Last week marked the beginning of an unprecedented one-year program through which the Bank of Canada is purchasing corporate bonds.
The program, originally announced on April 15, aims to support the corporate debt market’s liquidity and “proper functioning.” It involves TD Asset Management purchasing bonds through a tender process on the secondary market on behalf of the bank.
“A liquid and efficient market for Canadian dollar corporate bonds allows companies, currently challenged by the impact of the COVID-19 pandemic, to continue to obtain necessary longer-dated financing to support their operations, ultimately aiding the Canadian economy,” said the BoC’s website. “It also strengthens the pass-through of monetary policy actions to borrowers.”
The corporate debt market was essentially frozen in mid-March, says Catherine Heath, vice-president and portfolio manager at Leith Wheeler Investment Counsel Ltd., noting investors couldn’t sell high-quality corporate bonds, particularly in the short end of the market. “We just saw everyone heading in one direction. Everyone was selling due to concerns about risk, but also there was a massive amount of rebalancing that occurred in mid-March with pension plans having to buy equities and sell bonds, including corporate debt, so it really caused this dislocation.”
Further, the regulatory environment has changed since the last financial crisis, so dealers can’t hold large amounts of inventory on their balance sheets for sustained periods of time without being penalized, she says. “Prior to the great financial crisis, you could ask a dealer for a bid on a corporate bond and they would be happy to do it, knowing that they could hold it for a few months before they eventually found a buyer. But now they’re penalized if the position has aged beyond a certain amount of days on their balance sheet.”
Heath notes the regulatory changes have had unintended consequences from the perspective of limiting liquidity.
Any pension plan would have a large amount of exposure to investment-grade fixed income. “And investment-grade fixed income, if you’re in a universe type-fund or a fund which has a benchmark of the FTSE universe, that universe is going to have at least 30 per cent corporate bonds just as the benchmark,” she says. “So generally, an active bond manager would have a normal overweight to that corporate bond weight. That means that a typical active corporate bond portfolio would have as much as 70 per cent — or maybe even, at times, higher — corporate bonds.”
With the market not functioning properly, spreads in corporate debt all rose sharply, leading to a sharp value drop in corporate bond prices across the board, adds Heath. “Plan sponsors would have experienced a drag on their corporate bond portfolio as a result of this.”
By looking for corporate bonds in specific sectors, the Bank of Canada is being very targeted. On May 26, it released a list of committee on uniform securities identification procedures, or CUSIPs, it’s willing to bid on. Dealers must bid on their corporate issues that match those CUSIPs through a blind auction. At the end of the auction, the best prices will be fulfilled.
To be eligible to participate, dealers must hold the positions on their own balance sheets and can’t be acting on behalf of a third party, Heath adds.
The program will be capped at $10 billion of domestic, investment-grade corporate debt, specifically targeting the shorter end of the yield curve — particularly debt with a term to maturity of less than five years. The $10 billion is a large amount, given that the Canadian bond market is about $430 billion, she notes.
The bank’s move to purchase corporate bonds is a first. In the global financial crisis, it only bought government debt and commercial paper. While it’s still early days, spreads have been decreasing since the program was initially announced and corporate bond values have improved. Certainly, some of the improvement can be attributed to the program, Heath says. “But it is difficult to know specifically what can be attributed to this program versus other things that have improved as well, including just general market sentiment.”
As well, since the program went live, corporate bond spreads have been modestly tighter, she adds.
The program is currently scheduled to last until May 25, 2021 and the Bank of Canada has noted “the program’s parameters may be expanded if conditions warrant.”