Fixed Income Securities and the Canadian Money Market

Learning Objectives 3

Overview of Fixed Income Securities 3

Factors that Determine the Interest Rate 3
Basics of Trading Fixed Income Securities 4
Fixed Income and Stock Markets - Key Differences 4

The Money Market 5

Impact on Economic Growth 5
Brief History of the Canadian Money Market 6
Advantages for Borrowers 7
Advantages for Investors 8
Important Characteristics of Money Market Securities 8
Calculating Price and Yield on a Discount Note 9

Types of Money Market Securities 10

Composition of the Canadian Money Market 10
Treasury Bills 11
- Canada Treasury Bill Auctions 12
Bank Paper 13
Bankers' Acceptances 13
Commercial Paper 13
- Information Memorandum 14
- Credit Ratings and Default Risk 16
- DBRS Short Term Credit Ratings 16

Yields and Spreads 17

Trading Money Market Securities 18

Delivery and Settlement 18
Innovation in Securities Trading -CDS 19

Securitization, ABCP and the Financial Crisis of 2007/2008 19

Asset Backed Commercial Paper (ABCP) 19
The Financial Crisis of 2007/2008 20

Key Terms 23

Charts
1 Canadian Yields and Rates 7

1
 2 Composition of the Canadian Money Market 9
3 Primary Dealers - Canada T bill Auctions 12
Commercial Paper Information Memorandum - Home Depot
4 Canada 15
5 Percentage of Total Outstandings by Credit Rating 17
6 Interest Rate Spreads 18
7 The Securitization Process 20
8 Composition of th eShort Term Debt Market 21

Appendix Gov't of Canada T-Bill Auction Announcement & Results 24

FIXED INCOME SECURITIES AND THE CANADIAN MONEY MARKET

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Learning Objectives

1. Describe the basic characteristics of fixed income securities

2. Understand the features of various types of money market securities

3. Calculate the price and yield of discount notes

4. Explain the basics of trading money market securities

Overview of Fixed Income Securities

Governments and corporations must frequently borrow money to finance their operations. Most
corporations borrow from the banking system, using bank loans and bank lines of credit, but the largest
corporations and governments also obtain debt financing directly through the financial market by
issuing fixed income securities which they sell to investors.

To understand fixed income securities, consider the following three basic points:

 Investors who buy fixed income securities are loaning money directly to the borrower (also
called “the issuer”) for fixed period of time (called the “term to maturity”).

 Issuers have a contractual obligation to pay interest to investors, usually at a predetermined

fixed interest rate, and to repay the principal amount borrowed on a specific date (called the
“maturity

 The interest rate is fixed when the security is first issued, and normally does not change over the
life of the security, regardless of future changes in the level of interest rates in financial markets.

Fixed income securities can be issued for almost any term to maturity, but terms typically range from
few days to 30 years. Consequently, the financial market provides good flexibility for issuers who need
to borrow cash for different periods of time. It also offers broad range of alternatives for lenders who
have cash to invest.

By convention, fixed income securities with terms to maturity of 365 days or less are called “money
market securities” and will be discussed in this chapter. Securities with longer terms to maturity are
called “bonds” or “notes” and will be discussed later in Chapter XX.

Factors that Determine the Interest Rate on Fixed Income Securities

To understand how the interest rate on fixed income securities is determined, remember that investors
who buy them are loaning money to the issuer. Investors will purchase securities only if they believe

3
that they will be compensated for default risk – the risk that the issuer may not repay the loan. If there is
no default risk, as in the case of securities that are issued and guaranteed by the governments of
financially strong countries like Canada and the United States, investors earn only the real rate of
interest plus an inflation premium. Consequently, the interest rate that investors earn on default-free
government securities is determined by only by the security’s term to maturity and the general level of
interest rates in the financial market.

When investors buy securities issued by more risky borrowers, such as corporations and some
governments, they demand a higher interest rate that is determined by the financial strength of the
issuer and the probability of default. The difference between the interest rate on a risky security and the
rate on a default-free security with the same term to maturity is called the credit spread (or simply “the
spread”). It reflects the probability that the issuer may not pay interest and principal in full and on a
timely basis.

