With your host Hank Cunningham
Harry Koza's Weekly Column
March 30, 2007
Street will welcome Ottawa's debt consolidation with open armsHARRY KOZA
Last week I mentioned the two measures in the new federal budget that were of particular interest to the bond market, but really only had space to elaborate on the first one, the elimination of withholding tax on interest paid to foreigners. The second measure, consolidating the borrowing requirements of some of the Crown corporations into the federal borrowing program, is also worth delving into.
Starting in 2008, Ottawa will do all the borrowing on behalf of the Business Development Bank of Canada, Canada Mortgage and Housing Corp. (CMHC) and Farm Credit Canada. Last year, those three agencies borrowed $5.6-billion in total, and the consolidation will save $90-million a year, including commissions paid to underwriters and the extra spread over Canada government bonds at which agency paper trades. That's a significant saving, though applied to tax cuts it would amount to, I dunno, a whopping 17 cents per taxpayer or so. Mind you, there are still plenty of other Crowns out there, so this could be the start of something meaningful.
Nonetheless, while any government frugality is to be applauded, the real reason behind the move is more fundamental to the bond market. In recent years, as governments have discovered the fiscal benefit of no longer having debt servicing costs as the biggest single spending program in their budgets, they have begun to run surpluses, and actually to pay down existing debt. Suddenly, the veracity of the old trader's truism -- "the bond crop never fails" -- was thrown into doubt.
Back in my bond desk days, I recall some of the guys on the sales desk ranting about the latest federal budget, and complaining that the national debt was still way too big and needed to be paid off. My trading mentor, the late Prince of Darkness, happened to be within ear-shot. Muting the two phones he had been yelling into against his chest, he cautioned the lads, "Be careful what you wish for, guys. If the government ever pays off the national debt, you bozos will be selling shoes for a living," which pretty much ended the indignation.
Anyway, shrinking government borrowing needs have caused occasional liquidity problems with Canada bonds, with shorts being squeezed by high repo rates (repurchase and sale agreements, basically borrowing bonds for a fee in order to make delivery against trades). The Bank of Canada has doggedly been trying to ease these problems, both through special overnight repo auctions -- lending some of its bond hoard to dealers for a small fee -- and by bond switch operations, whereby it buys off-the-run bond issues and issues extra amounts of two, five, 10 and 30-year benchmark issues, making them larger and thus more liquid. This has helped somewhat, but government borrowing requirements continue to decline.
So consolidating the Crown borrowing not only saves money in spread and commissions, but also increases the supply of Canada bonds in the market. In the current fiscal year, this will amount to about $1.5-billion. A third will go into new regular 30-year bonds and a third in new 30-year inflation-linked real-return bonds (or RRBs, pronounced "Ribbies"). There'll be a billion dollars more in two-year issuance, and about a billion less in five years.
In the 2008-09 fiscal year, gross Government of Canada issuance will increase by as much as $10-billion because of the consolidation, which should help increase market liquidity nicely.
Interestingly, some of the other Crowns aren't included in the consolidation.
Export Development Canada, for instance, is not part of the plan, likely because EDC mainly does a lot of structured-note financing, generally at yields lower than Canada bonds. Besides, since EDC has pretty much morphed itself into Bombardier-Nortel Finance Inc. in recent years, the last thing Ottawa wants is to have that dog's breakfast on its balance sheet. Somehow, issuing more federal government debt to make loans to bankrupt U.S. airlines so they can buy Bombardier jets may not be all that appealing to voters -- not outside of Quebec, at least.
The Canada Wheat Board is also not included in the consolidation. That may be because the CWB is going to be toast soon anyway, provided the Harper government has the stones to finally put the old Soviet-style dinosaur out of its misery (one can but hope). The resounding rejection of the CWB monopoly by western barley farmers this week looks like the first nail in the CWB's coffin.
And while CMHC borrowings will be agglomerated, it's still hands off for their Canada mortgage bond (CMB) program. There's around $90-billion in CMBs issued so far, at roughly 12 basis points higher yield than similar term Canada bonds. Ottawa could save a lot of money and create a lot of liquidity in the bond market by taking that borrowing on, too.
Finance Department boffins are still studying the idea, though if they ever implemented it, the Street would plotz. After all, CMBs are cheap financing for the banks, and a nice earner for the dealers. If you ever took that revenue stream away, why, the banks might become so financially etiolated that they might have to merge with each other just to survive! Gee, maybe the banks should be jumping on the consolidation bandwagon.
Sr. Market Analyst,
36 Green Meadow Crescent,
Richmond Hill, Ontario,