The removal of limits on foreign investments for Canadian institutions is expected to result in the transformation of Canada's fixed income markets.
More than 40% of Canadian institutional investors say they expect to increase their holdings of U.S. Treasuries and investment-grade corporate bonds in the wake of the elimination of the 30% Foreign Property Rule, according to a new report from Greenwich Associates.
The removal of limits on foreign investments for Canadian institutions will commence a period of transformation in Canada's fixed-income markets as institutional investors add these and other foreign bonds to their asset mixes, domestic dealers build out their cross-border capabilities, and global dealers re-build Canadian businesses.
"While the impact will be smaller in fixed income than in equities, Greenwich Associates latest research does suggest that the removal of the rule will have a meaningful impact on Canadian institutions' relationships with fixed-income dealers," says Greenwich Associates' Toronto-based consultant Lea Hansen. "In all likelihood, after the rule revision, there will be a brief period of rapid evolution as domestic dealers augment or develop their global capabilities — be it independently or through partnerships with non-Canadian firms — and foreign dealers reconstitute their sales capabilities after virtually withdrawing from the Canadian market over the past several years."
These comments are based on the results of Greenwich Associates' 2005 Canadian Fixed Income study and a special study conducted by Greenwich on the impact of the removal of the 30% Foreign Property Rule.
The new Greenwich Report presents the key findings of both studies, including:
• Canadian institutions' plan to increase their holdings of foreign bonds from the current 3% of total assets under management to 5% if the 30% Foreign Property Rule is removed.
• Over the 12-month period ending in March 2005, cash bond trading volume declined 15% while fixed-income assets under management at Canadian institutions increased 17%.
• While the proportion of Canadian institutions trading fixed income electronically was stable year-to-year at about 30%, the proportion of investors planning to start e-trading is on the decline.
• More than 25% of Canadian institutions expect to add to their foreign investments within six months of the proposed elimination of the Foreign Property Rule, and another 30% said they would do so within a year of the change.
A quarter of all Canadian plan sponsors and 45% of plan sponsors with more than $1 billion in assets under management tell Greenwich Associates they intend to increase their allocations to foreign investments if the 30% Foreign Property Rule is removed.
According to the Greenwich study on the removal of the 30% foreign property rule, foreign fixed income currently accounts for only 3% of the total assets under management by Canadian institutions. If and when regulators scrap the 30% rule, institutions expect to increase these holdings to 5% of total assets.
Perhaps even more dramatic than the expected shift in asset allocations is the percentage of Canadian institutions that say they plan to invest in foreign bonds for the first time after the rule revision. Currently, one-in-10 Canadian investment managers invests in foreign bonds, but in the wake of the rule removal, over 20% of Canadian institutions expect to be investing in foreign fixed income.
The new Greenwich research suggests that the move into global and international bonds could happen quickly. Of Canadian institutions that said they plan to increase their allocations to foreign investments, more than 25% expect to do so within six months of the rule change, and another 30% said they would do so within a year. Among institutional fixed-income managers, more than 30% expect to increase their allocations to investments denominated in foreign currencies within six months of the elimination of the rule, and another third expect to do so within 12 months.
U.S. bonds will likely be the biggest beneficiaries of the shift. U.S. Treasuries and investment-grade corporates already are far and away the most popular foreign fixed-income products among Canadian institutions, and more than 40% of Canadian institutions say they expect to increase their use of U.S. Treasuries and high-grade corporates if the change takes effect. Almost 40% say they plan to increase their use of European investment-grade corporate bonds, while more than 30% plan to use more U.S. Agencies and more than a quarter expect to use more European government debt.
While Canadian institutions are preparing for a relatively quick move into foreign fixed income, Woody Canaday cautions that the magnitude of the shift should not be overstated: "As mentioned previously, international equities will provide much of the new foreign exposure taken on by Canadian institutions after the removal of the 30% Foreign Property Rule," he says. "In particular, one potential factor that seems to be mitigating a substantial build-up of foreign fixed-income assets: Canadian pension plan liabilities are in Canadian dollars while foreign bonds are denominated in foreign currencies."
Nevertheless, the introduction or expansion of foreign bond holdings in Canadian institutional portfolios could shake up the country's fixed-income markets for an extended period of time. "The Canadian market is dominated by five domestic dealers," says Lea Hansen. "We can assume that as institutions pick up the pace of their activity in foreign bonds over the next several years, they will look to those dealers with significant expertise in international markets, which in at least some cases will be foreign or global dealers."
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