The fact that the interest rate is fixed for the entire term of the security creates another source of risk
for investors, especially when they buy a security that will not mature for many years. If future economic
conditions, such as strong growth or inflation, cause interest rates to rise, investors will receive no
additional return and they will suffer an opportunity cost. To compensate investors for that uncertainty,
long term fixed income securities usually pay higher interest rates than those with shorter terms to
maturity.

Basics of Trading Fixed Income Securities

Unlike stocks, fixed income securities are not listed or traded on an organized exchange. Instead,
transactions are conducted through a network of investment dealers who buy and sell securities by
telephone or computer. This is called the OTC or “over the counter” market. Transaction costs also differ
because commissions are charged on stock trades but not on trades involving fixed income securities.
On fixed income trades, the only transaction cost to investors is the “bid–ask spread” which is the
difference between the price at which the dealer will buy (the bid price) or sell (the ask or offer price) a
security.

Most fixed income securities are marketable – they can be sold to an investment dealer or to another
investor in the OTC market at any time prior to their maturity date. However, the fact that a security is
marketable does not mean that it has good liquidity. If a security is very liquid, you can sell a very large
amount very quickly and for a good price. On the other hand, selling an illiquid security may be difficult,
expensive or, at times, impossible. Generally, fixed income securities issued by the government are very
liquid, while those issued by corporations are not. The liquidity of different types of securities will be
discussed later in this chapter.

Fixed Income Markets and Stock Markets – Key Differences

Almost everyone is aware of stocks and stock exchanges, but many outside the investment industry do
not understand fixed income securities. They also do not realize that the fixed income market is at least
10 times larger than the stock market.
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Information on fixed income markets is difficult to obtain because fixed income securities are traded in
the OTC dealer market which provides relatively little data on individual prices and amounts traded.
Stock market data, by contrast, is very easy to obtain because stock prices and trading volumes are
published daily in the Globe and Mail, Financial Post, Wall Street Journal and other business
newspapers, and they are also available on free public websites such as Yahoo Finance and Globe
Investor. This easy access to accurate, timely market information is called “transparency”.

The Money Market

Debt or “fixed income” securities with terms to maturity of less than one year are issued and traded in a
part of the financial market called the “Money Market”. Participants in the money market are large
borrowers, including governments, corporations, banks and other entities that require short term debt
financing, and large investors who have cash to invest for short time periods. The most popular money
market investment is government treasury bills.

Impact on economic growth

A liquid, well-developed money market is essential for the growth of a modern economy because it
provides corporations and governments with a reliable source of short-term financing, denominated in
local currency.

For large corporations, the money market provides a steady supply of low-cost working capital which
they require to expand their domestic business operations and export their products to foreign markets.
Businesses and individuals who need to borrow money from the banking system also benefit because
the money market is an additional source of funding that banks can use to make loans whenever their
customers’ loan demand exceeds the amount of cash they can obtain from depositors.

Investors, including businesses and corporations who have temporary cash surpluses, also benefit
because the money market provides them with an opportunity to invest large amounts of cash easily
and safely, and earn a reasonable return. For that reason, a well developed money market helps to
create wealth, further contributing to economic growth and confidence.

Finally, all aspects of the economy benefit because a well-developed money market helps the central
bank to implement monetary policy. If the money market is active and reliable, the central bank can
easily sell or buy large amounts of Treasury bills to increase or decrease liquidity, and influence interest
rates.

A Brief History of the Canadian Money Market

Canadian financial markets were undeveloped until the Bank of Canada was established in 1935, and the
Canadian money market did not exist. Before World War I, the government of the Dominion of Canada,

5
as our country was called then, obtained short term financing by selling treasury bills to investors in the
London money market. Since British investors demanded payment in pounds sterling, the Canadian
government could not obtain short term funding in its own currency.

While Canada’s historic political ties to Britain caused our government to borrow in the London money
market, Canadian banks turned to New York for short term funding. Most bank financing transactions
were denominated in US dollars, so the Canadian banks were exposed to exchange rate risks. Yet,
despite those risks, the lack of Canadian dollar alternatives did not seem to deter the banks from using
the New York market because it offered good liquidity and a convenient location, close to Canadian
financial centers of Montreal and Toronto. In fact, the banks’ easy access to a well-developed money
market in New York probably inhibited the development of a money market in Canada for many years.

