End-User Profile: Northern Exposure
With a big appetite for finance in a small capital market, Ontario’s surefooted treasury must employ creative derivative strategies to get what it needs.
By Simon Boughey
The province of Ontario may be a Goliath in the global capital markets, but it can’t afford to be a lumbering giant. With C$10 billion to raise in the next 12 months and a deficit of C$100
billion, the Ontario Financing Authority will be making regular visits to debt markets inside and outside Canada. Tapping international markets, particularly the U.S., calls for a surefooted use of
derivatives instruments. It is here that Ontario demonstrates a skill that allows it to hedge exposures efficiently and lower funding costs.
Ontario’s status as a fixture in the public capital markets came as the result of a change in government policy. The social democratic government Ontario elected in 1991 was committed to a
large-scale program of public works. While the province is resource rich and did have access to fully funded pension funds, it was not sufficiently endowed to fund the new works program. In April
1991 the government announced the first of its new budget deficits’ which came in at C$9.7 billion; since then has had yearly shortfalls of about C$10 billion.
Canada does not have a capital market big enough to meet Ontario’s voracious needs, so the province has been forced to look south of the border for finance. Since all of Ontario’s bills are in
Canadian dollars, any U.S. dollar finance must be swapped back into fixed or floating Canadian dollars. The province will keep no more than 20 percent of overall debt in floating rate; in practice,
the figure is usually closer to 10 percent.
Swaps are only one piece of the province’s derivatives strategy. The operative word in the strategy is “hedging”; speculative or leveraged transactions are not used. For hedging purposes, the instruments used cover the gamut available: interest rate and currency swaps, bond and FX options, swaptions and FRAs.
Even in derivatives products the Canadian market is woefully underdeveloped compared to the U.S. In swaps the Canadian market is fragile and illiquid. If the province tried to swap a global bond
of $1 billion or more into Canadian dollars in one go, it would risk flooding the market.
Accordingly, the province will often pre-hedge a portion of the bond through the use of spreadlocks, scheduling the swap to occur perhaps six months after the issue has been launched. In this way
the province is able to swap manageable pieces of debt on a staggered basis. “We want to avoid the situation where all the counterparties are waiting for us,” says Mike Manning, director of risk
management for the province.
Under a spreadlock agreement, the chosen counterparty agrees to pay a fixed rate to the province at a future date, at an agreed level above the reference rate. This would be the U.S. Treasury rate
in the case of a dollar-denominated bond. The date will not usually be more than six months in the future. The counterparty hedges the position through the purchase of government bonds and then sells
them upon the date of the swap. At this point the province is able to lock in a rate on the swap.
Even though Ontario is seeking not to disrupt the Canadian markets, its use of spreadlocks, which involve large-scale purchases of Treasuries, have led to accusations from the dealer community
that it is “cranking” the markets. By purchasing spreadlocks at the same time as a bond issue, an issuer could bid up Treasury prices and depress yields, thereby ensuring a more positive climate for
its own paper. In fact, says Gadi Mayman, executive director of capital markets for the province, Ontario is always careful to buy the notes away from when its bonds are being launched.
In tapping non-domestic markets, Ontario is also looking to lower the cost of funding. Its benchmark is rates on comparable domestic issuance. Only one of the eight global bonds it has issued so
far has failed to achieve this goal. Equally, its floating-rate debt after-swap target depends on funding conditions in the indigenous market. Generally, this means it hopes to swap into floating at
a level slightly below the bankers acceptances rate (BAs).
This is more easily said than done. Funding costs in the U.S. dollar market are generally 25 basis point more expensive than in Canada. To recoup this differential, the province must often take a
view on the exchange rate, interest rates or Canadian/U.S. spreads.
A good example of how this works well is the $1 billion 10-year global bond the province issued in July 1995. At the time Canadian/US spreads were 188 basis points, which looked wide to the
provincial treasury’s research department. Though Ontario swapped the proceeds out of U.S. dollars at the time of issue, it left the basis swap untouched. The province was paying fixed-rate U.S.
dollars to investors on the bond issue, and paying Canadian BAs and receiving U.S. Libor on the swap. Sure enough, the spread began to narrow and the province began locking in the swap when it had
tightened below 160 basis points. It continued to lock it in as the spread decreased to 130 basis points, and in the end it had made a aggregate saving of 4552 basis points, says Mayman.
Watching the orbs
Ontario keeps a lookout for reasonable arbitrage opportunities, like the one thrown up by the abnormally low yen interest rates at the end of last year. Although Japanese rates are still low, at the end of 1995 and beginning of 1996 they were around 0 percent at the short end and only 2 percent in mid-term maturities. At the time it was feared that short-term rates would drop below zero. Domestic investors that were rolling over assets that had yielded 5 percent or 6 percent could get only 1 percent or 2 percent.
Faced with these unattractive returns, they began turning to foreign currencies and proved nearly completely indifferent to spreads. Ontario was able to swap a A$600m three-year note sold to
Japanese investors into floating U.S. dollars at very deep sub-Libor rates. After-swap levels like these had not been seen since the halcyon days of the structured note market in 1992 and 1993.
Subsequently, Ontario has completed another two issues, targeted at Japanese retail investors, which were designed to secure low-cost funds. In the last two months it issued a Canadian dollar five-year zero coupon bond which resulted in a funding cost equal to government of Canada bonds, compared to its benchmark funding cost of 25 basis points over.
One constraint on the province has been a law limiting it to holding only 2 percent of overall debt in currencies other than Canadian dollars. A change under consideration would raise this limit to 5 percent, or the equivalent of C$5 billion, thus allowing Ontario a greater degree of flexibility with regard to the timing of currency swaps. If the law is amended, Manning and Mayman also foresee an increased use of currency options to hedge the new FX exposure. To date, the province has chiefly used plain vanilla puts and calls, but recently it has developed the capacity to price knock in/knock out options, says Manning.
On occasion, it uses bond options as a cheaper alternative to outright purchases of securities. For example, if the province predicts a fall in U.S. rates, it may want to receive fixed and pay floating in the swap market. However, it is able to achieve the same economic result by buying U.S. Treasuries and funding the purchase in the repo market. In this case it may buy a call on U.S. Treasuries. Alternatively, it could buy a swaption, conferring on it the right to receive fixed and pay floating at a given strike date.
Swaptions have also come in useful when the province has wished to delay the timing of swaps to eliminate the cost differential between the U.S. and Canadian markets. For example, when it has issued U.S. dollar debt at a time it thought swap spreads would widen, it has delayed executing the swap until spreads have moved the right way. However, the province is not a significant user of swaptions, says Mayman.
With skills developed out of necessity, Ontario’s treasury operation takes cautious advantage of the opportunities presented to it. Mayman and Manning’s conservative approach is designed to make sure the province makes no missteps in its debt management practices.