Headnote
National Policy 11-203 – Process for Exemptive Relief Applications in Multiple Jurisdictions – exemption from section 2.7(1)(a) of NI 81-102 to permit existing and future funds to enter into an interest rate swap or a credit default swap, or if the transaction is for hedging purposes, currency forwards, with a remaining term to maturity of greater than 3 years; and exemption from section 2.8(1) to permit mutual funds to cover specified derivatives positions with any bonds, debentures, notes, including floating rate notes, and money market fund securities subject to conditions – the relief will enhance returns to investors while still providing adequate safeguards.
Applicable Legislative Provisions
National Instrument 81-102 Mutual Funds, 2.7(1)(a), 2.8(1) and 19.1
November 18, 2010
In the Matter of
the Securities Legislation of Ontario
(the Jurisdiction)
and
In the Matter of
the Process for Exemption Relief Applications in Multiple Jurisdictions
and
In the Matter of
AlphaPro Management Inc.
(the Filer)
and
In the Matter of
Horizons AlphaPro Floating Rate Bond ETF (the ETF)
Background
The principal regulator in the Jurisdiction (the Decision Maker) has received an application from the Filer on behalf of the ETF and such other exchange traded funds (each, a Future ETF and collectively with the ETF, the Funds and individually a Fund) that the Filer, or an affiliate of the Filer may establish in the future, for a decision under the securities legislation of the Jurisdiction (the Legislation) for relief from the following sections of National Instrument 81-102 Mutual Funds (NI 81-102):
- (a) Subsection 2.7(1)(a) of NI 81-102, insofar as it requires a swap or forward contract to have a remaining term to maturity of 3 years or less (or 5 years or less in certain circumstances), to permit the Funds to enter into interest rate swaps, credit default swaps and currency forwards, in all cases with a remaining term to maturity of greater than 3 years; and
(b) Subsection 2.8(1) of NI 81-102, to the extent that cash cover is required in respect of specified derivatives, to permit each of the Funds to cover specified derivative positions with:
(i) evidences of indebtedness, other than cash equivalents, that have a remaining term to maturity of 365 days or less and an "approved credit rating" as that term is defined in NI 81-102 (Fixed Income Securities);
(ii) floating rate evidences of indebtedness (Floating Rate Securities); or
(iii) securities of money market mutual funds (“Money Market Securities”).
(collectively, the Exemption Sought).
- Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):
(a) the Ontario Securities Commission is the principal regulator for this application; and
(b) The Filer has provided notice that subsection 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in each of the other provinces and territories of Canada.
Interpretation
Terms defined in National Instrument 14-101 Definitions, and MI 11-102 have the same meaning if used in this decision, unless otherwise defined.
Representations
This decision is based on the following facts represented by the Filer.
Background
The Filer is a corporation governed by the Canada Business Corporations Act. The Filer or an affiliate of the Filer is or will act as, the trustee and manager of the Funds.
The Funds are, or will be, mutual funds established under the laws of the Province of Ontario.
The investment objectives of the Funds permit the investment of their assets in fixed income securities.
The Funds are, or will be, reporting issuers in one or more of the provinces and territories of Canada. Neither the ETF nor the Filer is in default of any requirements of the securities legislation of any jurisdiction.
Any Fund that is not currently permitted to engage in the use of derivatives will only do so in accordance with Section 2.11 of NI 81-102.
The Funds that are, or will be, permitted to use specified derivatives can use specified derivatives to reduce risk by hedging against losses caused by changes in securities prices, interest rates, exchange rates and/or other risks. The Funds may also use specified derivatives for non-hedging purposes under their investment strategies in order to invest indirectly in securities or financial markets or to gain exposure to other currencies, provided the use of specified derivatives is consistent with the particular Fund’s investment objective. When specified derivatives are used for non-hedging purposes, the Funds are subject to the cash cover requirements of NI 81-102.
In all cases where the Funds may use derivatives, hedging of risks is permitted, including currency risks, whether the currency risk relates to income or equity securities or otherwise.
When specified derivatives are used for non-hedging purposes, the Funds are subject to the cash cover requirements of NI 81-102.
Term of Interest Rate Swaps, Credit Default Swaps and Currency Forwards
Section 2.7(1)(a) of NI 81-102 prohibits mutual funds from entering into swaps or forward contracts with terms to maturity of greater than 3 years, or greater than 5 years if the contract provides the fund with a right to eliminate its exposure within 3 years. The Filer, on behalf of the Funds, seeks the ability to enter into interest rate swaps, credit default swaps and currency forwards without a restriction as to the term of the swap or forward.