Because the Canadian banking industry focused on New York, our domestic money market did not
develop until the Bank of Canada and the government of Canada decided to take action in the 1930’s. In
its first annual report, released in 1935?, the Bank of Canada emphasized that effective implementation
of monetary policy required the development of an active money market in Canada: “It is universally
recognized that a central bank is hampered in its operations where an active bill market does not exist”.

The need for a domestic money market prompted the Government of Canada to issue treasury bills in
Canadian dollars in 1934. Regular Canada treasury bill auctions started three years later in 1937.
However, an active money market did not begin to develop in Canada until the 1960’s because most
treasury bills were bought by banks which held them to maturity and did not trade. Also, due to banking
regulations that persisted through the 1960’s, non-government issuers were absent from our money
market.

Then, in 1967, the Bank of Canada initiated a series of changes, including the removal of interest rate
ceilings on bank loans, which increased money market participation by banks and investment dealers.
Banks became more active, corporate borrowers began to issue money market securities as an
alternative to bank loans, and bankers’ acceptances were introduced. These pivotal events promoted
the development of the active money market that exists in Canada today.

Source:
http://www.g20.utoronto.ca/docs/capitalmarkets-canada.pdf

Advantages for Borrowers

For governments and large corporations who borrow to finance their short term working capital
requirements, the money market provides a reliable source of low cost debt financing.

Their borrowing costs are reduced because the interest rate they pay to issue money market securities is
usually lower that the rate they would have to pay on a bank loan. Savings can be significant, as
6
illustrated in Chart 1. Note that money market rates are much lower than the “Prime Rate”, which
determines the interest rate that banks charge on loans made to their best customers.

Flexibility is better, too, because the money market allows borrowers to match the amount and maturity
date of their borrowing to their cash requirements. Unfortunately, not all borrowers can access the
money market. Issuance is limited to borrowers who routinely require large amounts of short term debt
financing, typically $50 to $100 million or more, and have strong balance sheets.

CHART 1

Canadian Yields and Rates

   
Previous Week 4 Weeks
  Latest Day Ago Ago
T-bills
1-month 0.86 0.87 0.89 0.91
3-month 0.88 0.88 0.89 0.95
6-month 0.95 0.94 0.93 1.00
1-year 1.00 0.99 0.94 1.03
Banker's Acceptances
1-month 1.16 1.21 1.22 1.21
3-month 1.20 1.27 1.26 0.98
6-month 1.28 1.28 1.27 1.32
Bank Loans & Deposits      
Banks' Prime Rate 3.00 3.00 3.00 3.00
GIC's 90 days 0.60 0.60 0.60 0.60

Source: Financial Post; June 22, 2012

http://www.financialpost.com/markets/data/money-yields-can_us.html

Advantages for Investors

For investors, money markets offer the opportunity to invest their cash easily and safely, while also
earning interest rates that are usually superior to the rates they can earn on bank deposits.

The money market also provides investors with the opportunity to invest in securities with different
terms to maturity, ranging from overnight to 365 days, so can select the maturities that best meet their
needs. In addition, most money market securities are “negotiable” so ownership can be transferred

7
from one investor to another. They are also “marketable” so investors can sell them in the OTC market if
they need cash prior to the maturity date.

However, the fact that a security is marketable does not necessarily imply that investors can sell a large
amount at a fair market price. The ability to resell a large holding of a security quickly for a good price is
called “liquidity”. Liquidity in the money market is variable, depending on the security type. As we will
see later in this chapter, Government of Canada Treasury Bills have excellent liquidity, and trade actively
in very large amounts in the secondary market. By contrast, most money market securities issued by
corporations have low liquidity so investors must often accept a lower price if they sell them before the
maturity date.

Investors who buy money market securities include financial intermediaries such as pension funds,
insurance companies, mutual funds and banks, as well as corporations and governments that have short
term cash surpluses to invest. Individual or “retail” investors may also invest in money markets, but their
participation is usually limited by the fact that this is a “wholesale market” in which the minimum
transaction size is very large (typically $100,000 or more).

