The Importance Of Alternative Fixed Income Investments
By: Judith Lowes & Ian McKinnon
Alternative investments can also be found in the fixed income area. Private Placements (PP), Asset Backed Securities (ABS), and Commercial Mortgage Backed Securities (CMBS) all provide diversification and add value without increasing risk. Judith Lowes and Ian McKinnon, of Co-operators Investment Counselling Limited, examine some of these investment vehicles.
As equity markets languish and active bond managers are driven to distraction by previously unheard of volatility, plan sponsors and managers alike look for investment opportunities to add value to their portfolios without increasing risk. Alternative fixed income investments – such as Private Placements (PP), Asset Backed Securities (ABS), and Commercial Mortgage Backed Securities (CMBS) – offer just such opportunities. Like corporate bonds, they require research and fundamental analysis, but with analysis and good judgment, they can add significant value without significantly increasing risk.
Traditionally, Private Placements were only marketed to sophisticated investors who were able to undertake extensive analysis and were required to deal directly with the issuer to negotiate legal and credit covenants. These considerations, as well as their illiquidity, small issue size, and lack of rating by a recognized agency, made them, by definition, non-public – or private – placements. It also made them a higher risk investment.
In spite of these drawbacks, fixed income Private Placements were popular with insurance companies who were seeking higher yield, were content with smaller sized investments, and did not require a high level of liquidity. They undertook their own analysis to establish an accurate credit rating. The legal covenants were negotiated to ensure a claim on assets and, traditionally, loans in the $10 million to $30 million range were issued to finance start-ups and special projects.
Times Have Changed
Today, Private Placements are large and liquid issues. They are used by companies like IBM Canada and Citibank Canada, or groups like the Montreal Airport and the PEI Bridge, to undertake infrastructure development. Distributed to a diversified group of investors, they are only considered ‘private’ as they are issued under an Offering Memorandum, rather than a Prospectus, as required in public bond issues. By issuing a Private Placement, corporations save time, money, and labour. Most important to plan sponsors though, Private Placements are now usually rated by a recognized rating agency and are included in domestic bond indices.
For a while, there was a strong debate between Scotia Capital Markets (Scotia) and the investment manager community about including Private Placements in the indices to provide a better representation of the investable Canadian bond market. Although Scotia Capital Markets did not include Private Placements in their indices, managers were assessed against these benchmarks.
The Importance Of Private Placements
Today’s Private Placements are also ideally suited for pension portfolios looking to add value without increasing risk. They provide diversification while requiring the same fundamental analysis as traditional corporate bonds. As these investments have now become part of the benchmark, the value added relative to the benchmark has diminished, although there are opportunities to outperform other similar corporate investments without any additional risk.
As an example look at Exhibit A, which illustrates the interest rate differential (spread) between the Master Credit Card Trust (a BMO Mastercard asset backed security) which is a private placement and a public Bank of Montreal bond. Both securities have $400 million bonds outstanding, a similar maturity, and coupon, but the MCCT issue is rated AAA versus AA for the BMO. At the widest level during the last five years, the MCCT bond traded at a yield seven basis points (a basis point is one hundredth of a per cent) higher than the BMO security, and currently the MCCT issue trades at a yield 11 basis points lower than the BMO bond. Therefore, as the private placement has become more accepted, it has outperformed the regular issue bank bond by 18 basis points.
The most common Asset Backed Securities (ABS) today were initially issued in 1996 as Private Placements to avoid lengthy filing delays and these non-public ABS were the first Private Placements to be included in the Scotia Capital Market Indices in 1998. They were typically part of large issue programs of greater than $1 billion, AAA rated, secured by pools of bank credit card receivables, lines of credit, or auto loans which were placed in a bankruptcy remote trust. They opened the door for the inclusion of additional liquid Private Placements in the Scotia Capital Markets Universe in later years.
Infrastructure bonds may be considered a different form of asset backed security. A better description of these securities are revenue bonds, as the issues are secured by the revenue stream which is generated by the project. A number of examples of revenue bonds which are available in Canada are the Greater Toronto Airport Authority, the Halifax Dartmouth Bridge in Nova Scotia, and Highway 407 in Ontario.
Commercial Mortgage Backed Securities (CMBS) were introduced to Canada in 1998, and have grown to a total size outstanding of $6 billion. These bonds are backed by one or more commercial mortgage loans secured by income producing properties. Payments of interest and principal are passed through to CMBS investors, with senior lenders receiving priority over junior investors. ACMBS deal usually consists of a number of tranches (different bond issues) which vary in size and rating category. Typically, the AAA tranche makes up the largest portion of the deal with a minor portion allocated to lower rated categories (AA to BBB). A 10-year AAA tranche of a current CMBS would offer approximately 70 basis points better than a Government of Canada bond with the same rating. Therefore, CMBS provide good opportunities to add value to fixed income portfolios without increasing risk. Currently, they have no representation in the Scotia Capital Markets Universe index.
Alternative fixed income investments provide opportunities for fixed income managers to add significant value to their portfolios, especially as some of these securities are not currently included in the Universe index. As these investments become a part of the benchmark, the opportunity to outperform the benchmark diminishes. By allowing investments in alternative fixed income securities, the portfolio manager has another avenue to diversify risk, as well as the ability to outperform the index. If they are not currently allowed by a policy statement, consideration of these types of securities would be beneficial as managers not allowed to buy liquid Private Placements, Asset Backed Securities, Revenue Bonds, and Commercial Mortgage Backed Securities may be at a disadvantage in terms of value added, and when reviewed against the Scotia Capital Markets Indices which include many of these securities.
Judith Lowes is vice-president, investment services, and Ian McKinnon is vice-president, fixed income, at Co-operators Investment Counselling Limited.
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