Fixed income investments have risks which include (but are not limited to) interest rate risk, credit risk and currency risk. These risks can be controlled or mitigated through the use of over-the-counter (OTC) derivatives. Interest rate risk may be managed by interest rate swaps, credit risk can be managed by credit default swaps and currency risk by currency forwards.
The term of a swap equals the maturity of its exposure, in contrast to other over-the-counter transactions, such as options and certain other types of forwards, where the contract term and maturity of the underlying security are not related. As a result, there is no restriction under NI 81-102, for example, on a forward with an underlying interest having a term of 10 years whereas there is a restriction if the derivative is in the form of a swap.
Credit default swaps have a similar risk profile to their reference entity (such as corporate or sovereign bonds or asset backed securities) or, in the case of an index of credit default swaps (such as CDX), to an average of all the reference entities in the index or, in the case of a basket of reference entities, to an average of all the reference entities in the basket. The term of a credit default swap imparts credit risk similar to that of a bond of the reference entity with the same term. The Funds may not be able to achieve the same sensitivity to credit risk as their respective benchmarks by using credit default swaps with a maximum term of 3 years because the relevant benchmark may have an average term that is longer. It should also be noted that the most liquid terms for single name credit default swaps and/or indices are 5 years and 10 years. There is no term restriction in NI 81-102 when investing directly in the reference entities.
A currency forward used for hedging purposes may or may not have a contract term and maturity that equals the maturity of the underlying interest. For example, if a 10 year bond is denominated in U.S. dollars, under the current provisions of NI 81-102, the term of the currency forward can be at most 5 years whereas the term of the underlying interest is 10 years. Ideally to manage the currency risk, a fund must enter into two consecutive 5-year currency forwards. However, the pricing for the currency forward in respect of the second 5 year period is not known at the time the U.S. dollar bond is purchased but only 5 years hence. Consequently, the inability to enter into a 10 year currency forward transaction indirectly introduces currency risk when a hedged 10 year position was the desired outcome. Accordingly, whenever the term of the bond is longer than 5 years, the current provisions of NI 81-102 may unintentionally expose a fund to currency risk. This constraint has become even more relevant given that there are no longer foreign investment restrictions under the Income Tax Act (Canada) which has resulted in many mutual funds increasing their foreign investment exposure.
It is also not a market practice to have a transaction with a 5-year term (subject to a right to eliminate the exposure within 3 years) as required by NI 81-102 and, as a result, from time to time, this off-market feature may subject a mutual fund to less efficient pricing.
The interest rate swap market, credit default swap market and currency forward markets are very large and liquid.
The interest rate swap market is generally as liquid as government bonds and more liquid than corporate bonds. The Bank for International Settlements reported that the notional amount of interest rate swaps outstanding was U.S. $347 trillion as of December 31, 2009. In Canada, there were over U.S. $3.2 trillion of interest rate swaps outstanding as of December 31, 2009, greater than the sum of all outstanding federal and provincial debt.
Credit default swaps, on average, are highly liquid instruments. Single name credit default swaps have become as liquid and in most cases more liquid than the cash bonds of their reference entities, while credit default swaps on CDX are generally more liquid than corporate or emerging market bonds. The Bank for International Settlements reported that the notional amount of credit default swaps outstanding was U.S. $32.7 trillion as of December 31, 2009. The International Swap and Derivatives Association’s 2009 year-end market survey estimated the notional amount outstanding to be U.S. $30.4 trillion. Using either source, the credit default swap market has surpassed the size of the equity derivatives markets and is one of the fastest growing financial markets.
With respect to foreign exchange, the Bank for International Settlements reported that the notional amount of outright forwards and foreign exchange swaps outstanding was U.S. $23 trillion as at December 31, 2009. Daily trading is many times larger for currencies and currency forwards than for well-known equity exchanges.
As swap and forward contracts are private agreements between two counterparties, a secondary market for the agreements would be a cumbersome process whereby one counterparty would have to find a new counterparty willing to take over its contract at a fair market price, get the original counterparty to approve the new counterparty, and exchange a whole new set of documents. To avoid that process, market participants can unwind their positions in interest rate swaps and currency forwards by simply entering into an opposing swap or forward with an acceptable counterparty at market value. In this way, the original economic position of the initial swap or forward is offset. Parties may also agree to terminate the agreement at a fair market price prior to the maturity date of the agreement.
Credit risk exposure to a counterparty on an interest rate swap transaction or currency forward transaction is generally a small fraction of the underlying notional exposure, equal to the cumulative price change since the inception of the swap or forward. Even that small risk will be mitigated because the counterparty will be required to have an approved credit rating prescribed by Section 2.7(1)(b) of NI 81-102.