Important characteristics of Money Market Securities:

Money market securities generally have the following four characteristics:

1. They mature in less than one year (365 days)

2. They are essentially IOU’s – “unsecured” loans made by investors to governments and
corporations

3. Most are marketable and highly liquid – they can be quickly converted to cash at full market
value

4. Almost all are “discount notes.

Money market securities do not make separate interest payments to investors. Instead, they are
“discount notes” which investors buy for a price that is less than their value at maturity. The difference
between the maturity value of a security (also called the face or par value) and the purchase price is the
amount of interest earned by the investor.

The interest rate or yield earned on a money market security is influenced by the “overnight rate” in the
financial market and expressed as an annual rate. By convention, money market yields are calculated on
a “bond equivalent basis” or BEY, that reflects simple interest (no compounding) and, for Canadian
securities, a 365 day year.

Calculating Price and Yield on a Discount Note:

8
 F
P 
 n 
1 k  
 365 

Where F = the face or par value, P = the market price, n = days to maturity, k = yield to maturity

By convention, the price is quoted as the cost of buying $100 face or par value

 Example 1: A Canadian discount note has a term of 80 days remaining until maturity and its
bond-equivalent yield is 4.5%. What is the quoted price of this note?

F $100
PT -bill    $99.0233.
 n   80 
1  k BEY   1  0.045 
 365   365 

So the quoted price is $99.0233 per $100 face or par value

• Example 2: How much must you pay to buy $1 million face value of this discount note?

 $1,000,000 
 $99.0233  $990,233
 $100 

• Example 3: What is the yield on a $100,000 Canadian treasury bill with 180 days until maturity
and a market price of $98,200?

F  P  365  $100,000  $98,200  365 

k BEY       3.72%
P  n  $98,200  180 

(Examples are adapted from Booth & Cleary)

In the United States, the price and yield on US government Treasury bills may be quoted differently, on
what is called a “bank discount basis”, using calculations that are based on a 360 day year, and use F as
the denominator

• Example 4: What is the yield on a $100,000 US treasury bill with 180 days until maturity and a
market price of $98,200, if the yield is expressed on a bank discount basis?

9
 F  P  360  $100,000  $98,200  360 
k BD       3.60%
F  n  $100,000  180 

Note how differences in Canadian and US market convention impacted the results we obtained in for the
treasury bill yield calculations shown in Examples 3 and 4.

Increasingly, the US is moving to a 365 day year for money market calculations, but methodology cannot
be assumed. When trading in US treasury bills, it is important to confirm the basis on which calculations
are being made because differences will cause price discrepancies, leading to significant errors in the
pricing of large trades.

Types of Money Market Securities

Money market securities are classified by the type of issuer – government, bank or corporation. All are
available for purchase by investors in multiples of $1,000 face or par value, but minimum transaction
amounts vary.

Composition of the Canadian Money Market

The amount outstanding of each type of security in the money market changes over time, and is
influenced by the relative borrowing needs of governments, banks and corporations. When
governments run large deficits, as they did during the recession that followed the financial crisis of 2008,
they must finance those deficits by borrowing from investors. As shown in Chart 2, deficit financing
causes the dollar value of government securities to increase, so government securities represent a larger
percentage of total securities available for investors to purchase in the money market. Note that short
term borrowings by governments, which represented only 42% of all money market securities in 2006,
increased to 66% by 2011.

CHART 2 Composition of the Canadian Money Market by Dollar Value of Securities Outstanding

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 Source: DBRS

 Treasury bills are short term securities issued and guaranteed by a government. Also called T-
bills, they are usually the safest and most liquid securities in any local market. T-bills issued by
the federal governments of financially strong countries, such as Canada and the United States,
are considered “risk free” investments. Due to their low risk and high liquidity, they provide the
lowest yields, relative to other money market securities with the same term to maturity.

Canada Treasury Bills (CTB’s) are one of the most popular investment alternatives in the
Canadian money market. They are viewed as the safest investment because they are a direct
obligation of the Government of Canada. They are also the most liquid, so they can be sold, even
in very large amounts, whenever investors need to raise cash on very short notice.

