Trading and Capital-Markets Activities Manual
Profiles: Canadian Government Bonds
The federal government of Canada issues bonds, known as "Canadas," to finance its public debt. The Canadian government bond market is the sixth largest in the world, with about C$270 billion (U.S.$195 billion) in bonds outstanding as of April 1996. Overall, this market is structurally similar to the U.S. bond market, particularly with regard to the types of securities issued. Canadas come in a wide variety of maturities ranging from 2 to 30 years. Recently, the longer maturity bonds have increased in popularity.
CHARACTERISTICS AND FEATURES
Canadas are issued at a price close to par value and are denominated in C$1,000, C$25,000, C$100,000, and C$1 million allotments. Canadas are available in bearer form with coupons attached or in registered form. All new Canadian bonds are issued with bullet maturities and are not callable; there is one callable issue outstanding that matures in 1998. All Canadas have fixed coupons ranging from 3 percent to 18 percent. Real return bonds, inflation-indexed bonds, were introduced in December 1991 and are currently issued once per quarter. Principal and coupon payments for these bonds are linked to the Canadian consumer price index.
Interest on Canadas is paid semi-annually and is accrued from the previous coupon date (exclusive) to the settlement date (inclusive) up to a maximum value of 181.5 days. As a result, the value date is always the same as the settlement date. New issues may offer short first coupons, but not long first coupons. Interest on short first coupons is accrued from the dated date to the first coupon date. Any "reopened" bonds include the accrued interest in the issue price to ensure that the new tranches carry the same coupons as the existing bond and trade indistinguishably. Canadas with remaining maturities of less than three years settle two market days after the trade date (T+2), while Canadas with maturities over three years settle three market days after the trade date (T+3).
Canadas are held for investment, hedging, and speculative purposes by both domestic (Canadian) and foreign investors. U.S. banks purchase Canadas to diversify their portfolios, speculate on currency and Canadian interest rates, and hedge Canadian-denominated currency positions and positions along the Canadian yield curve.
DESCRIPTION OF MARKETPLACE
Canadas are issued by two methods: by allotment and auction. With the allotment system, the amount, coupon, and issue price for each of the maturity tranches is announced after consultation with the primary distributors. The Bank of Canada pays a commission to all primary distributors who are responsible for placing the issue.
The auction system is very similar to the U.S. system. On the Thursday before the regular Wednesday auction, the Bank of Canada announces details, including the size, maturity, and delivery date for the upcoming auction, and active open market trading begins on a yield basis. The coupon for new issues is not known until auction results are released, and it is set at the nearest 14 percent increment below the auction average. The Bank of Canada accepts both competitive and non-competitive bids from primary distributors. However, it will only accept one non-competitive bid, which may have a maximum value of C$2 million.
On the auction date, bids are submitted to the Bank of Canada and primary distributors receive bonds up to 20 percent of the total amount issued based on the competitiveness of their bids. The delivery date and dated date are usually ten days to two weeks after the auction. Issues typically range from C$100 million to C$8.8 billion, and any issue may be reopened by the Department of Finance based on market conditions.
Canadas are not listed on any stock exchanges but trade in over-the-counter (OTC) markets 24 hours a day. Settlement occurs through a book-entry system between market participants and the Canadian Depository for Securities (CDS). Therefore, Canadas may trade when issued without an exchange of cash.
Primary distributors include investment dealers and Canadian chartered banks. Buy Side A wide range of investors use Canadas for investing, hedging, and speculation, including domestic banks, trust and insurance companies, and pension funds. The largest Canadian holders of Canadas are trust pension funds, insurance companies, chartered banks, and the Bank of Canada.
Foreign investors are also active participants in the Canadian government bond market. In general, foreign market participants are institutional investors such as banks, securities firms, life insurance companies, and fund managers.
Price transparency is relatively high for Canadas and several information vendors disseminate prices to the investing public. Trading of Canadas, both domestically and internationally, is active and prices are visible.
Bonds trade on a clean-price basis (net of accrued interest) and are quoted in terms of a percentage of par value, with the fraction of a percent expressed in decimals. Canadas typically trade with a 18- to 14-point spread between bid and offer prices. Canadas do not trade ex-dividend. If a settlement date occurs in the two weeks preceding a coupon payment date, the seller retains the upcoming coupon but must compensate the buyer by postdating a check payable to the buyer for the amount of the coupon payment.
Interest-rate risk on Canadas may be hedged using interest-rate swaps, forwards, futures (such as futures on 10-year and 5-year Canadas, which are traded on the Montreal Stock Exchange), and options (such as options on all Canadas issues, which are traded on the MSE). Hedging may also be effected by taking a contra position in another Canadian government bond. Foreign exchange risk may be hedged through the use of currency forwards, futures, swaps, and options. The effectiveness of a particular hedge depends on the yield curve and basis risk. For example, hedging a position in a 10-year Canadas future with an over hedged position in a 5-year bond may expose the dealer to yield-curve risk. Hedging a 30-year bond with a Canadas future exposes the dealer to basis risk if the historical price relationships between futures and cash markets are not stable. Also, if a position in notes or bonds is hedged using an over-the-counter option, the relative illiquidity of the option may diminish the effectiveness of the hedge.
The Canadian bond market is considered to be one of the most liquid bond markets in the world, with Canadas traded actively in both domestic and international capital markets. Most investment dealers in Canadas will make markets on all outstanding issues. The most liquid issues are the short-term issues of less than 10 years, but several 15-year and 30-year Canadas are actively traded and very liquid. All government bond issues are reasonably liquid when their outstanding size, net of stripping, is over C$1 billion. "Orphaned" issues, small issues that are not reopened, are the only Canadas that are very illiquid because they are not actively traded.
Canadas are subject to price fluctuations due to changes in interest rates. Longer-term issues tend to have more price volatility than shorter-term issues and, therefore, a large concentration of longer-term maturities in a bank's portfolio may subject the bank to a high degree of interest-rate risk.
Due to the low volatility of the Canadian dollar exchange rate, there has been a low level of foreign-exchange risk associated with Canadian bonds. To the extent that this risk exists, it can be easily reduced by using foreign-currency derivatives instruments as described above.
A change in the political environment, withholding tax laws, or market regulation can have an adverse impact on the value and liquidity of an investment in foreign bonds. Investors should be familiar with the local laws and regulations governing foreign bond issuance, trading, transactions, and authorized counterparties.
The accounting treatment for investments in foreign debt is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," as amended by SFAS 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, "Accounting for Derivatives and Hedging Activities." (See section 2120.1, "Accounting," for further discussion.)
RISK-BASED CAPITAL WEIGHTING
Canadas are assigned to the 0 percent risk-weight category.
LEGAL LIMITATIONS FOR BANK INVESTMENT
Canadas are type III securities. As such, a bank's investment in them is limited to 10 percent of its equity capital and reserves.
Crossan, Ruth, and Mark Johnson, ed.
"Canadian Dollar." The Guide to International Capital Markets
1991. London: Euromoney Publications PLC, 1991, pp. 37-49.
Continue to FRENCH GOVERNMENT BONDS
Back to Activities Manual Index