Over the summer we saw investors look for a safe haven from the volatile markets of late. Usually money market type funds are the investment of choice when investors want something “risk free.” Now, in the era of the subprime dilemma, money market funds are considered risky! What is going on?

Recent Developments
To understand what has happened with money market funds we need to look at the panic in the market which is being caused by global financial market volatility which has been driven by the U.S. subprime mortgage crisis. Subprime mortgages are issued to home buyers with poor credit histories. They can be issued in a variety of exotic structures and often with variable interest rates(sometimes low introductory rates). When the rates adjust upwards, foreclosures increase. After years of lax lending standards stemming from a previously robust housing market, mortgage defaults are rising. The fear of increasing defaults has caused turmoil in U.S. debt markets. The effects of this trouble(changing risk tolerances and increased volatility)have spread to securities and markets that are not directly related to subprime lending(e.g., the Canadian asset-backed commercial paper market)and have created a liquidity crunch.

This liquidity crisis has affected the commercial paper market. Commercial paper is a form of debt obligation issued with short-term maturities. Asset-backed commercial paper(ABCP)is created when issuers securitize(or repackage)various types of debt and sell the package to investors. The types of underlying debt can include trade receivables, credit card debt, car loans and mortgages. The Canadian market includes approximately $75 billion of ABCP issued by banks and another $40 billion issued by non-bank third-party issuers.

Third-party issuers of ABCP have experienced difficulty in finding buyers for some of their maturing paper as a result of the recent liquidity crisis. The largest third-party issuer in Canada is Toronto-based Coventree Capital, which has issued approximately $16 billion of third-party ABCP and been the subject of much scrutiny. When ABCP matures and issuers cannot not find buyers, they call upon their “liquidity providers”—parties that agree to be the lenders of last resort to ensure the paper is rolled over. However, in the recent crisis, liquidity providers of third-party paper have largely refused to provide the liquidity subject to legalities that allow them to avoid this obligation.

Investors who hold commercial paper that has not been rolled over have experienced difficulty in accessing their funds. It is important to clarify that the failure of ABCP issuers to roll over their paper has been limited to third-party issuers. In August, the leaders of Canada’s large banks released a joint statement reaffirming their commitment to their own ABCP programs. An important distinction should be made here. The banks are the liquidity providers for their own ABCP programs; third-party ABCP issuers generally rely on other institutions to be liquidity providers, typically large European banks. The Canadian banks’ ability to provide liquidity for their ABCP programs removes a source of uncertainty vs. third party providers—most market participants believe that bank-issued ABCP is less risky than third-party paper.

Various affected parties have taken action. A consortium led by a large public pension plan in Quebec proposed a plan to convert illiquid paper to term debt in line with the underlying assets. The parent organizations of some money market funds have purchased third-party ABCP from their funds at full value plus accrued interest in order to provide support and liquidity.

Investment Manager Exposure
In light of recent developments in the ABCP market, Aon’s Investment Consulting Practice conducted a surveyed of 28 large firms that manage assets for Canadian institutional clients. We were interested in their level of exposure to ABCP and particularly what portion was third-party sponsored.

Also, given the turmoil in the U.S. subprime mortgage market, we also inquired about their exposure to Maple bonds(bonds issued in Canada by non-Canadian domiciled issuers). While most Maple bond issuers carry strong credit ratings and are generally perceived to be stable issuers, some do have varying degrees of sub-prime lending exposure through their operations in the U.S.

We have highlighted some of the observations of our research below.

  • All but four of the respondents reported having no exposure to third-party ABCP. Many claimed to have internal rules prohibiting third-party paper, or that it had not passed their credit research reviews. Two of the four respondents reported greater than 10% exposure in their money market funds.
  • Eleven respondents reported holding bank-sponsored ABCP within their money market funds(largest exposure reported was 43%-most were quite lower).
  • Over half of the respondents reported some Maple bond exposure in their bond strategies. Exposure generally ranged from less than 0.25% to 13%.
  • A small subset of respondents voluntarily disclosed limited exposure to Canadian subprime mortgages through mortgage-backed securities(MBSs). It is generally accepted that the problems being experienced in the U.S. subprime mortgage market are not as severe in Canada.

Conclusions
After completing our survey, we have taken comfort regarding the liquidity of institutional managers’ cash investments as they relate to current news in the Canadian ABCP market. Almost all managers report only holding Canadian-bank sponsored ABCP and the Canadian banks have publicly committed to supporting the liquidity of their ABCP programs. Maple bond exposure among Canadian fixed income manager portfolios does not appear to be excessive. Also, while some Maple issuers do have subprime lending exposure, this should not immediately imply a threat to their ability to service their own debt. Maple issuers are typically among the larger multinational firms with strong credit ratings. Some investment managers have expressed their comfort with these issuers, even in the event of significant writeoffs of subprime loans. While Aon cannot give an expert opinion on the credit quality of these issuers, we caution that the broader U.S. subprime crisis may continue to affect volatility in all capital markets in the near future.

Brian White is a vice-president and regional co-head at Aon Consulting in Toronto. Tony Corona is a senior analyst at Aon and also in Toronto.

Copyright © 2020 Transcontinental Media G.P. Originally published on benefitscanada.com

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