In Canada, the governments of large provinces, such as Ontario and Quebec, also issue treasury
bills on a regular basis. Provincial T-Bills are guaranteed by the issuing province and provide
investors with slightly higher yields than T-bills issued by the Government of Canada because
they are less liquid and may have small default risk.

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 How are new Canada treasury bills created?

Canada Treasury Bill Auctions

Government of Canada treasury bills are issued through an auction process conducted by the
Bank of Canada, which acts in its capacity as the fiscal agent of the federal government.
Auctions, which are announced in advance on the Bank of Canada’s website, are held twice a
month on Tuesdays, for a previously announced dollar amount and range of terms to maturity,
usually 3 months, 6 months and one year. The announcement of a recent Canada treasury bill
auction is shown in Appendix 1.

Participation in the treasury bill auction is strictly controlled by the Bank of Canada to ensure
that the market remains fair, transparent and very liquid. Only authorized primary dealers and
government securities distributors are permitted to bid for the new treasury bills, and they may
submit bids for their own account and on behalf of their customers.

Two types of bids are allowed:

 Competitive bids, in which the dealer states the price and yield at which he is will to buy
an amount of T- bills, up to a specified amount, and

 Non-competitive bids, in which the dealer agrees to buy a specified amount of T-bills at
the weighted average auction price of successful competitive bids.

The amount that a single bidder can buy is limited to prevent one or more dealers from
dominating the market. Results for a recent Government of Canada T-bill auction are shown in
Appendix 2.

CHART 3

Primary Dealers – Canada T-Bill Auctions

Bank of Montreal
Canadian Imperial Bank of Commerce
Deutsche Bank Securities Limited
HSBC Bank Canada
Laurentian Bank Securities Inc.
Merrill Lynch Canada Inc.
National Bank Financial Inc.
RBC Dominion Securities Inc.
Scotia Capital Inc.
The Toronto-Dominion Bank

Source: Bank of Canada

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 Bank paper is issued by chartered banks to fund their short term cash needs, and sold to
investors in the money market. Called certificates of deposit (CD’s) or bearer deposit notes
(BDN’s), and issued in denominations of at least $100,000, these securities are effectively large
size bank deposits. The banks frequently issue CD’s and BDN’s to obtain large amounts of
wholesale funding , which supplements the deposits they receive from their retail customers,
and is used to make loans. Some bank paper pays interest separately, but most is sold in the
form of discount notes for which price calculations are identical to treasury bills. Most bank
paper is negotiable but liquidity is generally poor, so investors who purchase bank paper usually
hold it until the maturity date.

 Bankers’ acceptances (BA’s) are short term promissory notes issued by corporations and
unconditionally guaranteed by a Canadian chartered bank. Essentially, they are loans that the
bank has guaranteed and sold to investors. The term "acceptance" means that the borrowing
corporation paid the bank a “stamping fee”, usually between 0.75% and 1.5%, to guarantee
timely repayment of the amount borrowed. For that reason, the riskiness of bankers’
acceptances is determined only by the financial strength and credit rating of the “accepting”
bank.

Bankers' acceptances are usually issued for terms of 1 to 3 months, and trade in the money
market under the name of the bank that provided the guarantee (ie BMO 3 month BAs). They
are attractive to investors because they are liquid securities that provide higher yields than
Government of Canada T-bills of comparable term to maturity, and have only slightly more risk.
Like treasury bills, they are discount notes.

Bankers’ acceptances are a large and very important component of the Canadian money market.
In 2011, they accounted for $51 billion, or almost 50% of all non-government securities.
(see CHART 2)

Note: Bankers' acceptances are unique to the Canadian market. The term “bankers’ acceptance”
is also used in the US but there it refers to a different type of security that is used to finance
international trade.

 Commercial paper is a short term, unsecured promissory note (an IOU) issued by a major
corporation. These discount notes are usually issued for 1, 2 and 3 month terms to maturity,
but may be issued for any term from 1 day to 1 year. The yield on commercial paper is
determined by the creditworthiness of the issuer, the term to maturity and current financial
market conditions. Minimum transaction amounts are large, typically $100,000 or more.
Commercial paper is negotiable but liquidity is not good, so investors who purchase commercial
paper usually hold it until its maturity date.