Potential credit exposure to a counterparty on a credit default swap on a credit default index is equal to the pro-rated notional exposure to any issuer in the index who has defaulted or, in the case of a single name credit default swap, equal to the full notional exposure. As is the case with interest rate swaps, this exposure is mitigated because the counterparty will be required to have an approved credit rating prescribed by paragraph 2.7(1)(b) of NI 81-102 and exposure to any individual counterparty is limited by subsection 2.7(4) of NI 81-102.
Like interest rate swaps and credit default swaps, credit risk exposure to a counterparty is only a small fraction of the underlying notional exposure of a currency forward.
By permitting the Funds to enter into swaps and forwards beyond 3-year terms, the Funds have better opportunities to increase their returns, due to the fact that they will have a broader selection of investment opportunities, and a greater ability to target exposures that might not otherwise be available in the cash bond markets or could not be achieved as efficiently as in the cash bond markets. Further, the use of swaps and forwards beyond 3-year terms enables the Funds to effect hedging transactions that are more efficient and tailored which should help to mitigate underlying investment risks.
The Filer has or will have, the right to terminate the swap or forward early if a counterparty’s credit rating drops below the approved credit ratings established by NI 81-102 in accordance with the requirements of Subsection 2.7(1)(b) of NI 81 102 and the definition of “approved credit rating” in NI 81-102.
Cash Cover
The purpose of the cash cover requirement in NI 81-102 is to prohibit a mutual fund from leveraging its assets when using certain specified derivatives and to ensure that the mutual fund is in a position to meet its obligations on the settlement date.
This is evident from the definition of “cash cover”, which is defined as certain specific portfolio assets of the mutual fund that have not been allocated for specific purposes and that are available to satisfy all or part of the obligations arising from a position in specified derivatives held by the mutual fund. Currently, the definition of “cash cover” includes six different categories of securities, including certain evidences of indebtedness (cash equivalents and commercial paper) that generally have a remaining term to maturity of 365 days or less and that have an approved credit rating, and/or are issued or guaranteed by an entity with an approved credit rating (collectively, “short-term debt”).
In addition to the securities currently included in the definition of cash cover, the Funds would also like to invest in Fixed Income Securities, Floating Rate Securities and/or Money Market Securities for purposes of satisfying their cash cover requirements.
It is submitted that the proposed use of Fixed Income Securities, Floating Rate Securities and Money Market Securities as cash cover for the Funds should be granted by the securities authorities for the reasons set out below.
With Respect to Fixed Income Securities:
While the money market instruments that are currently permitted as cash cover are highly liquid, these instruments typically generate very low yields relative to longer dated instruments and similar risk alternatives.
Other fixed income instruments with maturities less than 365 days and approved credit ratings are also liquid but provide the potential for higher yields.
The definition of cash cover addresses regulatory concerns of interest rate risk and credit risk by limiting the terms of the instruments and requiring the instruments to have an approved credit rating. It is submitted that by permitting the Funds to use for cash cover purposes Fixed Income Securities with a remaining term to maturity of 365 days or less and an approved credit rating, the regulatory concerns are met, since the term and credit rating will be the same as other instruments currently permitted to be used as cash cover.
With Respect to Floating Rate Securities:
Floating Rate Securities are debt securities issued by the federal or provincial governments, the Crown or other corporations and other entities with floating interest rates that reset periodically, usually every 30 to 90 days.
Although the term to maturity of Floating Rate Securities can be more than 365 days, the Funds propose to limit their investment in Floating Rate Securities used for cash cover purposes to those that have interest rates that reset at least every 185 days.
Allowing the Funds to use Floating Rate Securities for cash cover purposes could increase the rate of return earned by each of the Fund’s investors without reducing the credit quality of the instruments held as cash cover. It is submitted that the frequent interest rate resets mitigate the risk of investing in Floating Rate Securities as cash cover. For the purposes of money market funds under NI 81 102 meeting the 90 days dollar-weighted average term to maturity, the term of a floating rate evidence of indebtedness is the period remaining to the date of the next rate setting. If a Floating Rate Security resets every 185 days, then the interest rate of the Floating Rate Security is about the same as a fixed rate instrument with a term to maturity of 185 days.
Financial instruments that meet the current cash cover requirements have low credit risk. The current cash cover requirements provide that evidences of indebtedness of issuers, other than government agencies, must have approved credit ratings. As a result, if the issuer of Floating Rate Securities is an entity other than a government agency, the Floating Rate Securities used by the Funds for cash cover purposes will have an approved credit rating as required by NI 81-102.
