*he settlement period is the number of days between the trade date and settlement date/ which is the date on which cash is paid or received-( oda& when an investor bu&s or se11s a mone& mar"et securit&: cash is (aid or received on the same da&? In other words: the trade date and sett1ement date are the same?

Inno'ation in Securities Tradin$ he ,anadian De(ositor& for Securities Limited <,DS Ltd?= was incor(orated on Iune 5: 15/6 in res(onse to rising bac" office costs and increased vo1umes in the ca(ita1 mar"ets resu1ting from a vibrant ,anadian econom&? It was formed to 1everage new techno1ogies and automation to create a centra1i9ed de(ositor& service and an e1ectronic c1earing and sett1ement s&stem that cou1d not on1& hand1e higher vo1umes: but meet future needs? In 15/-: ,DS began c1earing trades executed on the #ontrea1 )xchange and b& the fo11owing &ear: the oronto exchange was on board? ,DSGs re(utation for re1iabi1it& and innovation grew over the decade: as did the number of (artici(ants? In 15/5: ,DS became a (artici(ant of he De(ositor& rust ,om(an& <D ,= in 4ew 3or": a first ste( toward meeting the growing need for access to the @?S? mar"et? D , became a direct ,DS (artici(ant in 1550: ma"ing cross$border c1earing and sett1ement a rea1it&? In 1501: the first eAuit& securities were de(osited in the boo"$based s&stem? *overnment of ,anada bonds were added to the s&stem in the 1ate 1506s: fo11owed b& the im(1ementation of the Debt ,1earing S&stem for bonds and mone& mar"et instruments in the ear1& 1556s? SourceB ,DS

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Securiti@ationA Asset *acked Commercia. 3a,er and the Financia. Crisis o) 6BBC
Asset *acked Commercia. 3a,er 4A*C35 is a t&(e of commercia1 (a(er issued b& a trust or a s(ecia1 (ur(ose vehic1e <common1& ca11ed an S2S or SIS=? hrough a (rocess ca11ed Csecuriti9ationD: the SIS issues commercia1 (a(er and se11s it to investors? ,ash obtained from the sa1e of commercia1 (a(er to acAuire various financia1 assets which ma& inc1ude accounts receivab1e: credit card receivab1es: car 1oans: eAui(ment 1eases or mortgages? he financia1 assets are he1d b& the SIS and are co11atera1 for the commercia1 (a(er? he financia1 assets he1d in the SIS generate cashf1ows: through interest and (rinci(a1 (a&ments: which the SS2 uses to re(a& investors who (urchased the commercia1 (a(er? o reduce defau1t ris" for ho1ders of the commercia1 (a(er: the SIS is over co11atera1i9edB the va1ue of financia1 assets he1d as co11atera1 exceeds the amount of commercia1 (a(ers issued? Investors are a1so (rotected b& ban" guarantees obtained b& the SIS?

,1ear1&: the ris" 1eve1 of asset bac"ed commercia1 (a(er <.B,2= is inf1uenced b& the Aua1it& of the financia1 assets he1d b& the SIS? If too man& of those assets defau1t: investors who own the .B,2 wi11 not receive fu11 (a&ment? C ART D + The Securiti@ation 3rocess C ART D + The Securiti@ation 3rocess

The )inancia. crisis o) 6BBDE6BBC 2rior to Se(tember: 766/: .B,2 was a (o(u1ar investment a1ternative that man& be1ieved to be a1most as safe as government treasur& bi11s and the next best thing to cash? Financia1 mar"et histor& su((orted that (oint of view? First deve1o(ed in the ear1& 1556Gs: securiti9ations and .B,2 had a 1ong trac" record of (roviding investors with 15

good returns: combined with 1ow defau1t ris"? #ost were rated R$1<high= or ... b& major credit rating agencies? Securiti9ations a1so (rovided benefits to cor(orations whose business activities generated 1arge vo1umes of accounts receivab1e? B& se11ing their high Aua1it& accounts receivab1e to an SIS: those cor(orations shortened their cash c&c1e and im(roved the 1iAuidit& of their ba1ance sheets? Investors began to Auestion the safet& of securiti9ations in 1ate 766/ when .B,2 started to defau1t: s(ar"ing the g1oba1 financia1 crisis that occurred in 766/;7660? ca(ab1e of severe1& damaging the financia1 mar"ets? he crisis caused man& investors to be1ieve that securiti9ations are ver& ris"& investments: hat conc1usion is not correct? he 1osses investors ex(erienced on .B,2 were caused b& defau1ts in the under1&ing assets he1d as co11atera1 b& the SIS: and not b& the securiti9ation structure itse1f?