Before purchasing commercial paper, investors usually contact the OTC trading desks of several
major banks and investment dealers to obtain information on available securities, rates and

13
 price quotations. Investors who are very knowledgeable and active in the money market
sometimes bypass the dealers and obtain slightly better rates by purchasing commercial paper
directly from the treasury department of an issuing corporation. In Canada , only very large
corporations with well developed commercial paper programs, such as GE Capital, sell their
notes directly to investors.

Information Memorandum

Corporate borrowers who want to issue securities in the money market must provide investors
with a legal document called an Information Memorandum which outlines key facts about their
commercial paper program, including the maximum amount to be issued, the extent of back-up
bank lines of credit available to cover any cash shortfalls, the credit rating and the investment
dealers who will sell the notes to investors.

Chart 4 shows highlights of the Information Memorandum for Home Depot Canada’s
commercial paper program. Key facts that investors need to know before purchasing this paper
include:

 Who is the issuer?

 Who is the guarantor?

 What is the maximum total dollar amount of paper that can be outstanding at any time?

 What will the issuer do with the proceeds?

 Which investment dealers should you contact if you want to buy Home Depot Canada’s
commercial paper?

 What is the credit rating?

 In your opinion, how safe is it to invest in Home Depot Canada commercial paper?

CHART 4

14
Credit Ratings and Default Risk

The financial strength of the issuer is very important because

investors who buy commercial paper are making an unsecured loan
15
to the issuing corporation. Since the loan is backed only by the issuer’s promise to pay (an IOU),
investors will purchase only commercial paper issued by corporations that have low default risk, and
have received an investment grade credit rating from at least one of the major credit rating agencies:
Dominion Bond Rating Service (DBRS), Moodys and Standard and Poors (S&P). Commercial paper with
an R1 rating from DBRS is considered to be “investment grade”. It is divided into sub-sections: R1 -
High, R1 - Medium and R -1 Low. e of these three ratings.

DBRS Short-Term Debt Ratings

The DBRS® short-term debt rating scale provides an opinion on the risk that an issuer will not
meet its short-term financial obligations in a timely manner. Ratings are based on quantitative and
qualitative considerations relevant to the issuer and the relative ranking of claims. The R-1 and R-2
rating categories are further denoted by the subcategories “(high)”, “(middle)”, and “(low)”.

R-1 (high)
Highest credit quality. The capacity for the payment of short-term financial obligations as they fall
due is exceptionally high. Unlikely to be adversely affected by future events.

R-1 (middle)
Superior credit quality. The capacity for the payment of short-term financial obligations as they fall
due is very high. Differs from R-1 (high) by a relatively modest degree. Unlikely to be significantly
vulnerable to future events.

R-1 (low)
Good credit quality. The capacity for the payment of short-term financial obligations as they fall
due is substantial. Overall strength is not as favourable as higher rating categories. May be
vulnerable to future events, but qualifying negative factors are considered manageable.

R-2 (high)
Upper end of adequate credit quality. The capacity for the payment of short-term financial
obligations as they fall due is acceptable. May be vulnerable to future events.

R-2 (middle)
Adequate credit quality. The capacity for the payment of short-term financial obligations as they
fall due is acceptable. May be vulnerable to future events or may be exposed to other factors that
could reduce credit quality.

R-2 (low)
Lower end of adequate credit quality. The capacity for the payment of short-term financial
obligations as they fall due is acceptable. May be vulnerable to future events. A number of
challenges are present that could affect the issuer’s ability to meet such obligations.

Source: DBRS

16
According to records maintained by DBRS, all commercial paper currently outstanding in the Canadian
money market is rated R-1. (Note: Equivalent investment grade ratings used by other credit rating
agencies are: Moodys P-1 and S&P A-1.)

The data presented in Chart 5 clearly indicates that investors will not accept the default risk associated
with buying non- investment grade paper, rated R-2 or lower. The implication is that corporations with
lower credit ratings cannot borrow directly through the money market. Instead, they must obtain a
bank guarantee and issue banker’s acceptances.