Given the frequent interest rate resets, the nature of the issuer and the adequate liquidity of Floating Rate Securities, the risk profile and the other characteristics of Floating Rate Securities are similar to those of short-term debt, which constitute cash cover under NI 81-102.
With respect to Money Market Securities:
Under NI 81-102, in order to qualify as money market funds, the issuers of Money Market Securities are restricted to investments that are, for the most part, considered to be cash cover.
If the direct investments of the issuers of Money Market Securities would constitute cash cover under NI 81-102 then it is submitted that indirectly holding these investments through an investment in Money Market Securities should also satisfy the cash cover requirements of NI 81-102.
It is therefore submitted that Money Market Securities should constitute cash cover for the Funds for purposes of NI 81-102.
Derivatives Policies and Risk Management
The Filer and JovInvestment Management Inc. (JovInvestment), an affiliate of the Filer, have developed a number of policies and mechanisms to monitor the use of derivatives by the Funds, in order to comply with the rules set out in NI 81-102.
In addition, the Filer and JovInvestment have written control policies and procedures that set out the risk management procedures applicable to derivative trading. These policies and procedures set out specific procedures for the authorization, documentation, reporting, monitoring and review of derivative strategies ensuring that these functions are performed by individuals independent of those who trade. Compliance personnel employed by both the portfolio advisors/sub-advisors and the Filer review the use of derivatives as part of their ongoing supervision of Fund investment practices.
Limits and controls on derivatives trading are part of the Filer’s compliance regime. All derivatives transactions are reviewed by a specially trained team that ensures that the derivative positions of the funds are within the existing control policies and procedures.
The prospectus and annual information form of the Funds discloses the internal controls and risk management processes of the Filer regarding the use of derivatives and, upon renewal, will include disclosure of the nature of the exemptions being sought in respect of the Funds.
Without these exemptions the Funds will not have the flexibility to enhance yield and to manage more effectively their exposure under specified derivatives.
General
The Filer contends that the requested approval is (i) not against the public interest, (ii) is in the best interests of the Funds, and (iii) represents the business judgment of responsible persons uninfluenced by considerations other than the best interests of the Funds.
The Exemption Sought will be in the best interests of the Funds as the Exemption Sought will help to save costs, potentially enhance performance of the Funds or reduce risks and does not leave the Funds exposed to any material incremental risk beyond the risk that the portfolio manager is targeting. The Exemption Sought is, or will be, consistent with the investment objectives and strategies of the respective Funds.
The use of derivatives by investors and portfolio managers has increased substantially during the last 20 to 30 years. The Filer is seeking the Exemption Sought to permit the Funds to engage in strategies consistent and/or familiar with industry practice.
Decision
The Decision Maker is satisfied that the decision meets the test set out in the Legislation for the Decision Maker to make the decision.
The decision of the Decision Maker under the Legislation is that the Exemption Sought is granted provided that:
the Fixed Income Securities have a remaining term to maturity of 365 days or less and have an “approved credit rating” as defined in NI 81-102;
the Floating Rate Securities meet the following requirements:
(a) the floating interest rates of the Floating Rate Securities reset no later than every 185 days;
(b) the Floating Rate Securities are floating rate evidences of indebtedness with the principal amounts of the obligations that will continue to have a market value of approximately par at the time of each change in the rate to be paid to the holders of the evidences of indebtedness;
(c) if the Floating Rate Securities are issued by a person or company other than a government or “permitted supranational agency” as defined in NI 81-102, the Floating Rate Securities must have an “approved credit rating” as defined in NI 81-102;
(d) if the Floating Rate Securities are issued by a government or permitted supranational agency, the Floating Rate Securities have their principal and interest fully and unconditionally guaranteed by:
(i) the government of Canada or the government of a jurisdiction in Canada; or
(ii) the government of the United States of America, the government of one of the states of the United States of America, the government of another sovereign state or a “permitted supranational agency” as defined in NI 81-102, if, in each case, the Floating Rate Securities have an “approved credit rating” as defined in NI 81-102; and
(e) the Floating Rate Securities meet the definition of “conventional floating rate debt instrument” in section 1.1 of NI 81-102; and
- at the time of the next renewal and all subsequent renewals of the prospectus and annual information form the Funds shall:
(a) disclose the nature and terms of this relief in the annual information form of the Fund with a cross reference thereto in the prospectus of any Fund; and
(b) shall include a summary of the nature and terms of this relief in the prospectus of a Fund under the Investment Strategies section or in the introduction to Part B of the prospectus with a cross reference thereto under the Investment Strategies section for such Fund.
“Darren McKall”
Darren McKall
Assistant Manager, Investment Funds Branch
Ontario Securities Commission
SEDAR Project No.: 1639567