he assets that caused (rob1ems were 1ow Aua1it& sub(rime @S mortgages 1oans that had been made to home bu&ers who had (oor credit scores : had 1itt1e or no cash avai1ab1e for a down (a&ment: and insufficient income to afford their month1& mortgage (a&ments? hose homeowners freAuent1& defau1ted? Hhen the @S housing mar"et crashed: (ro(ert& va1ues fe11 and 1enders who forec1osed on defau1ted sub(rime mortgages were unab1e to recover the fu11 amount of the 1oan? #an& sub(rime mortgages had been securiti9ed and used as co11atera1 to issue .B,2: so mortgages defau1ts 1ed to defau1ts in the .B,2: causing investors: investment dea1ers and ban"s that owned them to suffer huge 1osses? he events of 766/;7660 high1ighted the im(ortance of eva1uating the Aua1it& of under1&ing assets before investing in .B,2 on? Since the financia1 crisis: securiti9ations have fa11en from 75O to 5O of tota1 mone& mar"et securities outstanding in ,anada and the number of securiti9ation issuers fa11en from /7 to 7-? he issuers that remain active in the mar"et toda& offer so1id investment o((ortunities for 1arge: so(histicated investors who have the ex(ertise and resources to ana1&9e the under1&ing assets? C ART C

76

'ource 0+1'

#essons #earned )rom the US Financia. Crisis He 1earn good 1essons from ever& financia1 crisis? he 1oss of confidence in securiti9ations that occurred during the crisis was c1eansing for the mar"et because it focused investorsG attention on the need to ana1&9e and understand ever& securit& the& (urchase: and not to re1& so1e1& on (ub1ished credit ratings? For most individua1 investors and others who 1ac" s(ecific ex(ertise: treasur& bi11s are the usua11& the best a1ternative for investing short term funds?

ABCP maker misled investors: OSC Financia1 2ost John Greenwood Sep 28, 2011 12:33 PM ET | Last Updated: Sep 29, 2011 11:52 AM ET
Four years after Canadas asset backed commercial paper market froze up leaving holders with huge losses, the Ontario Securities Commission has ruled that the company at the centre of the mess and two of its top executives breached provincial securities laws by misleading investors. The judgement means that the maker of much of the supposedly-safe investment vehicle knew the market was in deep trouble, but failed in its duty as a public company to give investor a public warning.The regulator said the company was aware of important invents that would impact the investments liquidity and, It is unlikely that any

71

investor would have purchased Coventree-sponsored ABCP if they had been aware of those market events and developments. The Toronto-based boutique investment bank was the largest sponsor of third-party ABCP, a $35-billion market that stopped functioning in September 2007 after worried investors dumped their holdings because of fears that it might contain U.S. sub-prime mortgages. Following a marathon restructuring, the ABCP market was revamped, with investors ranging from average middle-class individuals to giant pension funds swapping stalled paper for longer-term notes that now trade for significantly less than face value. ABCP markets around the world froze up around the same time but Canada was the only country where holders ended up shouldering the losses after banks that agreed to provide emergency liquidity declined to step up. Indeed part of the government bailouts of banks in the United States and Europe were used to pay for ABCP losses taken as a result of making investors whole. Critics say sophisticated players involved in the Canadian market were aware of flaws such as weak liquidity agreements and took advantage. Holders thought they were buying liquid, short-term notes almost equivalent to cash but in fact much of what they owned was opaque derivatives linked to dodgy U.S. home loans. As the implosion of the subprime mortgage market gathered speed in early 2007 some of these sophisticated investors got nervous and started shifting out of ABCP linked to U.S. mortgages. When the market finally stopped on Sept. 13, 2007, it was mostly the out-of-the-loop investors who ended up holding the frozen ABCP. The OSC found that Coventree failed to alert the market of key events affecting its business plan as well as the broader ABCP market. For instance, in January 2007 it failed to put out a news release when it learned of changes at the ratings agency DBRS that would severely impact its business. And over the course of the next few months as concern over the sub-prime mortgage meltdown grew, it failed to advise shareholders of emerging problems in the ABCP market that ultimately led to the freeze up. Wednesdays ruling is contained in a 188-page document including detailed testimony submitted during 45 days of hearings that took place last year. The OSC said penalties for Coventree and the two executives will be considered at a later date.

"ey Terms .sset Bac"ed ,ommercia1 2a(er Ban" 2a(er Ban"ers8 .cce(tances Bearer Form Bid$.s" S(read Bond )Auiva1ent 3ie1d ,ommercia1 2a(er ,redit Rating ,redit S(read Defau1t Discount 4ote Face Sa1ue Fixed Income Securities

LiAuidit& #ar"etab1e #one& #ar"et 4egotiab1e O , #ar"et 2ar Sa1ue Securiti9ation Sett1ement Date S(ecia1 2ur(ose Sehic1e erm to #aturit& rade Date ransaction ,ost rans(arenc& 77

Information #emorandum Issuer A33ENDIX Announcement o) Treasury *i.. Auction

reasur& Bi11s

73

Auction Resu.ts

7!

C ARTS AND TA*#ES FOR USE IN T IS C A3TER

7'

7-