CHART 5

Source: DBRS

Yields and Spreads

The yield on a money market security reflects investors’ perception of the probability that the issuer
may default. The difference between the yield on risk free T-bills and the yield on commercial paper
with the same term to maturity, called the “credit spread”, is the compensation demanded by investors
for assuming the risk that an issuer may not repay the amount borrowed. Credit spreads are impacted
by the default risk and credit rating of the specific issuer, and also by financial market conditions.

During high risk periods, such as occurred during the financial crisis of 2007 and 2008 when several
banks and corporations failed or required government bailouts, all credit spreads increased sharply as
worried investors refused to assume any risk. They refused to buy commercial paper at any price, and
purchased only Government Treasury bills because of their risk-free status. In times of crisis, this “flight
to quality” disrupts markets, creating circumstances that make it expensive and, sometimes impossible,
for some large corporations to finance their working capital requirements.

CHART 6

17
 Interest Rate “Spreads”
Difference between the yields on CP & T-Bills

Money Market Spreads

(CansimV121812,V121778,V121796)

300

250

200

150

100

50

0
1 1 /4 /2 0 0 6

1 1 /4 /2 0 0 7

11 /4/2 0 08

11 /4/2 0 09
1 /4/20 0 6
3 /4/20 0 6
5/4 /2 0 0 6
7 /4/20 0 6

9/4 /2 0 0 6

1 /4/20 0 7
3/4 /2 0 0 7
5 /4/20 0 7
7/4 /2 0 0 7

9 /4/20 0 7

1/4 /2 0 0 8
3/4 /2 0 0 8

5 /4/20 0 8
7/4 /2 0 0 8

9/4 /2 0 0 8

1 /4/20 0 9
3 /4/20 0 9

5/4 /2 0 0 9
7 /4/20 0 9

9/4 /2 0 0 9

1/4 /2 0 1 0
3 /4/20 1 0
CP BA

Trading Money Market Securities – Delivery and Settlement

In the past, Treasury bills were physical paper certificates, issued in “bearer form” to facilitate liquidity
and fast trading. No records of ownership were kept and whoever had physical possession of the
treasury bill certificate was deemed to be the owner. Understandably, the use of bearer certificates
created an unsafe situation that left the financial system open to theft and fraud. For safety, other types
of money market securities were registered in the name of the owner, using paper records which
required time-consuming manual adjustment whenever the securities were bought or sold.

With the advent of computer technology in the 1980’s, trading became safer and more efficient.
Electronic ownership records, maintained by the Canadian Depository for Securities (CDS) and its global
counterparties, replaced paper certificates, bearer securities and paper transfers for most types of
securities.

Since November 1995, Treasury bills and most commercial paper are issued in global certificate form
only. The full amount owned by an investor is registered electronically at CDS, and trades are processed
electronically.

This important innovation, which replaced physical trading of paper security certificates with a “book
based” (electronic) system, shortened the “settlement period” on trades and reduced trading risks. (The
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). Today when an investor buys or sells a money market security, cash
is paid or received on the same day. In other words, the trade date and settlement date are the same.

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Innovation in Securities Trading

The Canadian Depository for Securities Limited (CDS Ltd.) was incorporated on June 9, 1970 in response
to rising back office costs and increased volumes in the capital markets resulting from a vibrant Canadian
economy. It was formed to leverage new technologies and automation to create a centralized
depository service and an electronic clearing and settlement system that could not only handle higher
volumes, but meet future needs.

In 1976, CDS began clearing trades executed on the Montreal Exchange and by the following year, the
Toronto exchange was on board.

CDS’s reputation for reliability and innovation grew over the decade, as did the number of participants.
In 1979, CDS became a participant of The Depository Trust Company (DTC) in New York, a first step
toward meeting the growing need for access to the U.S. market. DTC became a direct CDS participant in
1998, making cross-border clearing and settlement a reality.

In 1981, the first equity securities were deposited in the book-based system. Government of Canada
bonds were added to the system in the late 1980s, followed by the implementation of the Debt Clearing
System for bonds and money market instruments in the early 1990s.

Source: CDS

Securitization, Asset Backed Commercial Paper and the Financial Crisis of 2008

 Asset Backed Commercial Paper (ABCP) is a type of commercial paper issued by a trust or a special
purpose vehicle (commonly called an SPV or SIV). Through a process called “securitization”, the SIV
issues commercial paper and sells it to investors. Cash obtained from the sale of commercial paper
to acquire various financial assets which may include accounts receivable, credit card receivables,
car loans, equipment leases or mortgages.

 The financial assets are held by the SIV and are collateral for the commercial paper.

 The financial assets held in the SIV generate cashflows, through interest and principal
payments, which the SVP uses to repay investors who purchased the commercial paper.

 To reduce default risk for holders of the commercial paper, the SIV is over collateralized:
the value of financial assets held as collateral exceeds the amount of commercial papers
issued. Investors are also protected by bank guarantees obtained by the SIV.

Clearly, the risk level of asset backed commercial paper (ABCP) is influenced by the quality of the
financial assets held by the SIV. If too many of those assets default, investors who own the ABCP
will not receive full payment.

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 CHART 7 – The Securitization Process

CHART 7 – The Securitization Process

 The financial crisis of 2007/2008

Prior to September, 2007, ABCP was a popular investment alternative that many believed to be
almost as safe as government treasury bills and the next best thing to cash. Financial market
history supported that point of view. First developed in the early 1990’s, securitizations and
ABCP had a long track record of providing investors with good returns, combined with low
default risk. Most were rated R-1(high) or AAA by major credit rating agencies.

Securitizations also provided benefits to corporations whose business activities generated large
volumes of accounts receivable. By selling their high quality accounts receivable to an SIV, those
corporations shortened their cash cycle and improved the liquidity of their balance sheets.

Investors began to question the safety of securitizations in late 2007 when ABCP started to
default, sparking the global financial crisis that occurred in 2007/2008. The crisis caused many
investors to believe that securitizations are very risky investments, capable of severely
damaging the financial markets. That conclusion is not correct. The losses investors
experienced on ABCP were caused by defaults in the underlying assets held as collateral by the
SIV, and not by the securitization structure itself.

The assets that caused problems were low quality subprime US mortgages loans that had been
made to home buyers who had poor credit scores , had little or no cash available for a down
payment, and insufficient income to afford their monthly mortgage payments. Those
homeowners frequently defaulted. When the US housing market crashed, property values fell
and lenders who foreclosed on defaulted subprime mortgages were unable to recover the full
amount of the loan.

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 Many subprime mortgages had been securitized and used as collateral to issue ABCP, so
mortgages defaults led to defaults in the ABCP, causing investors, investment dealers and banks
that owned them to suffer huge losses.

The events of 2007/2008 highlighted the importance of evaluating the quality of underlying
assets before investing in ABCP on. Since the financial crisis, securitizations have fallen from 29%
to 9% of total money market securities outstanding in Canada and the number of securitization
issuers fallen from 72 to 26. The issuers that remain active in the market today offer solid
investment opportunities for large, sophisticated investors who have the expertise and
resources to analyze the underlying assets.

CHART 8

Source: DBRS

Lessons Learned from the US Financial Crisis

We learn good lessons from every financial crisis. The loss of confidence in securitizations that
occurred during the crisis was cleansing for the market because it focused investors’ attention on
the need to analyze and understand every security they purchase, and not to rely solely on
published credit ratings. For most individual investors and others who lack specific expertise,
treasury bills are the usually the best alternative for investing short term funds.

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ABCP maker misled investors: OSC
Financial Post

John Greenwood  Sep 28, 2011 – 12:33 PM ET | Last Updated: Sep 29, 2011 11:52 AM ET

Four years after Canada’s 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 investment’s liquidity and, “It is unlikely that any
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.

Wednesday’s 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.

Key Terms

Asset Backed Commercial Paper Liquidity

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Bank Paper Marketable
Bankers' Acceptances Money Market
Bearer Form Negotiable
Bid-Ask Spread OTC Market
Bond Equivalent Yield Par Value
Commercial Paper Securitization
Credit Rating Settlement Date
Credit Spread Special Purpose Vehicle
Default Term to Maturity
Discount Note Trade Date
Face Value Transaction Cost
Fixed Income Securities Transparency
Information Memorandum Treasury Bills
Issuer

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APPENDIX Announcement of Treasury Bill Auction

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Auction Results

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CHARTS AND TABLES FOR USE IN THIS CHAPTER

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